1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have standard wording.

Audit Reports 1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have standard wording. 2) List the seven parts of a standard unqualified audit report and explain the meaning of each part. How do the parts compare with those found in qualified report? 3) What are the purposes of the scope paragraph in the auditor’s report? Identify the most important information included in the scope paragraph. 4) What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important information included in the opinion paragraph. 5) On February 17, 2006, a CPA completed the field work on the financial statements for the Buckheizer Technology Corporation for the year ended December 31, 2005. The audit in satisfactory in all respects except for the existence of a change in accounting principle from FIFO to LIFO inventory 6) What five circumstances are required for a standard unqualified report to be issued? 7) Describe the additional information included in the introductory, scope, and opinion paragraphs in a combined audit report on financial statements and the effectiveness of internal control over 8) What type of opinion should an auditor issue when the financial statements are not in accordance with GAAP because such adherence would result in misleading statements? 9) Distinguish between an unqualified report with explanatory paragraph or modified wording and a qualified report. Give examples when an explanatory paragraph or modified wording should be used in an unqualified opinion. 10) Describe what is meant by a reports involving the use of other auditors. What are the three options available to the principal auditor and when should each be used? 11) The client has restated the prior-year statements because of a change from LIFO to FIFO. How should be this reflected in the auditor’s report? 12) Distinguish between changes that affect consistency and those that may affect comparability but not consistency. Give an example of each. 13) List the three conditions that require a departure from unqualified opinion and give one specific example of each those conditions. 14) Distinguish between a qualified opinion, adverse opinion, and a disclaimer of opinion, and explain the circumstances under which each is appropriate. 15) Define materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of materiality? 16) Explain how materiality differs for failure to follow GAAP and for lack of independence. 17) How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations resulting from conditions beyond the client’s control? Under which of these two 18) Distinguish between a report qualified as to opinion only and one with both a scope and opinion qualification. 19) Identify the three alternative opinion that may be appropriate when the client’s financial statements are not accordance with GAAP. Under what circumstances is each appropriate. 20) Discuss why the AICPA has such strict requirements on audit opinions when the auditor is not independent. 21) When an auditor discovers more than one condition that requires departure from or modification of standard unqualified report, what should the auditor’s report include? 22) What responsibility does the auditor have for information on the company’s web site that may be inked to electronic versions of the company’s annual financial statements and auditor’s report? How does this differ from the auditor’s responsibility for other information in the company’s annual report that includes the financial statements and auditor’s report? The Audit Process-Audit Responsibilities and objectives 1) State the objective of the audit of financial statements. In general terms, how do auditors meet that objective? 2) Distinguish between management’s and auditor’s responsibility for the financial statements being audited. 3) Distinguish between the terms errors and fraud. What is the auditor’s responsibility for finding each? 4) Distinguish between fraudulent financial reporting and misappropriation of assets. Discuss the likely difference between those two types of fraud on the fair presentation of financial statements. 5) “It is well accepted in auditing that throughout the conduct of the ordinary audit, it is essential to obtain large amounts of information from management and to rely heavily on management’s judgments. After all, the financial statements are management’s representations, and simple, it is extremely difficult, if not impossible, for the auditor to evaluate the obsolescence inventory as well as management can in a highly complex business. Similarly, the collectability of accounts receivable and the continued usefulness of machinery and equipment are heavily dependent on management’s willingness to provide truthful responses to questions.” Reconcile the auditor’s responsibility for discovering material misrepresentations by management with these comments. 6) List two major characteristics that are useful in predicting the likelihood of fraudulent financial reporting in an audit. For each of the characteristics, state two things that the auditor can do to evaluate its significance in the engagement. CHARACTERISTIC AUDIT STEPS 1. Management’s characteristics and influence over the control environment.  Investigate the past history of the firm and its management. 2. Industry conditions.  Research current status of industry and compare industry financial ratios to the company’s ratios. 3. Operating characteristics and financial stability.  Perform analytical procedures to evaluate the possibility of business failure. 7) Describe what is meant by the cycle approach to auditing. What are the advantages of dividing the audit into different cycles? 8) Identify the cycle to which each of the following ledger accounts would ordinarily be assigned: sales, account payable, retained earnings, account receivable, inventory and repairs and maintenance. 9) Why are sales, sales R&A, bad debts, cash discounts, AR, and allowance for uncollectible accounts all included in the same cycle? 10) Define what is meant by a management assertion about financial statements. Identify the five board categories of management assertions. 11) Distinguish between the general audit objectives and management assertions. Why are the general audit objectives more useful to auditors? 12) An acquisition of fixed-asset repair by a construction company is recorded on the wrong date. Which transaction-related audit objective has been violated? Which transaction-related audit objective has been violated if the acquisition had been capitalized as a fixed asset rather than expensed? 13) Distinguish between the existence and completeness balance- related audit objectives. State the effect on financial statements (overstatement or understatement) of a violation of each in the audit of accounts receivable. 14) What are specific audit objectives? Explain their relationship to the general audit objectives. 15) Identify the management assertion and general balance-related audit for the specific balance-related audit objective: All recorded fixed assets exist at the balance sheet date. 16) Explain how management assertions, general balance-related audit objectives, and specific balance-related audit objectives are developed for an account balance such as accounts receivable. 