Details of ANSWER KEY TO Applied Auditing, Ma. Elenita Balatbat Cabrera
CHAPTER
1 OVERVIEW OF THE
AUDIT PROCESS
1-2 Solutions Manual to Accompany
... [Show More] Applied Auditing, 2006 Edition
1-7. The main feature distinguishing the interim audit phase from the final audit phase
is the focal point. In the interim audit, the primary focus is on testing the client’s
internal controls as a means for further reduction of assessed control risk. In the
final audit, the auditor is primarily concerned with the examination of transactions
and balances.
1-8. The accuracy of transactions and balances is a function of the reliability of the
information system. An effective control environment, accounting system, and
control activities (the information system), together with a system of monitoring
such that controls adapt to a changing environment, serves to produce accurate
financial data. Weak controls are more likely to produce inaccurate financial data.
By first testing the information system, the auditor is able to increase or decrease
the nature, timing, and extent of transaction and balance testing according to
his/her assessment of control risk.
1-9. The ten generally accepted auditing standards, along with the related statements
on auditing standards, provide a framework by defining the requisite quality to be
achieved in performing an audit.
1-10. Attestation refers to an expert communicating a conclusion about the reliability of
someone else’s assertion. Auditing is a form of attestation in that the auditor
communicates, to third party financial statement users, his/her conclusions
regarding the fairness of management’s assertions contained in the financial
statements. The independent auditor is considered an “expert” in both accounting
and auditing.
1-11. In planning an audit, an auditor must be familiar with the client’s industry,
business activities, accounting system, and policies and procedures. Once the
assertions to be tested have been identified, the auditor must assess the risk of
their being misstated. Auditors must be reasonably sure of issuing an appropriate
opinion. Hence, they must consider the risk of misstatements and the various
procedures available for gathering audit evidence as a basis for forming an
opinion. Audit planning includes designing the specific procedures to be
performed and assigning personnel to work on the audit.
The audit report indicates that auditors conduct audits in accordance with
generally accepted auditing standards. Further, the report communicates the role
of risk in the audit process by stating that those standards require auditors to plan
and perform the audit to obtain reasonable assurance about (not to prove) whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. Hence, an audit involves risk. Finally, auditors express an
opinion, not a guarantee. However, they believe that their audit provides a
reasonable basis for their opinion.
Overview of the Audit Process 1-3
1-12. Auditing standards indicate that auditors should report major issues discussed with
the entity’s management prior to being retained as auditor, including discussions
regarding the application of accounting principles and auditing standards.
Discussion of such matters may place pressure on the auditor to yield to
management’s view. Making the audit committee members aware of such matters
should enable them to better monitor the auditor’s independence. Standards do
not preclude clients from making suggestions about audit staff. Clients frequently
make requests to have persons on the audit who have experience in the industry.
If a client requests that minority persons not be assigned to an audit, however, the
auditor must carefully consider the ethical implications of that request.
1-13. Auditing standards require auditors associated with financial statements to issue a
report on them. An auditor is associated with financial statements when he or she
(a) “has consented to the use of his [her] name in a report, document, or written
communication containing the statements,” or (b) has prepared or assisted in
preparing the financial statements. An auditor who prepares or assists in
preparing financial statements is associated even if his or her name is not included
with the statements. Typing the financial statements on plain paper rather than on
the auditor’s letterhead therefore cannot be used to avoid association and the
requirement to issue a report.
1-14. In determining whether financial statements are presented fairly in conformity
with GAAP, the auditor should consider whether:
The accounting principles selected and applied have general acceptance. The
accounting principles followed in preparing the financial statements must
have general acceptance, which means that the principles must be GAAP.
Auditing standards define GAAP as a “technical accounting term which
encompasses the conventions, rules, and procedures necessary to define
accepted accounting practice at a particular time.” No single reference source
exists for GAAP. Rather, auditing standards establish a hierarchy of sources
to be followed when determining which principle applies to a particular
situation.
The accounting principles are appropriate in the circumstances.
The statements contain appropriate disclosures.
The financial statements reflect the underlying events and transactions in a
manner that presents the financial position, results of operations, and changes
in financial position within a range of acceptable limits; that is, limits that are
reasonable and practicable to attain in financial statements.
1-15. Auditing standards require the auditor to disclose the effects of deviations from
GAAP on the financial statements. As a result, clients often choose to adjust the
financial statements for the deviations.
1-16. An auditor may not offer reasons for the lack of independence since such
explanations might mitigate the lack of independence in the view of the reader.
2-1. Audit risk: The risk that the auditor may unknowingly fail to appropriately
modify his/her opinion of financial statements that are materially misstated.
