Audit Final Study Guide

Identify the special purpose framework used in each of the following situations. 1. A real estate company reports to its partners on the basis used to complete the income tax return. 2. A company has its financial statements prepared on a price-level adjusted basis as required by its lender. 3. An insurance company reports in compliance with the rules of a state insurance commission. 4. A partnership reports on revenues received and expenses paid. What modifications must be made to the standard auditor's report for these situations?

1. Tax basis; 2. Contractual basis; 3. Regulatory basis; 4. Cash basis. The financial statements listed in the introductory paragraph must be titled so they are not confused with financial statements prepared on a GAAP basis. Also, the basis used to prepare the financial statements should be stated, as well as a reference to the note in the financial statements that describes the basis in more detail. In some situations (regulatory basis), a paragraph restricting the use of the financial statements must also be included.

Define Type I

A Type I error is equivalent to incorrectly rejecting a population. In terms of an audit, this means that the sample supports a conclusion that an effective control is not operating effectively or an account is materially misstated when, in fact, it is not materially misstated. In terms of internal control, this risk is referred to as the risk of underreliance or the risk of assessing the control risk too high. This error relates to the efficiency of the audit.

Define Type II

A Type II error is a risk of incorrect acceptance. In terms of an audit, this means that the sample supports a conclusion that an ineffective control is operating effectively or an account is not materially misstated when, in fact, it is materially misstated. In terms of internal control, this risk is referred to as the risk of overreliance or the risk of assessing the control risk too low. This error relates to the effectiveness of the audit.

You have been placed in charge of determining the sample size for an audit of accounts receivable. Your superior would like a confidence level of 99%. How does this affect your determination of sample size? What can you infer about the level of risk of incorrect acceptance that your superior is willing to accept?

A lot of work will be required to achieve a 99% confidence level. This work is reflected in a relatively large sample size. Because confidence levels and the risk of incorrect acceptance are complements, the superior is willing to accept a 1% risk of incorrect acceptance.

What assertion does the following test? Recompute financial information on a sample of sales invoices

Accuracy

What is one advantage of classical variables sampling?

Advantages: 1. When the auditor expects a large number of differences between book and audited values, classical variables sampling will normally result in a smaller sample size than monetary-unit sampling. 2. Classical variables sampling techniques are effective for both overstatements and understatements. No special evaluation considerations are necessary if the sample data include both types of misstatements. 3. The selection of zero balances generally does not require special sample design considerations because the sampling unit will be not an individual dollar, but rather an account, a transaction, or a line item.

Describe two advantages of monetary-unit sampling (MUS).

Advantages: 1. When the auditor expects no misstatements, MUS sample size can be computed and usually results in a smaller sample size than classical variables sampling. 2. The calculation of the sample size and the evaluation of the sample results are not based on the variation between items in the population. 3. When applied using a probability-proportional-to-size sample selection procedure, MUS automatically results in a stratified sample because sampled items are selected in proportion to their dollar amounts. In effect, larger dollar items have a higher probability of being selected.

What assertion does the following test? Review of cash receipts journal for unusual items

Classification

What assertion does the following test? Observe the endorsement of checks

Completeness

What assertion does the following test? Compare the dates on the sales invoices with the dates of the relevant shipping documents

Cutoff

Assume you are working on a 12/31 year-end audit. It is now March 31st and the 12/31 accounts receivable aging shows a large receivable that was outstanding on 12/31 for 120 days. Further, the entity's receivables are typically collected in less than 45 days. You anticipate that the entity's allowance for doubtful account should be increased and inform the entity about your disposition. Management disagrees. Is there an alternative substantive procedure that you could perform that would provide convincing evidence that this balance is collectible? If so, explain.

Determining that the balance was paid after year-end would provide convincing evidence that the accounts receivable balance was in fact collectible as of 12/31.

Indicate which of the following audit procedures, used as tests of controls, do not involve audit sampling.

Does not involve sampling 1. Observing and evaluating segregation of duties 3. Reviewing entity's procedures for accounting for the numerical sequence of shipping documents. 6. Comparing the average days outstanding in accounts receivable with industry averages. Involves sampling 2. Testing of whether sales invoices are supported by authorized customer orders and shipping documents. 4. Examining sales orders for proper credit approval. 5. Recomputing the information on copies of sales invoices.

You are auditing the allowance for doubtful accounts (ADA) and perform the analytical procedures shown below. Assume that no significant changes have occurred during the year in either the entity's credit policies or customer base. What concerns, if any, about adjusting the ADA should the auditor have based on the information shown below?

It appears that the industry has remained relatively stable in both its ADA/AR and Days AR Outstanding, while the entity has significantly increased in the Days AR Outstanding in 2013. Assuming no significant changes in customer base or credit policies, the entity should increase the allowance in 2013, since Days AR Outstanding has increased.

Summarize the concept behind monetary-unit sampling (MUS). How does MUS use attribute-sampling theory?

MUS uses attribute-sampling theory to estimate the percentage of monetary units in a population that might be misstated and then multiplies this percentage by an estimate of the degree to which the dollars are misstated.

We know from cost accounting that there are three components that make up the standard costs for inventory. Explain how an auditor could test each of these components for a company that manufactures pillows.