17) Identify the four phases of the audit. What is the relationship of the four phases to the objective of the audit of financial statements? The Audit Process-Audit Evidence 1) Discuss the similarities and differences between evidence in a legal case and evidence in an audit of financial statements. 1) Discuss the similarities and differences between evidence in a legal case and evidence in an audit of financial statements. 3) Describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully worded? 4) Describe what is meant by an audit program for accounts receivable. What four things should be included in an audit program? 5) State the third standard of field work. Explain the meaning of each of the major phrases of the standard. 6) Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced, that the financial statements are correct. : There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather than be convinced that the financial statements are correct: 1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be completely convinced. 2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confirmations from customers may come back with erroneous information, which is the fault of the customer rather than the client. 7) Identify the two factors, that determine the persuasiveness of evidence. How are these two factors related to audit procedures, sample size, items to select, and timing? : The two determinants of the persuasiveness of evidence are competency and sufficiency. Competency refers to the degree to which evidence can be considered believable or worthy of trust. Competency relates to the audit procedures selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence and it is related to sample size and items to select. 8) Identify the seven characteristics that determine the competence of evidence. For each characteristics, provide one example of a type of evidence that is likely to be competent. 7.8 : Following are seven characteristics that determine competence and an example of each. FACTOR DETERMINING COMPETENCE EXAMPLE OF COMPETENT EVIDENCE Relevance Trace inventory items located in the warehouse to their inclusion in the inventory subsidiary records Independence of provider Confirmation of a bank balance Effectiveness of client's internal controls Use of duplicate sales invoices for a large well-run company Auditor's direct knowledge Physical examination of inventory by the auditor Qualifications of provider Letter from an attorney dealing with the client's affairs Degree of objectivity Count of cash on hand by auditor Timeliness Observe inventory on the last day of the fiscal year 9) List the seven types of audit evidence included in this chapter and give two examples of each. : TYPES OF AUDIT EVIDENCE EXAMPLES 1. Physical examination 2. Confirmation  Count petty cash on hand  Examine fixed asset additions  Confirm accounts receivable balances of a sample of client customers  Confirm client’s cash balance with bank 3. Documentation 4. Analytical procedures  Examine cancelled checks returned with cutoff bank statement  Examine vendors’ invoices supporting a sample of cash disbursement transactions throughout the year  Evaluate reasonableness of receivables by calculating and comparing ratios  Compare expenses as a percentage of net sales with prior year’s percentages TYPES OF AUDIT EVIDENCE EXAMPLES 5. Inquiries of the client 6. Re-performance 7. Observation  Inquire of management whether there is obsolete inventory  Inquire of management regarding the collectibility of large accounts receivable balances  Re-compute invoice total by multiplying item price times quantity sold  Food the sales journal for a one-month period and compare all totals to the general ledger  Observe client employees in the process of counting inventory  Observe whether employees are restricted from access to the check signing machine 10) What are the four characteristics of the definition of a confirmation? Distinguish between a confirmation and external documentation. : The four characteristics of the definition of a confirmation are: 1. Receipt 2. Written or oral response 3. From independent third party 4. Requested by the auditor A confirmation is prepared specifically for the auditor and comes from an external source. External documentation is in the hands of the client at the time of the audit and was prepared for the client's use in the day-to-day operation of the business. 11) Distinguish between internal documentation and external documentation as audit evidence and give three examples of each. : Internal documentation is prepared and used within the client's organization without ever going to an outside party, such as a customer or vendor. Internal documentation is prepared and used within the client's organization without ever going to an outside party, such as a customer or vendor. Examples:  check request form  receiving report  payroll time card  adjusting journal entry External documentation either originated with an outside party or was an internal document that went to an outside party and is now either in the hands of the client or is readily accessible. Examples:  vendor's invoice  cancelled check  cancelled note  validated deposit slip 12) Explain the importance of analytical procedures as evidence in determining the fair presentation of the financial statements. : Analytical procedures are useful for indicating account balances that may be distorted by unusual or significant transactions and that should be intensively investigated. They are also useful in reviewing accounts or transactions for reasonableness to corroborate tentative conclusions reached on the basis of other evidence. 13) Identify the most important reasons for performing analytical procedures. : The most important reasons for performing analytical procedures are the following: 1. Understanding the client's industry and business 2. Assessment of the entity's ability to continue as a going concern 3. Indication of the presence of possible misstatements in the financial statements 4. Reduction of detailed audit tests 14) Your client, Harper Company, has a contractual commitment as a part of a bond indenture to maintain a current ratio of 2.0. if the ratio falls below that level on the balance sheet date, the entire bond becomes payable immediately. In the current year, the client’s financial statements show that the ratio has dropped from 2.6 to 2.05 over the past year. How should this situation affect your audit plan? : The decrease of the current ratio indicates a liquidity problem for Harper Company since the ratio has dropped to a level close to the requirements of the bond indenture. Special care should be exercised by the auditor to determine that the 2.05 ratio is proper since management would be motivated to hide any lower ratio. The auditor should expand procedures to test all current assets for proper cutoff and possible overstatement and to test all current liabilities for proper cutoff and possible understatement. 