Inherent risk: Relates to the susceptibility of an account balance or class of
transactions to error that could be material. . .assuming that there were no related
internal controls.
Control risk: The risk that material errors or irregularities are not prevented or
detected by the system of internal control.
Detection risk: The risk that errors or irregularities which are not prevented or
detected by the system of internal control, are not detected by the independent
auditor.
2-2. Study of the business and industry, and application of analytical procedures during
the planning stage of the audit assist in evaluating inherent risk. These procedures
may permit the auditor to assess inherent risk below the initial 100% assumed
level.
2-3. Sources of business and industry information are the following:
a. Management inquiry
b. Permanent audit workpaper file
c. Internal client documents (e.g. correspondence files, minutes, accounting
manuals, and policy and procedures manuals)
d. PICPA audit and accounting guides
e. Industry trade publications
f. Government publications
g. Credit reports (Dunn & Bradstreet, banks, etc.)
h. Computer data bases
i. Business periodicals
2-4. a. The audit risk model is
Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)
b. The audit risk model is useful in managing audit risk for assertions. By
determining planned audit risk for an assertion, assessing inherent and control
risks, an auditor can determine the allowable detection risk (the amount of
CHAPTER
2 AUDIT PLANNING
2-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition
detection risk an auditor can allow) for an assertion. Allowable detection risk
is used to determine the nature, timing, and extent of audit procedures for the
assertion.
2-5. The amount of audit evidence an auditor must gather varies inversely with
allowable detection risk. As allowable detection risk decreases, the amount of
evidence required increases, and vice versa. Chapter 2 introduces audit
procedures and discusses how auditors modify audit procedures to obtain
sufficient competent evidential matter by changing (1) the nature, (2) the timing,
or (3) the extent of procedures.
2-6. a. Analytical procedures are used for these broad purposes:
To assist the auditor in planning the nature, timing, and extent of other
auditing procedures.
As a substantive test to obtain evidential matter about particular
assertions related to account balances or classes of transactions.
As an overall review of the financial information in the final review stage
of the audit.
b. An auditors’ expectations are developed from the following sources of
information:
Financial information for comparable prior periods giving consideration
to know changes.
Anticipated results--for example, budgets, forecasts, and extrapolations.
Relationships among elements of financial information within the period.
Information regarding the industry in which the client operates.
Relationships of financial information with relevant nonfinancial
information.
c. The factors that influence an auditor’s consideration of the reliability of data
for purposes of achieving audit objectives are whether the
Data were obtained from independent sources outside the entity or from
sources within the entity.
Sources within the entity were independent of those who are responsible
for the amount being audited.
Data were developed under a reliable system with adequate controls.
Data were subjected to audit testing in the current or prior year.
Expectations were developed using data from a variety of sources.
2-7. a. (4) b. (4)
2-8. a. (1) b. (1) c. (1)
2-9. a. (1) b. (2) c. (3)
Audit Planning 2-3
2-10. a. The audit risk model gives the following results:
AR = IR x CR x DR (or) DR x AR / (IR x CR)
(1) 2.5% (4) 3.33%
(2) 0.67% (5) 2.5%
(3) 1
In the third situation, the auditor does not have to accumulate any evidence
because inherent risk and control risk give the appropriate level of planned
audit risk.
b. (1) 3 (tied) (4) 2
(2) 5 (5) 3 (tied)
(3) 1
2-11. a. 1. Audit risk is the risk that the auditor may unknowingly fail to
appropriately modify an opinion on financial statements that are
materially misstated.
2. Inherent risk is the susceptibility of an account balance or class of
transactions to error that could be material, when aggregated with error in
other balances or classes, assuming that there were no related internal
controls.
Control risk is the risk that error in an account balance or class of
transactions that could be material, when aggregated with error in other
balances or classes, will not be prevented or detected on a timely basis by
controls.
Detection risk is the risk that an auditor’s procedures will lead the auditor
to conclude that error in an account balance or class of transactions that
could be material, when aggregated with error in other balances or
classes, does not exist, when in fact such error does exist.
3. Inherent risk and control risk differ from detection risk in that they exist
independently of the audit of financial statements, whereas detection risk
relates to the auditor’s procedures and can be changed at the auditor’s
discretion. Detection risk should bear an inverse relationship to inherent
and control risk. The less inherent and control risk the auditor believes
exists, the greater the acceptable detection risk.
b. 1. Materiality is the magnitude of an omission or misstatement of
accounting information that, in the light of 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. This concept recognizes that some matters, either
2-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition
individually or in the aggregate, are important for the fair presentation of
financial statements in conformity with generally accepted accounting
principles whereas other matters are not important.
