Solutions for Chapter 7 Audit Evidence: A Framework

Review Questions: 7-1. Audit evidence is all the information used by auditors in arriving at the conclusions on which the audit opinion is based. The basic sources of evidence are knowledge of the business and industry, analytical procedures, tests of controls, and direct tests of account balances and transactions. The auditor must decide how much evidence is needed e!tent", what kind of evidence is needed nature", and when to gather the evidence timing". The assertions form the framework for gathering sufficient, competent audit evidence as re$uired by the professional standards. The assertions tie into generally accepted accounting principles in that those assertions are also embodied in %AA&. The five main assertions are defined as'
Existence/occurrence. The assets, liabilities, and e$uity interests e!ist and all transactions reflected in the financial statements actually occurred. Completeness. All assets, liabilities, e$uity interests, and transactions that should have been recorded have been recorded, i.e., nothing is left out of the financial statements. Rights/obligations. The entity holds or controls the legal ownership to assets, and liabilities are legally owed by the entity. Valuation/allocation. Assets, liabilities, and e$uity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation ad(ustments are appropriately recorded. Presentation/disclosure. Assets, liabilities, and e$uity interests are appropriately classified on the financial statements, and are ade$uately described in the footnotes to the financial statements.

7-2. 7-#.

7-).

*aluation is usually one of the most important assertions to address in most audits. The intent of this $uestion is to have the students think about the detail re$uired by %AA& in forming specific assertions to be tested with individual accounts. The basic components of the valuation assertion for investments in marketable securities are these' The securities are initially recorded at cost and are thereafter valued at market. +ost includes all costs, including brokerage fees, to purchase the securities.

7-0

,arket is' o -efined as aggregate market value determined either by classes of securities or treating all securities as one class. o ,easured by year-end market prices, assuming a li$uid market such that sales of the securities would not have a ma(or impact on market value. All gains.losses due to sales during the current period are properly reflected in the accounts. +arrying values of marketable securities sold are removed. All ad(ustments re$uired for the unreali/ed ad(ustments to market value are properly recogni/ed.

The basic characteristics that distinguish the reliability of audit evidence are' More reliable in ormation -irectly observable evidence 1vidence derived from well controlled information system 1vidence from independent outside sources -ocumented evidence 2riginal documents !ess reliable in ormation 3ndirectly observable evidence 1vidence derived from a poorly controlled system or easily overridden information system 1vidence from within the client4s organi/ation *erbal evidence &hotocopies or facsimiles

7-5.

Audit risk and reliability of audit evidence are related. 3f audit risk is low rather than high, it implies that the auditor has to gather more evidence of the same $uality, more reliable evidence, or some combination of each. 6or e!ample, if audit risk has been established at a minimal amount because the auditor is concerned with overstatement of sales and accounts receivable, the auditor may seek more persuasive evidence such as subse$uent payment of a receivable, direct contact with the customer by the auditor, or verification of invoices by direct reference to shipping documents as opposed to only a confirmation of the account balance sent to a customer address at a post office bo! number". The auditor would be seeking more reliable evidence. 3n other situations, the auditor would control audit risk by taking larger sample si/es that statistically control the risk of making an incorrect inference as a result of the audit tests.
An audit ad(ustment is a correction of a misstatement of the financial statements that was or should have been proposed by the auditor, whether or not recorded by management, which could, either individually or when aggregated with other misstatements, have a material effect on the company7s financial statements.

7-7.

The &+A28 re$uires that auditors document audit ad(ustments, both proposed and recorded, so that there is a record of important issues that the auditor considered and was concerned about during the conduct of the audit. 3n fact, auditors are re$uired to discuss audit ad(ustments with the audit committee, so documentation helps establish a record of complying with the re$uirements regarding audit committee communications. 3f an audit is reviewed upon inspection by the &+A28, documentation regarding proposed ad(ustments, especially those that management refused to book i.e., reflect in the ad(usted financial statements", would shed light on the areas that were the most contentious and (udgmental in terms of financial reporting and disclosure. 8y evaluating ad(ustments in a given year, and especially in a pattern over time, the &+A28 can get a sense of how aggressive management is in its financial reporting choices and how the auditor responds to management.

7-9.

All things being e$ual, e!ternal documentary evidence is considered more reliable than internally generated evidence. :owever, it is seldom that ;all things are e$ual;. 1!ternal documentary evidence is generally more reliable when provided by independent, knowledgeable e!ternal parties. 1!amples of e!ternal documentation are original vendor invoices that are in the client4s possession and confirmations sent directly to the auditors by third parties. 3nternal documentary evidence can be very reliable when it is developed within a strong internal control environment. 1!amples of internal documentation are sales invoices, receiving reports, payroll records, and purchase orders.