15) Distinguish between attention-directing analytical procedures and those intended to eliminate or reduce detailed substantive procedures. : Attention directing analytical procedures occur when significant, unexpected differences are found between current year's unaudited financial data and other data used in comparisons. If an unusual difference is large, the auditor must determine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or misstatement due to fraud. When an analytical procedure reveals no unusual fluctuations, the implication is minimized. In that case, the analytical procedure constitutes substantive evidence in support of the fair statement of the related account balances, and it is possible to perform fewer detailed substantive tests in connection with those accounts. Frequently, the same analytical procedures can be used for attention directing and for reducing substantive tests, depending on the outcome of the tests. Simple procedures such as comparing the current year account balance to the prior year account balance is more attention directing (and provides less assurance) than more complex analytical procedures; i.e., those which rely on regression analysis. More sophisticated analytical procedures help the auditor examine relationships between several information variables simultaneously. The nature of these tests may provide greater assurance than simple procedures. 16) Explain why the statement “Analytical procedures are essential in every part of an audit, but these tests are rarely sufficient by themselves for any audit area” is correct or incorrect. : The statement is correct. Except for certain accounts with small dollar balances, analytical procedures are essential to help the auditor identify trends in a client's business and to see the relationship between the client's performance and industry averages. However, the auditor is responsible for gathering sufficient competent evidential matter through inspection, observation and confirmation in addition to the evidence obtained as a result of the analytical procedures. 17) List the purposes of audit documentation and explain why each purpose is important. : The purposes of audit documentation are as follows: 1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc. 2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed. 3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated. 4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient competent evidence was accumulated to justify the audit report. Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient competent evidence if there's a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code. The purposes of audit documentation are as follows: 1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc. 2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed. 3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated. 4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient competent evidence was accumulated to justify the audit report. Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient competent evidence if there's a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code. 18) What are the two criteria that auditors of public companies consider when determining whether memos, correspondence, and other documents must be maintained in the audit files? : The two criteria used by auditors of public companies when determining whether memos, correspondence, and other documents must be maintained in the audit files are as follows: 1. The materials are created, sent, or received in connection with the audit or review. 2. The materials contain conclusions, opinions, analyses, or financial data related to the audit or review. 19) For how long does the Sarbanes-Oxley Act require auditors of public companies to retain audit documentation? : The Sarbanes-Oxley Act of 2002 requires auditors of public companies to prepare and maintain audit schedules and other information related to any audit report in sufficient detail to support the auditor’s conclusions, for a period of not less than 7 years. 20) Explain why it is important for audit documentation to include each of the following: identification of the name of the client, period covered, description of the contents, initial of the preparer, date of the preparation, and an index code. : Audit schedules should include the following: Name of the client Enables the auditor to identify the appropriate file to include the audit schedule in if it is removed from the files. Period covered Enables the auditor to identify the appropriate year to which an audit schedule for a client belongs if it is removed from the files. Description of the contents A list of the contents enables the reviewer to determine whether all important parts of the audit schedule have been included. The contents description is also used as a means of identifying audit files in the same manner that a table of contents is used. Initials of the preparer Indicates who prepared the audit schedule in case there are questions by the reviewer or someone who wants information from the files at a later date. It also clearly identifies who is responsible for preparing the audit documentation if the audit must be defended. Date of preparation Helps the reviewer to determine the sequence of the preparation of the audit schedules. It is also useful for the subsequent year in planning the sequence of preparing audit schedules. Indexing Helps in organizing and filing audit schedules. Indexing also facilitates in searching between related portions of the audit documentation. 21) Define what is meant by a permanent file, and list several types of information typically included. Why does the auditor not include the contents of the permanent file with the current year’s audit file? : The permanent file contains data of an historical and continuing nature pertinent to the current audit. Examples of items included in the file are: 1. Articles of incorporation 2. Bylaws, bond indentures, and contracts 3. Analysis of accounts that have continuing importance to the auditor 4. Information related to the understanding of internal control: a. flowcharts b. internal control questionnaires 5. Results of previous years' analytical procedures, such as various ratios and percentages compiled by the auditors By separating this information from the current year's audit files, it becomes easily accessible for the following year's auditors to obtain permanent file data. 22) Distinguish between the following types of current period supporting schedules and state the purpose of each: analysis, trial balance, and tests of reasonableness. : The purpose of an analysis is to show the activity in a general ledger account during the entire period under audit, tying together the beginning and ending balances. The trial balance includes the detailed make-up of an ending balance. It differs from an analysis in that it includes only those items comprising the end of the period balance. A test of reasonableness schedule contains information that enables the auditor to evaluate whether a certain account balance appears to be misstated. One example of a test of reasonableness schedule is a schedule that compares current year expenses to prior years' amounts. This type of schedule is intended to show which accounts need investigation due to significant variances. 