2. Materiality is affected by the nature and amount of an item in relation to
the nature and amount of items in the financial statements under
examination, and by the auditor’s judgment as influenced by the
auditor’s perception of the needs of a reasonable person who will rely on
the financial statements.
2-12. The primary issue raised here is how friendly an auditor should be with client
personnel. This situation is especially interesting in light of the auditor’s view of
the relationship prior to being assigned significant responsibility. The issue is
whether Josie is trying to become friendly in order to try to manipulate the
auditor’s decisions.
3-1. Directly. Higher levels of control risk induce auditors to audit larger samples of
receivables, with confirmation date closer to the fiscal year end date. As for
nature of the procedures: higher levels of control risk induce auditors to use
positive confirmations instead of negative confirmations, and to consider
vouching subsequent payments by the customers.
3-2. The features of a cash receipts internal control system which would be expected to
prevent an employee from absconding with company funds and covering with
funds from the employee pension fund is the prohibition against one employee
having custody of company funds and noncompany funds. The auditor can detect
such transfers by controlling and counting both funds simultaneously.
To prevent the cash receipts journal and recorded cash sales from reflecting more
than the amount shown on the daily deposit slip, the internal control system
should provide that receipts be recorded daily and intact. A careful bank
reconciliation by an independent person could detect such errors.
3-3. A strength is defined as a control procedure that can detect, prevent or correct
errors in a timely matter from entering into the accounting records that form the
basis of financial statements. A weakness is the lack of a control procedure where
the auditor thinks one should exist.
Weaknesses are not subject to test of controls auditing because no reliance is
placed on a weakness. Strengths must be audited because the review phase only
describes apparent strengths that may not actually exist.
3-4. The evaluation after the review phase was to determine which controls appeared
adequate as a basis for justifying a low control risk assessment. The final
assessment after test of controls auditing is to determine if the controls are
actually operating as well as they appeared to be.
3-5. a. An order entry department generally receives customers’ requests to purchase
merchandise either by telephone or in the form of a written purchase order
from the customer. A purchase order is a legal offer to purchase goods under
the terms specified. In some entities, on receipt of an order, the order entry
department generally prepares a sales order. The sales order is the first
document prepared by the merchandiser in the sales and collections cycle,
CHAPTER
3 AUDIT OF THE REVENUE AND COLLECTION
CYCLE: TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS
3-2 Solutions Manual to Accompany Applied Auditing, 2062 Edition
and it should be prenumbered to facilitate control over processing
transactions. A copy of the sales order, acknowledging that the order has
been received and is being processed, may be mailed to the customer. Four
copies of the sales order are sent to the credit department, which either
approves or denies credit and returns a copy of the sales order to the order
entry department. The credit department then sends a copy bearing credit
approval (assuming it is granted) to the warehouse, the shipping department,
and the billing department. The sales order bearing credit approval serves as
authorization to warehouse personnel to release goods to shipping. Shipping
personnel verify that the quantity and description of goods received from the
warehouse match the copy of the sales order received directly from order
entry. Billing matches the customer order, the sales order, and the shipping
document before recording the sale.
In some entities, when an order is received, the purchase order is sent to the
credit department for approval. The credit department’s decision is returned
to the order entry department. When the credit department has approved the
sale, a multipart sales invoice is prepared. One copy serves as a shipping
order, another as the bill of lading, and another is sent to billing. The sale,
however, is not recorded (entered in the sales journal) until the bill of lading
is received by billing.
b. Before goods are shipped, the customer’s credit must be approved. The credit
department maintains a list of unauthorized customers and their credit limits,
which an employee must review to determine whether to accept an order. A
credit department employee signs a copy of the sales order authorizing the
credit sale. When an order is received from a prospective customer not on the
list or when a customer has exceeded the authorized credit limit, the credit
department generally conducts a credit investigation and makes a decision to
accept or reject the order. When the order is accepted, a copy of the sales
order is sent to the warehouse and a copy is retained in the credit department.
c. On the basis of the sales order approved by the credit department, warehouse
personnel issue goods to the shipping department. The accounting
department, rather than warehouse personnel, maintains perpetual records for
the inventory.
d. The shipping department verifies that the goods received from the warehouse
to be shipped agree with the quantity and description of goods on the sales
order. The shipping department then packs the merchandise, arranges
transportation with a common carrier, and prepares a shipping document.
The shipping document is a multicopy document that lists the items, gives
instructions to the common carrier as to whom and to what the address to ship
the merchandise, and may serve as a packing slip for the merchandise.