7-<.

-irectional testing is the design of audit tests to search primarily for either over-or understatements for particular accounts. 3t takes advantage of the double entry bookkeeping system. The auditor is normally concerned with overstatement of assets or revenues and understatement of liabilities or e!penses because there are greater risks associated with misstatements in those particular directions. -irectional testing can lead to audit efficiency because audit tests of an account in one direction provide evidence on other related accounts. An e!ample is auditing accounts receivable for an overstatement, which also provides indirect evidence on the potential overstatement of sales. 1fficiency comes from planning the audit to consider the relationships among a number of different accounts.

7-1=. The efficiency of directional testing comes from the double entry method of bookkeeping. 3f an asset increases, it must come from the recognition of revenue, the decrease of another asset, a misclassification of an e!pense item as an asset, or an increase in a liability. Thus, testing an asset for overstatement can provide information on potential understatement of another asset or e!pense or overstatement of revenue or a liability. "ccounts receivable example. Testing for overstatements provides evidence on overstatement of sales and understatement of e!penses. 3f Accounts >eceivable is overstated because of fictitious sales, sales are also overstated. 3f receivables are overstated because of an inade$uate allowance for doubtful accounts at year-end when

the allowance for bad debt is increased the corresponding debit belongs to 8ad -ebt 1!pense, thus providing evidence on potential understatement of the related e!pense account. #nventor$ example. Tests of overstatement of inventory provide indirect evidence regarding overstatement of revenues or liabilities and direct evidence regarding understatement of e!penses. 3f inventory is misstated, the corresponding entry is to +ost of %oods ?old. 3f inventory is overstated because of recording the receipt of inventory before title passes, accounts payable will also be overstated. 3f ending inventory is overstated because inventory was sold but the entry to record the cost of goods sold was not made, +ost of %oods ?old is understated. The evidence on revenue is more indirect. 3f the tests indicate that cost of goods sold represents only 00 percent of sales this year, but it had previously been over 5= percent let7s say for the last five years" and there is no ma(or change in product mi! or production technology, the tests may indicate potential fictitious sales. The auditor7s evidence is based on an analytical reasoning process. 7-11. 2bservation is best suited for testing the e!istence assertion, e.g. the e!istence of inventory and the ade$uacy of the client4s physical inventory count procedures can be observed. 3t may be indirectly useful in helping test some valuation assertions. 6or e!ample, the auditor can observe the $uality of inventory and make reasonable inferences about the value of inventory. 2bservation is strong evidence when physical e!istence is important. :owever, it is weak because observation can lead to misleading inferences. 6or e!ample, observing that an ob(ect e!ists does not warrant the inference that it is owned by the company. ?imilarly, observing an item in good shape does not mean that it is properly valued because it could still be technologically obsolete or be assigned the wrong unit cost. 7-12. 3n$uiries of management are sub(ect to management bias and seldom can be used without corroborating evidence. The strength of management responses must also be tempered by the auditor4s evaluation and assessment of the integrity of management and the potential motivation to misstate an account balance. ,anagement representations are best suited to situations covering management intent, or gathering corroborating evidence on valuation and e!istence issues, for e!ample, intent related to the use of marketable securities trading, available for sale or held to maturity", refinancing long-term debt, and the collectibility of a receivable. :owever, representations of the latter sort must always be corroborated by outside evidence. :igher risk situations should lead the auditor not to rely on management representations. 7-1#. 3n order to answer this $uestion, the student must identify the attributes of paper evidence that seem to make it more reliable. ?ome of these attributes might include' +lear identification of approval 1asy to identify modification of record 1vidence might e!ist outside of client4s system, for e!ample, in vendor4s files 1vidence may have been created from outside the client4s system