23) Why is it essential that the auditor not leave questions or exceptions in the audit documentation without an adequate explanation? : Unanswered questions and exceptions may indicate the potential for significant errors or fraud in the financial statements. These should be investigated and resolved to make sure that financial statements are fairly presented. The audit files can also be subpoenaed by courts as legal evidence. Unanswered questions and exceptions may indicate lack of due care by the auditor. 24) Define what is meant by a tick mark. What is its purpose? : Tick marks are symbols adjacent to information in audit schedules for the purpose of indicating the work performed by the auditor. An explanation of the tick mark must be included at the bottom of the audit schedule to indicate what was done and who did it. 25) Who owns the audit files? Under what circumstances can they be used by other people? : Audit files are owned by the auditor. They can be used by the client if the auditor wants to release them after a careful consideration of whether there might be confidential information in them. The audit files can be subpoenaed by a court and thereby become the property of the court. They can be released to another CPA firm without the client's permission if they are being reviewed as a part of a voluntary peer review program under AICPA, state CPA society, or state Board of Accountancy authorization. The audit files can be sold or released to other users if the auditor obtains permission from the client. 26) A CPA sells his auditing practice to another CPA firm and includes all audit files as part of the purchase price. Under what circumstances is this a violation of the code of professional conduct? : It is a violation unless the CPA obtains permission from each client before the audit files for that client are released. 27) How does the auditor read and evaluate information that is available only in machine-readable form? : When evidence can be examined only in machine-readable form, auditors use computers to read and examine evidence. There are commercial audit software programs designed specifically for use by auditors, such as ACL Software and Interactive Data Extraction and Analysis (IDEA). Spreadsheet software packages can also be used by auditors to perform audit tests on data that is available only in machine-readable form. 28) Explain the purposes and benefits of audit documentation software. : The purposes of audit documentation software are to convert traditional paper-based documentation into electronic files and to organize the audit documentation. The benefits of audit documentation software, such as Automated Client Engagement (ACE), are as follows:  The auditor can more efficiently prepare a trial balance, lead schedules, supporting audit documentation, financial statements, and ratio analysis using the computer rather than by hand.  The effects of adjusting journal entries are automatically carried through to the trial balance and financial statements, making last-minute adjustments easier to make.  Tick marks and review notes can be entered directly into computerized files.  Data can be imported and exported to other applications. For example, a client’s general ledger can be downloaded into ACE and tax information can be downloaded into a commercial tax preparation package after the audit is completed. The Audit Process-Audit Planning and Analytical Procedures 1) what benefits does the auditor derive from planning audits? : There are three primary benefits from planning audits: it helps the auditor obtain sufficient competent evidence for the circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client. 2) Identify the eight major steps in planning audits. : Eight major steps in planning audits are: 1. Accept client and perform initial planning 2. Understand the client’s business and industry 3. Assess client business risk 4. Perform preliminary analytical procedures 5. Set materiality, and assess acceptable audit risk and inherent risk 6. Understand internal control and assess control risk 7. Gather information to assess fraud risks 8. Develop overall audit plan and audit program 3) What are the responsibilities of the successor and predecessor auditors when a company is changing auditors? : The new auditor (successor) is required by SAS 84 (AU 315) to communicate with the predecessor auditor. This enables the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement. Permission must be obtained from the client before communication can be made because of the confidentiality requirement in the Code of Professional Conduct. The predecessor is required to respond to the successor’s request for information; however, the response may be limited to stating that no information will be given. The successor auditor should be wary if the predecessor is reluctant to provide information about the client. 4) What factors should an auditor consider prior to accepting an engagement? Explain. : Prior to accepting a client, the auditor should investigate the client. The auditor should evaluate the client’s standing in the business community, financial stability, and relations with its previous CPA firm. The primary purpose of new client investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially concerned with the possibility of fraudulent financial reporting since it is difficult to uncover. The auditor does not want to needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud. 5) What is the purpose of an engagement letter? What subjects should be covered in such a letter? : An engagement letter is an agreement between the CPA firm and the client concerning the conduct of the audit and related services. It should state what services will be provided, whether any restrictions will be imposed on the auditor’s work, deadlines for completing the audit, and assistance to be provided by client personnel. The engagement letter may also include the auditor’s fees. In addition, the engagement letter informs the client that the auditor cannot guarantee that all acts of fraud will be discovered. 6) Who is considered “the client” when auditing public companies? : Because the Sarbanes-Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from management to the audit committee for public companies, the audit committee is viewed as “the client” in those engagements. 7) Which services must be preapproved by the audit committee a public company? : All audit and non-audit services must be preapproved in advance by the audit committee for public companies. 8) Explain why auditors need an understanding of the client’s industry. What sources are commonly used by auditors to learn about the client’s industry? : Auditors need an understanding of the client’s business and industry because the nature of the business and industry affect business risk and the risk of material misstatements in the financial statements. Auditors use the knowledge of these risks to determine the appropriate extent of audit evidence to accumulate. The five major aspects of understanding the client’s business and industry, along with potential sources of information that auditors commonly use for each of the five areas are as follows: 1. Industry and External Environment – Read industry trade publications, AICPA Industry Audit Guides, and regulatory requirements. 