Copies of the shipping document are given to the carrier, and copies are sent
to the billing department. Sometimes entities use a bill of lading as a
AuditoftheRevenueandCollectionCycle: TestsofControlsandSubstantiveTestsofTransactions 3-3
shipping document; it may include a general description of the goods and a
quantity or number of pounds.
e. Billing involves notifying the customer (by means of an invoice) of the
amount due for the goods or services delivered. The billing function is
typically performed by a section of the accounting department and should be
independent of sales executives. Billing personnel should (1) account for the
sequence of shipping documents to determine that all shipments are billed, (2)
compare the details included on the sales order with the shipping documents
to serve as an independent check on shipping, (3) prepare the sales invoice
from data on the shipping document and sales order, (4) price the invoice by
reference to an authorized price list obtained from the sales department, (5)
extend and foot the invoices, and (6) account for the sequence of sales orders
and shipping documents to ensure that all sales are recorded.
Some entities prepare a turnaround document simultaneously with the sales
invoice. A turnaround document is a form the customer mails back to the
merchandiser, along with payment of the invoice that facilitates handling and
processing of cash receipts. It contains information, such as the customer’s
name and account number, and a place to indicate the amount of the payment.
Prior to mailing, each invoice should be reviewed by a person not involved in
its preparation. The review should cover the propriety and accuracy of prices,
extensions, footings, credit terms, and freight charges. The billing
department should develop a total of sales invoices and submit it directly to
the clerk responsible for maintaining the accounts receivable control account.
The accounts receivable subsidiary ledger clerk or data processing department
prepares the sales journal and posts debits to individual accounts in the
accounts receivable subsidiary ledger. Subsequent reconciliation of the
accounts receivable subsidiary ledger to the accounts receivable control
account is an important aspect of internal control. Shipping documents are
used by accounting to update perpetual inventory records when they are
maintained.
f. One of the best controls over cash receipts is a lockbox system in which
customers mail their remittances to a post office box controlled by a bank.
The bank’s bonded employees obtain the mail from the post office box, make
a listing of the amount by customer, mail the remittance advices and a copy of
the list to the business, and deposit the cash. When mail containing
remittances comes directly to the entity, the first step in the control process is
to obtain a listing of the cash and checks. This listing is generally prepared
by a receptionist or a mailroom employee designated to open mail. However,
the person should have a high level of integrity and not be otherwise involved
in handling cash or maintaining accounts receivable records. The listing of
cash receipts, referred to as a prelisting, serves to establish control over cash
receipts. Remittance advices are prepared if necessary, and when the listing
3-4 Solutions Manual to Accompany Applied Auditing, 2062 Edition
has been prepared, the cash and remittance advices are separated. The cash is
given to the cashier to prepare the bank deposit, and the remittance advices
are given to the accounts receivable clerk for preparing the cash receipts
journal and updating the accounts receivable subsidiary records. The
employee preparing the prelisting also develops a total of cash receipts to
send directly to the accounting department supervisor, who maintains control
over the general ledger accounts.
g. A business issues a credit memo when a customer returns merchandise or
when a price adjustment is allowed. Credit memo authorizations should bear
the signature of an employee with authority to issue a credit memo and should
be based on a receiving report when merchandise has been returned, or on
correspondence between the sales department and the customer when a price
adjustment has been authorized.
h. The allowance for uncollectible accounts expense is the result of an adjusting
entry, which should be approved by the controller or chief accountant. Any
entries recording uncollectible accounts expense should bear the written
authorization of the controller.
i. After exhausting all reasonable efforts to collect accounts, businesses should
write off accounts judged to be uncollectible. Frequently, accounts are
written off after the customer declares bankruptcy. Accounts written off
should be transferred to a separate control account, and statements should
continue to be sent to those debtors in an effort to collect the account.
3-6. a. A merchandiser prepares a shipping document that includes the name and
address of the customer and a description of the goods. The document is a
contract between the seller and the carrier and is signed by the carrier when it
accepts the goods. Businesses often use a bill of lading as a shipping
document. The document may be a copy of the invoice or a delivery ticket.
The signature of the carrier on the shipping document provides externally
created evidence that a sale has occurred. Accounting for the numerical
sequence determines that all shipments are recorded as sales.
b. A customer attaches a remittance advice to a check in payment of an invoice.
The document may be a turnaround document, a part of a check, or a
statement identifying the invoices being paid. Remittance advices facilitate
recording cash receipts. If a customer does not return a remittance advice, the
employee opening the mail usually prepares one. A remittance advice
indicates the date and amount of payment and the invoices paid. Remittance
advices are separated from cash and given to the accounts [Show Less]