Materials - The auditor could obtain a list of materials needed to manufacturer a certain type of pillow and compare that list with the standard cost card. The prices can then be traced to the vendors' invoices to verify that the proper cost is being applied for materials. Labor - Historical data regarding the amount of labor necessary to make a pillow can be obtained. It can then be compared to the amount of authorized wages. Overhead - The allocation of overhead should be reviewed by the auditor for reasonableness. The auditor should also verify that the amounts included in overhead are appropriate.

Define sampling risk

Sampling risk refers to the possibility that the sample drawn is not representative of the population and that, as a result, the auditor will reach an incorrect conclusion about the reliability of a control, an account balance, or class of transactions based on the sample.

How has the advancement in technology led to the creation of the Trust Services?

The advancement in technology has increased concerns such as maintaining reliable, effective systems for businesses, and confidentiality of information for individuals. To respond to these issues, the AICPA and CICA developed the Trust Services. Due to their integrity and objectivity, CPAs are well-suited to address the issues associated with advancing technology.

What inherent risk factors should an auditor consider when auditing the revenue process of a computer manufacturer?

The auditor will want to consider industry-related factors such as the high competition of the industry, as well as the high rate of technological change. If the company is unable to keep up with the competition, it may try to cover the poor performance with inflated sales. The auditor will also want to consider any long-term contracts the manufacturer may be in the process of completing. The timing of the revenue recognition for a large project could have a significant impact on the financial statements. Accounts that may be difficult to audit, such as Allowance for Uncollectible Accounts, and any prior misstatements in the financials may also increase the inherent risk assessment of the auditor.

For a particular audit, the sample size for testing controls over the revenue cycle is relatively large. What can you infer about the tolerable deviation rate?

The tolerable deviation rate, on the other hand, is inversely related to the sample size. Therefore, the tolerable deviation rate must have been relatively low.

Describe the two types of confirmations and indicate which one is more reliable and why.

The two types of confirmations are positive and negative. A positive confirmation requests that customers indicate whether they agree with the amount stated in the confirmation. A response is required either way. A negative confirmation only requires a response if there is disagreement. The positive confirmation is more reliable, because there is always a response. If a negative confirmation is not returned to the auditor, he/she must assume that there is no problem with the amount, which may or may not be true. There is less assurance provided about the correctness of the amounts from a negative confirmation.

Explain how revenue recognition is important to the audit of the revenue process.

The understanding of when it is appropriate to recognize revenue is very important in testing the occurrence and completeness assertions. Further, the revenue area is subject to high fraud risk. Numerous significant fraudulent financial reporting incidents involving improper revenue recognition schemes have been reported. Accordingly, the auditor must possess knowledge about the entity's revenue recognition process and plan the audit accordingly.

In nonstatistical sampling, describe the two methods auditors use to project sample results to the population. How does an auditor determine which method to use

With ratio projection, the auditor applies the misstatement ratio observed in the sample to the population. Ratio projection should be used if the auditor expects the amount of misstatement to relate closely to the size of the item. Difference projection projects the average misstatement of each item in the sample to all items in the population. Difference projection should be used if the auditor expects the misstatements to be relatively constant for all items in the population.

Internal auditors fall into two primary categories―assurance services and consulting services. Briefly explain these two categories in relation to internal auditors.

a. Assurance services involve the internal auditor's objective assessment of evidence to provide an independent opinion or conclusions regarding a process, system, or other subject matter. The nature and scope of the assurance engagement are determined by the internal auditor. b. Consulting services are advisory in nature, and are generally performed at the specific request of an entity. The nature and scope of the consulting engagement are subject to agreement with the entity.

From the list below, select the procedures that an auditor would use to test for contingent liabilities.

a. Inquire of SEC officials regarding reported violations by the entity that create claims. b. Read the entity's contracts, loan agreements, leases, and other documents. c. Read the entity's minutes of meetings of shareholders, directors, and committees. d. Request a representation letter from all the entity's employees. e. Read the legal briefs of all suits filed against the entity's competitors. f. Request the entity's management to prepare a letter of inquiry to the entity's attorney regarding pending litigation against the entity. Audit procedures 'b, c, and f' are typically used by auditors to test for contingent liabilities.

To bridge the gap between a changing business environment and the guidance that was then available, the IIA developed a Professional Practices Framework. This framework consists of two broad categories of guidance. List these categories of guidance and what they include.

a. Mandatory guidance (definition of internal auditing, code of ethics, and standards). b. Strongly recommended guidance (position papers, practice advisories, and practice guides).

For each of the following situations, indicate what type of audit report is most appropriate. a. The auditor lacks independence in fact, but not necessarily in appearance. b. There is a scope limitation and it is material but the overall financial statements are still presented fairly. c. The uncorrected misstatements are immaterial. d. There is a departure from GAAP and it is pervasively material.

a. The auditor lacks independence in fact, but not necessarily in appearance. b. There is a scope limitation and it is material but the overall financial statements are still presented fairly. c. The uncorrected misstatements are immaterial. d. There is a departure from GAAP and it is pervasively material. a. Disclaimer; b. Qualified; c. Unqualified/Unmodified; d. Adverse

3. MUS logical unit

the account or transaction that contains the selected dollar

4. MUS misstatement

the difference between monetary amounts in the entity's records and amounts supported by audit evidence

1. MUS Upper misstatement limit

the total of the projected misstatement plus the allowance for sampling risk

Whenever a statistical method is used, a decision rule determines whether the population is acceptable. The decision rule for monetary-unit sampling is "Accept the conclusion that the book value is not misstated by a material amount if ________________________."

the upper misstatement limit is less than or equal to the tolerable misstatement

What information is typically requested in a legal letter to an entity's attorney?