2. Business Operations and Processes – Tour the plant and offices, identify related parties, and inquire of management. 3. Management and Governance – Read the corporate charter and bylaws, read minutes of board of directors and stockholders, and inquire of management. 4. Client Objectives and Strategies – Inquire of management regarding their objectives for the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and other legal documents, such as those for notes and bonds payable, stock options, and pension plans. 5. Measurement and Performance – Read financial statements, perform ratio analysis, and inquire of management about key performance indicators that management uses to measure progress toward its objectives. 9) When a CPA has accepted an engagement from a new client who is manufacturer, it is customary for the CPA to tour the client’s plant facilities. Discuss the ways in which the CPA’s observations made during the course of the plant tour will be of help in planning and conducting the audit. : During the course of the plant tour the CPA will remember that an important aspect of the audit will be an effective analysis of the cost system. Therefore, the auditor will observe the nature of the company’s products, the manufacturing facilities and processes, and the flow of materials so that the information obtained can later be related to the functions of the cost system. The nature of the company’s products and the manufacturing facilities and processes will reveal the features of the cost system that will require close audit attention. For example, the audit of a company engaged in the custom-manufacture of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs, whereas the allocation of material and labor charges in the audit of a beverage-bottling plant would not be verified on the same basis. The CPA will note the stages at which finished products emerge and where additional materials must be added. He or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advisable, after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in similar audits. The auditor’s observation of the manufacturing processes will reveal whether there is idle plant or machinery that may require disclosure in the financial statements. Should the machinery appear to be old or poorly maintained, the CPA might expect to find heavy expenditures in the accounts for repairs and maintenance. On the other hand, if the auditor determines that the company has recently installed new equipment or constructed a new building, he or she will expect to find these new assets on the books. In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the observation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements. In this regard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in mind for further investigation any apparently obsolete inventory. The auditor’s study of the flow of materials will disclose the points at which various documents such as material requisitions arise. He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into production problems and other matters such as excess or obsolete materials, and scrap and spoilage. The auditor will be alert for the attitude of the manufacturing personnel toward accounting controls. The CPA may make some inquiries about the methods of production scheduling, timekeeping procedures and whether work standards are employed. As a result of these observations, the internal documents that relate to the flow of materials will be more meaningful as accounting evidence. The CPA’s tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to communicate fluently with the client’s personnel. The measures taken by the client to safeguard assets, such as protection of inventory from fire or theft, will be an indication of the client’s attention to internal control measures. The location of the receiving and shipping departments and the procedures in effect will bear upon the CPA’s evaluation of internal control. The auditor’s overall impression of the client’s plant will suggest the accuracy and adequacy of the accounting records that will be audited. 10) An auditor often tries to acquire background knowledge of the client’s industry as an aid to audit work. How does the acquisition of this knowledge aid the auditor in distinguishing between obsolete and current inventory? : One type of information the auditor obtains in gaining knowledge about the clients’ industry is the nature of the client’s products, including the likelihood of their technological obsolescence and future salability. This information is essential in helping the auditor evaluate whether the client’s inventory may be obsolete or have a market value lower than cost. 11) Define what is meant by a related party. What are the auditor’s responsibilities for related parties and related party transactions? : A related party is defined in SAS 45 (AU 334) as an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other. Material related party transactions must be disclosed in the financial statements by management. Therefore, the auditor must identify related parties and make a reasonable effort to determine that all material related party transactions have been properly disclosed in the financial statements. 12) Which types of loans to executives are permitted by the Sarbanes- Oxley Act? : Because of the lack of independence between the parties involved, the Sarbanes-Oxley Act prohibits related party transactions that involve personal loans to executives. It is now unlawful for any public company to provide personal credit or loans to any director or executive officer of the company. Banks or other financial institutions are permitted to make normal loans to their directors and officers using market rates, such as residential mortgages. 13) Your firm has performed the audit of Rogers Company for several years and you have been assigned the audit responsibility for the current audit. How would you review of the corporate charter and bylaws for this audit differ from that of the audit of a client who was audited by a different CPA firm in the preceding year? : In the audit of a client previously audited by a different CPA firm, it would be necessary to obtain a copy of the corporate charter and bylaws for the permanent files and to read these documents and prepare a summary abstract of items to test for compliance. In an ongoing engagement, this work has been performed in the past and is unnecessary each year. The auditor’s responsibility is to determine what changes have been made during the current year and to update and review the summary abstract prepared in previous years for compliance. 