3n virtually every case, the same attributes can be built into a well-designed computeri/ed information system. 3f the client has strong access controls to minimi/e the possibility of unauthori/ed addition, deletion, or modification of electronic documents and if electronically stored information contains the same attributes as those described above, it should be reasonable to assume that the information would be as reliable. 7-1). >eprocessing is an e!tended form of recalculation and begins with an initial source document and traces the document through the full recording process, including the appropriate (ournali/ing and the posting of transactions to accounts as well as verifying the accuracy of mathematical calculations. >eprocessing addresses the assertion that all existing transactions are properly recorded completeness". *ouching is complementary to reprocessing. *ouching involves taking a sample of already recorded transactions and tracing them back to their original source, usually a source document. *ouching addresses the assertion that all recorded transactions are valid occurrence". 8oth assertions are important to the overall audit process. ?imply performing reprocessing will not tell the auditor whether fictitious transactions might e!ist in the account. ?imilarly, vouching tells the auditor about transactions that have been recorded but provides no evidence to ensure that all transactions got recorded. 7-10. There are two reasons to seek additional corroboration to the e!ternal documentation obtained from the client' 1" because the documentation is obtained from the client, it is sub(ect to modification and 2" more important, the e!isting documentation may not answer all the important $uestions the auditor needs to address in evaluating contingencies or other related accounts. 7-15. +onfirmations are a form of testimonial evidence and therefore the assumptions that underlie testimonial evidence also apply to confirmations, which are whether' The confirmations will receive a conscientious review and response from the individual from whom the confirmation is re$uested. The respondent is knowledgeable and has a sufficient basis on which to respond to the re$uest. The respondent is being asked to confirm information they can independently confirm. The respondent is not biased toward giving a particular response i.e., does not stand to benefit from a particular response". The party receiving the confirmation re$uest is likely to respond to it.

7-17. There are a number of reasons to believe it is more efficient to test account balances at year end rather than testing the related transactions throughout the year. :owever, it is not always the case that this will be true -- or likely be true in an 1-3 environment. 3t is generally easier to test most balance sheet accounts at year end because there are usually

fewer items in the ending balance than there are transactions that have taken place during the year. 6urther, reliable evidence generally e!ists to facilitate the direct testing of the account balances. 6or e!ample, it is easier for the auditor to test ending inventory by observing the physical count and making test counts or to send confirmations or review subse$uent payments as evidence of the overall validity of the accounts receivable yearend balance than to test all of the transactions related to those accounts. The advantages of testing account balances at year end may change in heavily integrated systems, such as 1-3 systems. @ear end data may not e!ist in an independent form that provides the strength of evidence generally sought by auditors. 6urther, both auditors and management may find they need to test the systems throughout the year to ensure they are operating correctly. Thus, auditors may be able to attest to a company4s financial position by testing the process leading to the financial statements. 7-19. There are three primary purposes of audit programs' They provide evidence of audit planning They provide guidance to the audit team They are used to help monitor the progress of the audit. 7-1<. There are three basic factors for must be considered in developing an audit program. 6irst, the auditor assesses the risk of material misstatement and determines how much testing of internal controls needs to be performed and how much substantive testing of account balances should be performed. The ne!t factor to consider is the materiality of the account balance and of the items that make up that balance. The third factor is the relevant assertions that need testing. 7-2=. Audit documents record the work performed by the auditor. They document the items sampled, the work done, the conclusions reached, the auditor performing the tests, the date completed, and the auditor7s assessment of potential misstatements in the account balance or transactions tested. A well-developed audit document contains' A heading that includes the name of the audit client, e!planatory title, and the balance sheet date. The initials of the auditor performing the audit test and the date it was completed. The initials of the senior, manager, or partner who reviewed the document and the date the review was completed. A description of the nature of the test performed and the findings. An assessment of whether the test indicates the possibility of material misstatement in an account. This represents the auditor4s conclusion. Tick marks and legend indicating the nature of the work performed by the auditor. An inde! to identify the location of papers. A cross reference to other related documents, when applicable.

7-21. @es, a memo e!plaining the auditor7s conclusion and rational is an audit document. The auditor7s reasoning process is a critical part of the process of evidence evaluation and