• A list and evaluation of any pending or threatened litigation to which the attorney has devoted substantial attention. • A list of unasserted claims and assessments considered by management to be probable of assertion and reasonably possible of unfavorable outcome. • A description and evaluation of the outcome of each pending or threatened litigation. • Additions to the list provided by management or a statement that the list is complete. • Comment on unasserted claims where his or her views differ from management's evaluation.

List five things an auditor should do during the observation of the physical count of inventory.

• Ensure that no production is scheduled during the count. • Ensure that there is no movement of goods during the inventory count. • Make sure the count teams are following the inventory count instructions. • Ensure that inventory tags are issued sequentially to individual departments . • Perform test counts and record a sample of counts in the working papers. • Obtain tag control information for testing the entity's inventory compilation . • Obtain cutoff information. • Observe the condition of obsolete, slow-moving, or carried in excess inventories. • Inquire about goods held on consignment.

While auditing other business processes, an auditor may identify information about contingent liabilities. What specific audit procedures relating to other business processes could uncover these liabilities?

• Reading the minutes of the board of directors and committees of the board and stockholders. • Reviewing contracts, loan agreements, leases, and correspondence from government agencies. • Reviewing income tax liability, tax returns, and IRS agents' reports. • Confirming or otherwise documenting guarantees and letters of credit obtained from financial institutions or other lending agencies. • Inspecting other documents for possible guarantees.

State the two primary purposes of the management letter of representation.

• To corroborate oral representations made to the auditor and to document the continued appropriateness of such representations. • To reduce the possibility of misunderstanding concerning management's responses to the auditor's inquiries.

Is the following a test of controls, substantive analytical procedure, test of details of transactions or test of details of account balances? Select a sample of customer receivables and send positive confirmations to each customer.

1) Tests of details of account balances

What is one disadvantage of classical variables sampling?

1. Difference estimation does not work well with "clean" populations or populations with little to no error, which is common in auditing. The reason is that difference estimation requires information on differences to determine sample size and evaluate results. 2. In order to determine the sample size, the auditor must estimate the standard deviation of the audited value or differences. 3. If few misstatements are detected in the sample data, the true variance tends to be underestimated and the resulting projection of the misstatements to the population is likely to not be reliable.

According to the Association of Certified Fraud Examiners, there are eight common methods for committing financial statement fraud. List 4 of the 8 methods.

1. Early revenue recognition 2. Holding the books open past the accounting period 3. Fictitious sales 4. Failure to record returns 5. Fraud in the percentage of completion method 6. Related party transactions 7. Overstating receivables and inventory 8. Liability and expense omissions

For each of the following, state whether it is a test of details of account balances or a test of details of disclosures. Then note for which assertion the test provides evidence. 1. Inspect loan agreements under which an entity's inventories are pledged. 2. Review inventory compilation for proper classification among raw materials, work in process, and finished goods. 3. Observe the count of physical inventory. 4. Trace test counts and tag control information to the inventory compilation. 5. Inquire of management about issues related to LIFO liquidations. 6. Review book-to-physical adjustments for possible misstatements.

1. Inspect loan agreements under which an entity's inventories are pledged. 2. Review inventory compilation for proper classification among raw materials, work in process, and finished goods. 3. Observe the count of physical inventory. 4. Trace test counts and tag control information to the inventory compilation. 5. Inquire of management about issues related to LIFO liquidations. 6. Review book-to-physical adjustments for possible misstatements. Solution: 1. Disclosures - Occurrence, Rights and obligations 2. Disclosures - Classification and understandability 3. Account balances - Existence 4. Account balances - Completeness, Valuation and allocation 5. Disclosures - Accuracy, Valuation 6. Account balances - Valuation and allocation

Identify the types of audit evidence that are tested using audit sampling techniques

1. Inspection of tangible assets 2. Inspection of records or documents 3. Reperformance 4. Confirmation

For an auditor to examine management's assertions about the effectiveness of internal control in an attestation engagement, three conditions are necessary. Briefly explain them.

1. Management of the entity accepts responsibility for the effectiveness of the entity's internal control. 2. The responsible party evaluates the effectiveness of the entity's internal control using suitable criteria. 3. Sufficient appropriate evidence exists or could be developed to support the responsible party's evaluation.

Match the Trust Services Principle with its proper definition.

1. Online Privacy: Personal information is collected, used, retained, and disclosed in conformity with the commitments in the entity's privacy notice and with criteria set forth in Generally Accepted Privacy Principles issued by the AICPA/CICA. 1 2. Processing integrity: System processing is complete, accurate, timely, and authorized. 2 3. Availability: The system is available for operation and use as committed or agreed. 3 4. Confidentiality: Information designated as private is protected as committed or agreed 4 5. Security: The system is protected against unauthorized access (both physical and logical). 5

Identify four of the seven primary functions in the revenue cycle and describe each function.