14) For the audit of Radline Manufacturing Company, the audit partner asks you to carefully read the new mortgage contract with the First National Bank and abstract all pertinent information. List the information in a mortgage that is likely to be relevant to the auditor. The information in a mortgage that is likely to be relevant to the auditor includes the following: 1. The parties to the agreement 2. The effective date of the agreement 3. The amounts included in the agreement 4. The repayment schedule required by the agreement 5. The definition and terms of default 6. Prepayment options and penalties specified in the agreement 7. Assets pledged or encumbered by the agreement 8. Liquidity restrictions imposed by the agreement 9. Purchase restrictions imposed by the agreement 10. Operating restrictions imposed by the agreement 11. Requirements for audit reports or other types of reports on compliance with the agreement 12. The interest rate specified in the agreement 13. Any other requirements, limitations, or agreements specified in the document 15) Identify two types of information in the client’s minutes of the board of directors meetings that are likely to be relevant to the auditor. Explain why it is important to read the minutes early in the engagement. : Information in the client’s minutes that is likely to be relevant to the auditor includes the following: 1. Declaration of dividends 2. Authorized compensation of officers 3. Acceptance of contracts and agreements 4. Authorization for the acquisition of property 5. Approval of mergers 6. Authorization of long-term loans 7. Approval to pledge securities 8. Authorization of individuals to sign checks 9. Reports on the progress of operations It is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of conducting the audit. For instance, if a long-term loan is authorized in the minutes, the auditor will want to make certain that the loan is recorded as part of long- term liabilities. 16) Identify the three categories of client objectives. Indicate how each objective may affect the auditor’s assessment of inherent risk and evidence accumulation. : The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with laws and regulations. Each of these objectives affects the auditor’s assessment of inherent risk and evidence accumulation as follows: 1. Reliability of financial reporting – If management sees the reliability of financial reporting as an important objective, and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can often reduce inherent risk and planned evidence accumulation for material accounts. In contrast, if management has little regard for the reliability of financial reporting, the auditor must increase inherent risk assessments and gather more evidence during the audit. 2. Effectiveness and efficiency of operations – This area is of primary concern to most clients. Auditors need knowledge about the effectiveness and efficiency of a client’s operations in order to assess client business risk and inherent risk in the financial statements. For example, if a client is experiencing inventory management problems, this would most likely increase both the auditor’s assessment of inherent risk for the planned evidence accumulation for inventory. 3. Compliance with laws and regulations – It is important for the auditor to understand the laws and regulations that affect an audit client, including significant contracts signed by the client. For example, the provisions in a pension plan document would significantly affect the auditor’s assessment of inherent risk and evidence accumulation in the audit of unfunded liability for pensions. If the client were in violation of the provisions of the pension plan document, inherent risk and planned evidence for pension-related accounts would increase. 17) What is the purpose of the client’s performance measurement system? Give examples of key performance indicators for the following business: (1) a chain of retail clothing stores; (2) an internet portal; (3) a hotel chain. : The purpose of a client’s performance measurement system is to measure the client’s progress toward specific objectives. Performance measurement includes ratio analysis and benchmarking against key competitors. Performance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns as a percentage of clothing sales, and inventory turnover by product line. An Internet portal’s performance measurements might include number of Web site hits or search engine speed. A hotel chain’s performance measures include vacancy percentages and supply cost per rented room. 18) Define client business risk and describe several sources of client business risk. What is the auditor’s primary concern when evaluating client business risk? : Client business risk is the risk that the client will fail to achieve its objectives. Sources of client business risk include any of the factors affecting the client and its environment, including competitor performance, new technology, industry conditions, and the regulatory environment. The auditor’s primary concern when evaluating client business risk is the risk of material misstatements in the financial statements due to client business risk. For example, if the client’s industry is experiencing a significant and unexpected downturn, client business risk increases. This increase would most likely increase the risk of material misstatements in the financial statements. The auditor’s assessment of the risk of material misstatements is then used to classify risks using the audit risk model to determine the appropriate extent of audit evidence. 19) Describe top management controls and their relation to client business risk. Give examples of effective management and governance controls. : Management establishes the strategies and business processes followed by a client’s business. One top management control is management’s philosophy and operating style, including management’s attitude toward the importance of internal control. Other top management controls include a well-defined organizational structure, an effective board of directors, and an involved and effective audit committee. If the board of directors is effective, this increases management’s ability to appropriately respond to risks. An effective audit committee can help management reduce the likelihood of overly aggressive accounting. 20) What are the purposes of preliminary analytical procedures? What types of comparisons are useful when performing preliminary analytical procedures? : Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining the nature, extent, and timing of work to be performed. Preliminary analytical procedures also help the auditor identify accounts and classes of transactions where misstatements are likely. Comparisons that are useful when performing preliminary analytical procedures include:  Compare client and industry data  Compare client data with similar prior period data  Compare client data with client-determined expected results  Compare client data with auditor-determined expected results  Compare client data with expected results, using nonfinancial data 21) When are analytical procedures required to be performed during the audit? What is the primary purpose of analytical procedures performed during the completion phase of the audit? : Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in determining the nature, extent, and timing of work to be performed and (2) during the completion phase, as a final review for material misstatements or financial problems. Analytical procedures are also often done during the testing phase of the audit, but they are not required in this phase. 