1. Order Entry: Acceptance of customer orders for goods and services into the system in accordance with management criteria 2. Credit Authorization: Appropriate approval of customer order for creditworthiness 3. Shipping: Shipping of goods that have been authorized 4. Billing: Issuance of sales invoices to customers for goods shipped or services provided: also, processing of billing adjustments for allowances, discounts, and returns. 5. Credit Receipts: Processing of the receipt of cash from customers 6. Accounts Receivable: Recording of all sales invoices, collections, credit memoranda in individual customer accounts. 7. General Ledger: Proper accumulation, classification and summarization of revenues, collections, and receivables in the accounts.

Match the attestation standard with the generally accepted auditing standard that is most similar in nature.

1. The practitioner must have adequate technical training and proficiency in the attest function. The auditor must have adequate technical training and proficiency to perform the audit. 1 2. The practitioner must exercise due professional care in the planning and performance of the engagement. The auditor must exercise due professional care in the performance of the audit and the preparation of the report. 2 3. The practitioner must state all of the practitioner's significant reservations about the engagement, the subject matter and, if applicable, the assertion related thereto in the report. The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that an opinion cannot be expressed, in the auditor's report. 3 4. The practitioner must adequately plan the work and must properly supervise any assistants. The auditor must adequately plan the work and must properly supervise any assistants. 4 5. The practitioner must state the practitioner's conclusion about the subject matter or the assertion in relation to the criteria against which the subject matter was evaluated in the report. The auditor must state in the auditor's report whether the financial statements are presented in accordance with generally accepted accounting principles (GAAP). 5

Describe two disadvantages of monetary-unit sampling (MUS).

1. The selection of zero or negative balances generally requires special design consideration. 2. If the auditor detects items that are in error by more than 100 percent, special adjustments will be necessary when calculating sample results. 3. When more than one or two misstatements are detected using a MUS approach, the sample results calculations may overstate the allowance for sampling risk.

Match each factor of sample size to (1) its relationship to sample size (A-Direct or B-Inverse) and (2) the appropriate effect on the sample size if the factor increases (C-Increase or D-Decrease).

1. Tolerable misstatement (Inverse relationship with sample size, if tolerable misstatement increases sample size decreases) 2. Population size (Direct relationship with sample size, if population size increases sample size increases) 3. Desired confidence level (Direct relationship with samples size, if desired confidence level increases sample size increases) 4. Expected misstatement (Direct relationship with sample size, if expected misstatement increases then sample size increases)

Identify whether the following tests are tests of controls, substantive analytical procedures, tests of details of transactions, or tests of details of account balances: Examine monthly bank reconciliations for the internal auditors' initials indicating internal verification and review of the reconciliation.

2) Tests of controls

Identify whether the following tests are tests of controls, substantive analytical procedures, tests of details of transactions, or tests of details of account balances: Select a sample of entries in the sales journal and trace each to the shipping documents.

3) Tests of details of transactions

Identify whether the following tests are tests of controls, substantive analytical procedures, tests of details of transactions, or tests of details of account balances: Compute receivable turnover and compare with previous years.

4) Substantive analytical procedures

Identify whether the following tests are tests of controls, substantive analytical procedures, tests of details of transactions, or tests of details of account balances: For a sample of new customers, determine whether credit approval was properly administered and documented.

5) Tests of controls

Identify whether the following tests are tests of controls, substantive analytical procedures, tests of details of transactions, or tests of details of account balances: Compare the dates on a sample of sales invoices with the dates of shipment and the dates the transactions were recorded in the sales journal.

6) Tests of details of transactions

What is the difference between a contingent liability and a commitment?

A contingent liability is an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved by some future event. A commitment is an agreement made by the entity to a set of fixed conditions. The conditions in a commitment are specified in advance.

Define the term "contingent liability" and discuss the criteria used to classify these events or conditions. Provide some examples of contingent liabilities.

A contingent liability is defined as an existing condition, situation, or set of circumstances involving uncertainty as the possible loss to an entity that will ultimately be resolved when some future event occurs or fails to occur. FASB ASC Topic 450, "Contingencies," states that when a contingent liability exists, the likelihood that the future event will result in a loss or impairment of an asset or the incurrence of a liability can be classified into three categories: 1. Probable. The future event is likely to occur. If the event is probable and the amount of the loss can be reasonably estimated, the loss is accrued by a charge to income. 2. Reasonably possible. The chance of the future event occurring is more than remote but less than likely. When the outcome of the event is judged to be reasonably possible or the amount cannot be estimated, a disclosure of the contingency is made in the footnotes to the financial statements. 3. Remote. The chance of the future event occurring is slight. In general, loss contingencies that are judged to be remote are not disclosed in the footnotes. Examples of contingent liabilities include: pending or threatened litigation, actual or possible claims and assessments, income tax disputes, product warranties or defects, guarantees of obligations to others, and agreements to repurchase receivables that have been sold.

Why must an auditor use sampling? What tradeoffs occur when an auditor uses sampling?

An auditor must use sampling because to examine every accounting record and all the supporting documentation would take too much time and money. An audit of a large company without sampling would not be possible. As a result of sampling, the auditor can only provide a reasonable, not an absolute, assurance that the financial statements are fairly presented. Further, the market would not pay for the minor incremental assurance that came from examining all transactions and records.

What is an unasserted claim and why would an attorney and/or entity be reluctant to disclose an unasserted claim in the financial statements? (IMPORTANT: SOLUTION TO FOLLOW: Do You UNDERSTAND THIS? READ THIS CHAPTER THOROUGHLY TO UNDERSTAND:)

An unasserted claim is one in which the injured party or potential claimant has not yet notified the entity of a possible claim. The attorney may be reluctant to provide information on such claims due to client-attorney privilege. Also, both the entity and the attorney may be concerned that disclosing the unasserted claims could lead to the claims actually occurring.

An agreed-upon procedures engagement is significantly more limited in scope than an examination. An accountant may perform an agreed-upon procedures attestation engagement for prospective financial statements provided that attestation standards are complied with and ten criteria are met. Identify five of the ten criteria below.

Answer should include 5 of the following: Solution: 1. The practitioner is independent. 2. The practitioner and the specified users agree upon the procedures performed or to be performed. 3. The specified users take responsibility for the sufficiency of the agreed-upon procedures for their purposes. 4. The prospective financial statements include a summary of significant assumptions. 5. The prospective financial statements to which the procedures are to be applied are subject to reasonably consistent evaluation against criteria that are suitable and available to the specified parties. 6. Criteria to be used in determining findings are agreed upon between the practitioner and the specified users. 7. The procedures to be applied to the prospective financial statements are expected to result in reasonably consistent findings using the criteria. 8. Relevant evidence is expected to exist to provide a reasonable basis for the practitioner's report. 9. The practitioner and the specified users agree on materiality limits for reporting purposes, where applicable. 10. Use of the report is restricted to the parties who have agreed with the practitioner on the procedures to be performed.

Discuss the steps used by an auditor to evaluate an entity's ability to continue as a going concern.

Auditing standards indicate that the auditor has a responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time (defined as one year beyond the date of the financial statements being audited). The auditor should follow three overall steps in making the going concern evaluation: Step 1. Consider whether the results of audit procedures performed during the planning, performance, and completion of the audit indicate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time (one year). Step 2. If there is substantial doubt, the auditor should obtain information about management's plan to mitigate the going concern problem and assess the likelihood that such plans can be implemented. Step 3. If the auditor concludes, after evaluating management's plans, that there is substantial doubt about the ability of the entity to continue as a going concern, he or she should consider the adequacy of the disclosures about the entity's ability to continue and include an explanatory paragraph in the audit report. Auditing standards identify four major categories of conditions or events that are used to identify and assess going concern problems: negative financial trends, other financial difficulties, internal problems, and external matters

What assertion does the following test? Test a sample of cash receipts transactions for proper cash discounts

Authorization

The XYZ Company billing department has decided to assign one employee to each of its customers. This employee will be responsible for granting credit to the entity and then handling the billing. XYZ believes this will result in better customer service, because the entity will only have to deal with one person and that one person will be very familiar with the credit terms. As an auditor, would you agree with XYZ's decision?

From an audit perspective, the policy is risky. By not segregating the duties of granting credit and billing, sales can easily be made to customers who are not creditworthy, especially if the XYZ employee is in any way compensated for the number of sales made. Even if there is no compensation, the XYZ employee may give credit to a friend or family member who wouldn't otherwise qualify. All this could lead to a misstatement in Accounts Receivable.

Pretty People Incorporated, is the defendant in a pending discrimination lawsuit. What information about the lawsuit would you, as an auditor, need to know to decide whether to disclose the litigation in the financial statements?

If a negative outcome of the lawsuit is probable and the amount of the contingency can be estimated, the amount will have to be charged to income and appear as a liability in the financial statements. If the event has a reasonably possible chance of having a negative outcome or the amount cannot be estimated, the contingency should be disclosed in the footnotes of the financial statements. In general, loss contingencies that are judged to be remote are neither accrued in the financial statements nor disclosed in the footnotes.

As with most professionals, internal auditors must follow guidelines promoting ethical conduct. The IIA Code of Ethics is important for internal auditors because the reliability of their work depends on a reputation for a high level of personal integrity. The Code of Ethics consists of four main principles of ethical conduct and some associated rules that underpin the expected conduct of IIA members. List the four main principles of the Code of Ethics and explain each.

Integrity-The integrity of internal auditors establishes trust and thus provides the basis for reliance on their judgment. Objectivity-Internal auditors exhibit the highest level of professional objectivity in gathering, evaluating, and communicating information about the activity or process being examined. Internal auditors make a balanced assessment of all the relevant circumstances and are not unduly influenced by their own interests or by others in forming judgments. Confidentiality-Internal auditors respect the value and ownership of information they receive and do not disclose information without appropriate authority unless there is a legal or professional obligation to do so. Competency-Internal auditors apply the knowledge, skills, and experience needed in the performance of internal auditing services.

In your own words, describe how the Institute of Internal Auditors (IIA) defines internal auditing?

Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

Chapter 13- 71: Below is information relating to the inventory management of Quick Sell. Using analytical procedures, identify any concerns you have about misstatements in the financial statements.