22) Gale Gordon, CPA, has found ratio and trend analysis relatively useless as a tool in conducting audits. For several engagement, he computed the industry ratios included in publications by Robert Morris Associates and compared them with industry standards. For most engagements, the client’s business was significantly different from the industry data in the publication and the client would automatically explain away any discrepancies by attributing them to the unique nature of its operations. In cases in which the client had more than one branch in different industries, Gordon found the ratio analysis no help at all. How could Gordon improve the quality of his analytical procedures? : Gordon could improve the quality of his analytical tests by: 1. Making internal comparisons to ratios of previous years. 2. In cases where the client has more than one branch in different industries, computing the ratios for each branch and comparing these to the industry ratios. 23) At the completion of every audit, Roger Morris, CPA, calculates a large number of ratios and trends for comparison with industry averages and prior-year calculations. He believes the calculations are worth the relatively small cost of doing them because they provide him with an excellent overview of the client’s operations. If the ratios are out of line, Morris discusses the reasons with the client and often make suggestions on how to bring the ratio back in line in the future. In some cases, these discussions with management have been the basis for management consulting engagements. Discuss the major strengths and shortcomings in Morris’s use of ratio and trend analysis. : Roger Morris performs his ratio and trend analysis at the end of every audit. By that time, the audit procedures are completed. If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the findings. SAS 56 (AU 329) requires that analytical procedures be performed in the planning phase of the audit and near the completion of the audit. The use of ratio and trend analysis appears to give Roger Morris an insight into his client's business and affords him an opportunity to provide excellent business advice to his client. 24) Name the four categories of financial ratios and give an example of a ratio in each category. What is the primary information provided by each financial ratio category? : The four categories of financial ratios and examples of ratios in each category are as follows: 1. Short-term debt-paying ability – Cash ratio, quick ratio, and current ratio. 2. Liquidity activity – Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell inventory. 3. Ability to meet long-term debt obligations – Debt to equity and times interest earned. 4. Profitability – Earnings per share, gross profit percent, profit margin, return on assets, and return on common equity The Audit Process-Materiality and Risk 1) Chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of materiality and risk? : The planning phases are: accept client and perform initial planning, understand the client’s business and industry, assess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop overall audit plan and audit program. Evaluation of materiality is part of phase five. Risk assessment is part of phase three (client business risk), phase five (acceptable audit risk and inherent risk), phase six (control risk), and phase seven (fraud risk). 2) Define the meaning of the term materiality as it is used in accounting and auditing. What is the relationship between materiality and the phrase obtain reasonable assurance used in the auditor’s report? : Materiality is defined as: the magnitude of an omission or misstatement of accounting information that, in light of the surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. "Obtain reasonable assurance," as used in the audit report, means that the auditor does not guarantee or insure the fair presentation of the financial statements. There is some risk that the financial statements contain a material misstatement. 3) Explain why materiality is important but difficult to apply in practice. : Materiality is important because if financial statements are materially misstated, users' decisions may be affected, and thereby cause financial loss to them. It is difficult to apply because there are often many different users of the financial statements. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materiality is also difficult to apply because it is a relative concept. The professional auditing standards offer little specific guidance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment in the application of materiality. 4) What is meant by setting a preliminary judgment about materiality? Identify the most important factors affecting the preliminary judgment. : The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary judgment about materiality and are as follows: 1. Materiality is a relative rather than an absolute concept. 2. Bases are needed for evaluating materiality. 3. Qualitative factors affect materiality decisions. 4. Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely distributed. 5. The level of acceptable audit risk will also affect the preliminary judgment of materiality. 5) What is meant by using bases for setting a preliminary judgment about materiality? How would those bases differ for the audit of a manufacturing company and a government unit such as school district? : Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstatements are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is no net income before taxes, and therefore that would be an unavailable base. Instead, the primary bases would likely be fund balances, total assets, and perhaps total revenue. 6) Assume that Rosanne Madden, CPA, is using 5% of net income before tax, current assets, or current liabilities as her major guidelines for evaluating materiality. What qualitative factors should she also consider in deciding whether misstatements maybe material? : The following qualitative factors are likely to be considered in evaluating materiality: a. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts. b. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. c. Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. 7) Distinguish between the terms tolerable misstatement and preliminary judgment about materiality. How are they related to each other? : A preliminary judgment about materiality is set for the financial statements as a whole. Tolerable misstatement is the maximum amount of misstatement that would be considered material for an individual account balance. The amount of tolerable misstatement for any given account is dependent upon the preliminary judgment about materiality. Ordinarily, tolerable misstatement for any given account would have to be lower than the preliminary judgment about materiality. In many cases, it will be considerably lower because of the possibility of misstatements in different accounts that, in total, cannot exceed the preliminary judgment about materiality. 