Inventory has significantly increased, especially when compared to the industry average. At the same time, inventory turnover is decreasing and is significantly below the industry average in 2013. The auditor should be concerned about obsolescent or excess inventory and should do additional testing to ensure the inventory is being valued properly by the entity

Explain the importance of observing physical inventory during an audit.

Inventory is typically a large account on the financial statements, especially for manufacturing and retail companies. Examining physical inventory primarily provides evidence that the inventory does exist, but it can also provide evidence for the rights and obligations and valuation assertions. It is also a generally accepted auditing procedure.

State the six functions that make up the inventory management process. For each function, identify the related documents and/or records that would be used by a manufacturing company.

Inventory management function - The inventory management function maintains inventory at appropriate levels. It is responsible for producing the production schedule and issuing purchases requisitions. Raw materials stores function - This function would typically control the issuance of raw materials and therefore handle the materials requisition forms. Manufacturing function - The manufacturing function produces the product and therefore creates the production data information. This information is then used to update the perpetual inventory records (which is used by the general ledger function) and as input for the cost accumulation and variance reports (used by the cost accounting function). Finished goods stores function - The finished goods function uses the shipping order forwarded from the revenue process to ship goods to the customers. Cost accounting function - The cost accounting function ensures that costs are properly attached to inventory. It reviews the cost accumulation and variance reports to accomplish this. General ledger function - The general ledger function maintains the records for the inventory management process. Information from the inventory master file and inventory status report is used to reconcile the perpetual inventory records to the general ledger inventory accounts.

Your uncle Bob, a CPA, has recently started auditing and he wants your advice on some tests of sales transactions he is conducting. Bob selected a haphazard sample of 15 sales with a total book value of $75,000. In his sample, he found a total of $500 in net overstatement errors. The total sales balance per book is $10,000,000. Overall materiality for the engagement is $300,000. Tolerable misstatement for sales is $70,000. If the sample results indicate that Bob's best estimate of total misstatement in sales is $35,000, can Bob safely conclude that no additional work is needed in this area? Include in your answer a clear discussion of how sample results are compared to tolerable misstatement.

No, Bob cannot safely conclude that no additional work is needed. Bob has not considered sampling risk. His best estimate is a projected misstatement to the population. He has only sampled 15 transactions that amounted to less than 1% of the balance. Because this is a relatively small sample, the risk that the sample is not representative of the population is significant. If the true misstatement rate in the remainder of the population is higher, total misstatement could easily exceed tolerable misstatement. The approach that should be taken is to project the misstatement (that is, calculate the best estimate of total misstatement in the population) and incorporate an amount in consideration of sampling risk. There is an inverse relationship between sample size and sampling risk. Without statistical methods, judgments about sampling risk are difficult to make. Thus, sampling risk must be considered.

Define "nonsampling risk."

Nonsampling risk is the risk of auditor error and arises from the possibility that the auditor may sample the wrong population to test an assertion, fail to detect a misstatement when applying an audit procedure, or misinterpret an audit result. The uncertainty related to nonsampling risk can be controlled by adequate training, proper planning, and effective supervision.

What assertion does the following test? Test a sample of sales invoices for the presence of authorized customer order and shipping document

Occurrence

The audit of inventory is often the most involved aspect of an audit. Describe at least three inherent risk factors that affect the audit of inventory.

One inherent risk concerns the valuation of inventory. A company in a competitive or highly technological industry has the risk of having inventory that should be properly valued at lower-of-market or that is obsolete. These valuation issues can easily lead to material misstatements in the financial statements. There is also the risk of defalcation of inventory, especially in an industry where the inventory is small and high-valued. Proper controls should be in place to prevent misappropriation of assets. A third inherent risk is the number of estimations involved in valuing inventory. These estimates can lead to disagreements with management.

The fieldwork for the December 31, 2013 audit of Pumpkin Corporation ended on March 13, 2014. The financial statements and auditor's report were issued and mailed to stockholders on March 23, 2014. In each of the situations below, select from the list at the end of the problem the appropriate action to be taken by the auditor. Assume all situations are material. Situations: 1. On April 5, 2014, you discovered that on February 16, 2014, a flood destroyed the entire uninsured inventory in one of Pumpkin's warehouses. 2. On February 17, 2014, you discovered that on February 16, 2014, a flood destroyed the entire uninsured inventory in one of Pumpkin's warehouses. 3. On February 17, 2014, you discovered that on November 30, 2013, a flood destroyed the entire uninsured inventory in one of Pumpkin's warehouses. 4. On April 5, 2014, you discovered that on March 30, 2014, a fire destroyed one of Pumpkin's 10 plants. 5. On April 7, 2014, you discovered that a debtor of Pumpkin went bankrupt on January 6, 2014. 6. On January 16, 2014, a lawsuit was filed against Pumpkin for a patent infringement action that allegedly took place in early 2001. In the opinion of Pumpkin's attorneys, there is a reasonable (but not probable) danger of a significant loss to Pumpkin. 7. On February 19, 2014, Pumpkin settled a lawsuit out of court that had originated in 2000 and is currently listed as a contingent liability.

Situations: 1. On April 5, 2014, you discovered that on February 16, 2014, a flood destroyed the entire uninsured inventory in one of Pumpkin's warehouses. 2. On February 17, 2014, you discovered that on February 16, 2014, a flood destroyed the entire uninsured inventory in one of Pumpkin's warehouses. 3. On February 17, 2014, you discovered that on November 30, 2013, a flood destroyed the entire uninsured inventory in one of Pumpkin's warehouses. 4. On April 5, 2014, you discovered that on March 30, 2014, a fire destroyed one of Pumpkin's 10 plants. 5. On April 7, 2014, you discovered that a debtor of Pumpkin went bankrupt on January 6, 2014. 6. On January 16, 2014, a lawsuit was filed against Pumpkin for a patent infringement action that allegedly took place in early 2001. In the opinion of Pumpkin's attorneys, there is a reasonable (but not probable) danger of a significant loss to Pumpkin. 7. On February 19, 2014, Pumpkin settled a lawsuit out of court that had originated in 2000 and is currently listed as a contingent liability. Possible Actions: a. Adjust the December 31, 2013 financial statements. b. Disclose the information in a footnote in the December 31, 2013 financial statements. c. Request the entity revise and reissue the December 31, 2013 financial statements. The revision should involve an adjustment to the December 31, 2013 financial statements. d. Request the entity revise and reissue the December 31, 2013 financial statements. The revision should involve the addition of a footnote, but no adjustment, to the December 31, 2013 financial statements. e. No action is required. 1. d, 2. b, 3. a, 4. e, 5. c, 6. b, 7. a

Your manager, Sally, believes that nonstatistical sampling is the best method to use on the audit of YaYa Corporation. You, however, believe that statistical sampling is by far the better method. In addition, you have a great deal of training in the proper use of sampling techniques. Prepare an argument to convince Sally why statistical sampling should be used.

Statistical sampling permits the auditor to use the most efficient sample size and to quantify the sampling risk for the purpose of reaching a statistical conclusion about the population. The major advantages of statistical sampling versus nonstatistical sampling are that it helps the auditor (1) design an efficient sample, (2) measure the sufficiency of evidence obtained, and (3) quantify sampling risk. Disadvantages include the additional costs of (1) training auditors in the proper use of sampling techniques, (2) designing and conducting the sampling application, and (3) lack of consistent application across audit teams due to the complexity of the underlying concepts. Fortunately, this audit includes an auditor with training in statistical sampling, which will reduce these costs. Nonstatistical sampling may result in testing that is not as effective as statistical sampling due to a lack of knowledge of statistical principles and theory.

Listed below are six assertions regarding the financial presentations made in the revenue process. For each, give an example of how an auditor could use one of the types of documents contained in the revenue process to test the assertion. Occurrence Completeness Authorization Accuracy Cutoff Classification

Student Answers will vary, but here are some examples: Occurrence-The shipping document provides important evidence regarding the occurrence assertion. Because sales are not recorded until the product has been shipped, all recorded sales should have a valid shipping document that documents the sale. The auditor can use these documents to test whether the sales did occur. Completeness-The auditor can use the entity's sales invoices and sales journal to test for completeness. In this case, the auditor will trace the sales invoice to the sales journal. This will provide assurance that all invoices have been recorded as revenue. Additionally, the auditor should select shipments from the shipping records and trace them to sales invoices to ensure that all items shipped have been invoiced. Authorization-One example of a document used to test authorization is the write-off authorization form. This form authorizes the write-off of an uncollectible account. The auditor can determine that all written-off uncollectible accounts have been properly authorized by reviewing these documents. Accuracy-To ensure that Accounts Receivable is recorded at its proper net amount, the auditor will need to consider the Allowance for Uncollectible Accounts. The credit approval form can aid in this consideration, by giving the auditor an idea of the level at which credit is granted to determine the anticipated overall creditworthiness of the entity's customers. If the company has a loose credit policy, the allowance account will need to be larger than it would if the company had a tighter credit policy. Cutoff-The Open-Order Report can be helpful in testing for cutoff. The auditor could obtain this report for year-end and test that the orders listed as open have not been recorded as revenue. Classification-The Sales Journal is used to test for proper classification through an auditor's review of the journal. The journal provides details about each of the transactions made and to which accounts the transactions were recorded and posted.

When auditing accounts payable using classical variables sampling, Sue finds evidence indicating that the account may be materially misstated. What are Sue's options?

Sue can (1) increase the sample size, (2) perform additional substantive procedures, (3) require adjustment of the account by the auditee, or (4) issue a qualified or adverse opinion if management refuses to adjust the account.

Before performing sampling procedures in an audit of controls, Sue set the tolerable deviation rate at 4.0%. After the procedures, she computes a computed upper deviation rate of 5.4%. What can Sue conclude about the entity's controls?

Sue must conclude that the controls are not operating at an acceptable level, given that the computed upper deviation rate exceeds the tolerable deviation rate.

You are auditing SBT, which has a December 31st year-end. On December 24th, the person responsible for processing receiving reports and recording the receipt of inventory became very ill and was out of the office for a week. Due to the company's small staff and the holiday season, a number of the receiving reports were not processed on a timely basis. As an auditor, on which assertion would you place a high importance for this entity and how would you test for it?

The cutoff assertion would be very important in this situation. The risk of inventory transactions being recorded in the wrong period is very high. To test for misstatements, the auditor should trace a sample of receiving reports before and after year-end to ensure that the inventory was recorded in the proper period.