8) Assume a company with the following balance sheet accounts: Account Amount Cash $10,000 Fixed Assets $60,000 $70,000 Long-Term loans $30,000 M. Johnson Proprietor $40,000 $70,000 You are concerned only about overstatement of owner’s equity. Set tolerable misstatement for the three relevant accounts such that the preliminary judgment about materiality does not exceed $5,000. Justify your answer. : There are several possible answers to the question. One example is: Cash $500 Overstatement Fixed assets $3,000 Overstatement Long-term loans $1,500 Understatement Note: Cash and fixed assets are tested for overstatement and long-term loans for understatement because the auditor's objective in this case is to test for overstatements of owner's equity. The least amount of tolerable misstatement was allocated to cash and long-term loans because they are relatively easy to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of fixed assets in a typical audit. 9) Explain what is meant by making an estimate of the total misstatement in a segment and in the overall financial statements. Why is it important to make these estimates? What is done with them? : An estimate of the total misstatement in a segment is the estimate of the total misstatements based upon the sample results. If only a sample of the population is selected and audited, the auditor must project the total sample misstatements to a total estimate. This is done audit area by audit area. The misstatements in each audit area must be totaled to make an estimate of the total misstatements in the overall financial statements. It is important to make these estimates so the auditor can evaluate whether the financial statements, taken as a whole, may be materially misstated. The estimate for each segment is compared to tolerable misstatement for that segment and the estimate of the overall misstatement on the financial statements is compared to the preliminary judgment about materiality. 10) How would the conduct of an audit of a medium-sized company be affected by the company’s being a small part of a large conglomerate as compared with it being a separate entity? : If an audit is being performed on a medium-sized company that is part of a conglomerate, the auditor must make a materiality judgment based upon the conglomerate. Materiality may be larger for a company that is part of a conglomerate because even though the financial statements of the medium-sized company may be misstated, the financial statements of the large conglomerate might still be fairly stated. If, however, the auditor is giving a separate opinion on the medium-sized company, the materiality would be lower than for the audit of a conglomerate. 11) Define the audit risk model and explain each term in the model. : The audit risk model is as follows: PDR = AAR IR x CR Where PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk Planned detection risk A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Acceptable audit risk A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. Inherent risk A measure of the auditor's assessment of the likelihood that there are material misstatements in a segment before considering the effectiveness of internal control. Control risk A measure of the auditor's assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client's internal controls. 12) What is meant by planned detection risk? What is the effect on the amount of evidence the auditor must accumulate when planned detection risk is increased from medium to high? : Planned detection risk is a measure of the risk that the audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. When planned detection risk is increased from medium to high, the amount of evidence the auditor must accumulate is reduced. 13) Explain the causes of an increased or decreased planned detection risk. : An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either control risk or inherent risk. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit risk or an increase in control risk or inherent risk. 14) Define what is meant by inherent risk. Identify four factors that make for high inherent risk in audits. : Inherent risk is a measure of the auditor's assessment of the likelihood that there are material misstatements in a segment before considering the effectiveness of internal control. Factors affecting assessment of inherent risk include:  Nature of the client's business  Results of previous audits  Initial vs. repeat engagement  Related parties  Non-routine transactions  Judgment required to correctly record transactions and  Makeup of the population 15) Explain why inherent risk is set for segments rather than for overall audit. What is the effect on the amount of evidence the auditor must accumulate when inherent risk is increased from medium to high for a segment? Compare your answer with the one for question 12. : Inherent risk is set for segments rather than for the overall audit because misstatements occur in segments. By identifying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for misstatements in those segments. When inherent risk is increased from medium to high, the auditor should increase the audit evidence accumulated to determine whether the expected misstatement actually occurs. The audit evidence goes in the opposite direction in Review Question 9-12. 16) Explain the effect of extensive misstatements found in the prior year’s audit on inherent risk, planned detection risk, and planned audit evidence. : Extensive misstatements in the prior year's audit would cause inherent risk to be set at a high level (maybe even 100%). An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor increase the level of planned audit evidence. 17) Explain what is meant by term acceptable audit risk. What is its relevance to evidence accumulation? : Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is reduced, planned evidence should increase. 18) Explain the relationship between acceptable audit risk and the legal liability of auditors. : When the auditor is in a situation where he or she believes that there is a high exposure to legal liability, the acceptable audit risk would be set lower than when there is little exposure to liability. Even when the auditor believes that there is little exposure to legal liability, there is still a minimum acceptable audit risk that should be met. 19) State the three categories of factors that affect acceptable audit risk and list the factors that auditor can use to indicate the degree to which each category exists. : The first category of factors that determine acceptable audit risk is the degree to which users rely on the financial statements. The following factors are indicators of this:  Client's size  Distribution of ownership  Nature and amount of liabilities The second category of factors is the likelihood that a client will have financial difficulties after the audit report is issued. Factors affecting this are:  Liquidity position  Profits (losses) in previous years  Method of financing growth  Nature of the client's operations  Competence of management The third category of factors is the auditor's evaluation of management's integrity. Factors that may affect this are:  Relationship with current or previous auditors  Frequency of turnover of key financial or internal audit personnel  Relationship with employees and labor 20) Auditors have not been successful in measuring the components of the