For a particular audit, the sample size for testing controls over the revenue cycle is relatively large. What can you infer about the expected population deviation rate?

The expected population deviation rate has a direct relationship to sample size, so there must be a larger expected population deviation rate.

Explain each of the three PrimePlus Services typically offered by practitioners.

The first service typically offered is consulting/facilitating services. This involves establishing the standards of care expected. It could include giving the third party a list of services offered in the area or assisting the entity in choosing a care provider. Next, a practitioner can offer direct care services. These services include receiving, depositing, and accounting for the entity's income; paying bills for the entity; and arranging and paying for proper care. Finally, a practitioner can offer assurance services. Here, the practitioner issues periodic reports about the quality of care provided to the elderly person. It may involve visits and inspecting documentation of the services performed.

The audit of the inventory management process is affected by the audit results from multiple other processes. Identify the processes, other than the inventory management process, that affect the audit of inventory and explain how each affect the audit of inventory.

The inventory management process is affected by the control activities in the revenue, purchasing, and payroll processes. The revenue process accounts for the sale of finished goods. The purchasing process controls the acquisition and payment for inventory. The payroll process affects the costs of direct and indirect labor that is assigned to inventory. (See Figure 13-1 of the textbook for a diagram of the relationship between the processes.)

Discuss the internal control communication requirements of the PCAOB. What must auditors of public companies report to those charged with governance?

The items to be communicated are organized into three categories: the auditor's responsibilities under generally accepted auditing standards, an overview of the planned scope and timing of the audit, and significant findings from the audit. (See Table 17-4 for specific details of items to be communicated.) BUS 465 students should look at TABLE 17-4.

Discuss the conditions that prohibit the auditor from issuing an unqualified/unmodified opinion and the types of reports that the auditor may issue for a financial statement audit.

There are three circumstances that may require a departure from an unqualified/unmodified audit report: 1. Scope limitation. A scope limitation results from an inability to collect sufficient appropriate evidence, such as when management prevents the auditor from conducting an audit procedure considered necessary. 2. Departure from GAAP. The financial statements are affected by a departure from GAAP. 3. Lack of auditor independence. The auditor must comply with the second general standard and the Code of Professional Conduct in order to issue an unqualified/unmodified opinion. The three types of reports other than the standard unqualified/unmodified are: 1. Qualified. The auditor's opinion is qualified because of either a scope limitation or a departure from a GAAP, but overall the financial statements present fairly. 2. Disclaimer. The auditor disclaims an opinion on the financial statements either because there is insufficient appropriate evidence to form an opinion on the overall financial statements or because there is a lack of independence. 3. Adverse. The auditor's opinion states that the financial statements do not present fairly in conformity with GAAP because the departure materially affects the overall financial statements.

For a particular audit, the sample size for testing controls over the revenue cycle is relatively large. What can you infer about the desired confidence level?

There is a direct relationship between the confidence level and sample size. Therefore, one can infer from a large sample size that the auditor would like a higher confidence level.

When determining the sample size of accounts receivable to test, what are three factors that are important for you to consider?

Three important inputs to determine sample size are (1) desired level of assurance in the results (or confidence level), (2) acceptable defect rate (or tolerable error), and (3) historical defect rate (or estimated error).

Identify the two primary types of subsequent events that require consideration by management and evaluation by the auditor and give two examples of each type.

Type I. Subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet and affect the estimates that are part of the financial statement preparation process. Examples include declaration of bankruptcy by a customer with an outstanding accounts receivable balance (the deterioration existed at the balance sheet date) and the settlement of litigation at an amount different from the amount already recorded on the books. Type II. Subsequent events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date. Examples include a decline in the market value of securities held for temporary investment or resale during the subsequent period and loss due to natural disaster after the balance sheet date.

You are auditing accounts receivable for a small company and have found the following results:

Use ratio analysis to project your results

Jeff Johns is a staff accountant and has been assigned to the audit of Worldwide Enterprises, Inc. Subsequent to the completion of fieldwork, Jeff was assigned to draft the audit report. The content of one of the paragraphs he has drafted reads as follows: As explained in Note 2 to the financial statements, Worldwide Enterprises has charged goodwill and certain other intangible assets acquired in two separate acquisitions directly to shareholders' equity. Under generally accepted accounting principles, these intangibles should have been recorded as assets and amortized to income over future periods. Had these intangibles been capitalized, total assets would have increased by $400,000 as of December 31, 2011 and net income and earnings per share would be increased by $380,000 and $2.25, respectively (assuming a 20-year amortization period). a. Based on the contents of the paragraph above, which condition requiring a departure from a standard unqualified/unmodified opinion exists in the engagement? b. Assuming that the engagement partner agrees with the paragraph Jeff has prepared above, where in the auditor's report should the paragraph be placed? c. How would the materiality of the condition above affect the final choice of opinion?

a. The paragraph indicates a departure from GAAP, which would require a departure from a standard unqualified/unmodified opinion--either qualified or adverse, depending on the materiality of the issue. b. If a qualified or an adverse report is issued, the paragraph should be placed before the opinion paragraph. c. A material misstatement would require a qualified opinion. A pervasively material misstatement would require an adverse opinion.

2. MUS Sampling unit

an individual dollar