written information e!plaining it should thus be included as part of the audit documentation. 7-22. To answer this $uestion, the student must think through the characteristics that the auditor is looking for in paper documentation. 6or e!ample, the auditor needs to know that a purchase order has been properly approved, is written to fill a re$uest or a production schedule, and is issued to a vendor as the result of a contractual agreement or competitive bid and therefore reflects competitive prices for the $uality of goods needed by the organi/ation, and that shipments of goods are received only if they are in accordance with its terms. The major implication is that the auditor will have to determine if the client has sufficient controls to ensure that the same characteristics are retained in automated purchase orders, or other similarly computerized documents. The likely implications are that the auditor will focus more attention on the controls used by the organi/ation to restrict access to the purchasing component of the information system to those authori/ed to commit the organi/ation to a purchase and on the process by which authori/ed personnel initiate the purchase documents. A blanket, computeri/ed, purchase order is authori/ed by personnel who initially determine that automatic reorders ought to be generated whenever $uantities reach a specific level or whenever an approved production plan dictates the need for more inventory. The auditor will likely focus more testing on the computer system by evaluating the design of the purchasing application program and by submitting test data to determine whether it processes transactions as dictated by the application documentation. 7-2#. The concept is that the audit documents contain the evidence that the audit was conducted in accordance with generally accepted auditing standards including documentation of the planning process, the audit evidence gathered, the auditor7s conclusions regarding that evidence, the reasoning process utili/ed by the auditor in reaching conclusions regarding the sufficiency of the audit and the conclusions thereof, and the conclusions of the audit. The documents are like a complete ;book; of the audit. As such, it should be possible for anyone reviewing the documents to be able to read the ;book; without the aid of a ;storyteller; the auditor". 3t is also critical that the audit documentation be complete and show the audit was conducted with due professional care in case the audit is challenged in a liability case. 7-2). 1stimating an account balance through reference to outside data or other information gathered from outside the accounting system would be reliable when the following conditions are met' The auditor has evidence that the outside data are reliable The outside data are not influenced, or cannot be influenced, by management There is a direct logical link between the data and the account balance being estimated. 7-20 3t may be a challenge for auditors to react negatively toward companies4 preferences to reduce reserves because the components of those reserve accounts, and the estimates used

to determine an AappropriateB ending balance are sub(ective and (udgmental. 3t is also important to stress to students that it can also be a challenge to stand up to management when they wish to increase reserve accounts i.e., thereby setting up Acookie (arB reserves" because management may argue that they are (ust being AconservativeB. 3f the auditor argues against client management setting up the cookie (ar reserves in the first place, but ultimately allows management to do so, management may then argue later when they wish to tap into the reserves to bolster sagging income" that the auditor was right in the first place and say that they, management, are (ust doing what the auditor wanted them to do all along. The basic point to make is that auditors need to develop their own independent estimates and steadfastly adhere to what they believe is appropriate valuation. 3f they do not, they may be sub(ect to subse$uent game playing by management. Multiple Choice Questions: 7-25. 7-27. 7-29. 7-2<. 7-#=. 7-#1. 7-#2. 7-##. 7-#). b. a. a. b. ?ee solution 7-1= for related discussion" c. c. c. d. d.

%iscussion and Research Questions: 7-#0. a. Audit Assertion 1!istence all recorded payables e!ist". +ompleteness All e!isting payables are recorded". b. Audit 1vidence and &rocedures 1!amine documentation supporting accounts payable detail at the balance sheet date, e.g., vendor7s invoices and monthly statements". 1!amine a sample of payments made after year-end to determine whether they should have been recorded as a payable. 1!amine all open items items not yet recorded but for which documentation has been received" at year-end to determine whether they should be recorded as a payable. >econcile ma(or vendor monthly statements or confirmations with recorded accounts payable. &erform analytical procedures on ma(or e!pense accounts to determine whether there is any evidence that the

a. Audit Assertion 1!istence all recorded payables e!ist".

b. Audit 1vidence and &rocedures 1!amine documentation supporting accounts payable detail at the balance sheet date, e.g., vendor7s invoices and monthly statements". e!pense accounts might be understated in comparison with previous years. &erform a cutoff test using receiving reports of items received (ust before year end that should be recorded as payables according to the shipping terms.

>ights.2bligations Amounts recorded represent legal or business obligations of the organi/ation". *aluation Accounts payable is properly valued according to %AA&". &resentation and disclosure The account is properly classified and any contingencies are disclosed".

>eview invoices, etc., in connection with the first two assertions to determine that the client has actually received the goods or services by year end and thus has a legal obligation for payment. ,ost of the procedures in connection with the first three assertions establish the valuation. 1!amination of payments and invoices should determine the correct amounts at which the liability should be recorded. >eview documents to determine whether any of the payables carry purchase commitments that ought to be disclosed. >eview financial statements and footnotes for ade$uate disclosure.

c.

-esignating the company high risk because of the items in the scenario renders less reliable the first two procedures identified for the completeness assertion. There is no evidence that the client will pay all its obligations on a timely basis, and management might be motivated to systematically understate its obligations. Therefore, more evidence from the last two procedures for testing completeness will be needed. The auditor should reconcile with recorded accounts payable the monthly statements or confirmations from all ma(or vendors and, perhaps, a sample of the other vendors, as a basis to determine whether all trade payables have been properly recorded. The auditor should also perform analytical procedures on ma(or e!pense accounts to determine whether there is any evidence that the e!pense accounts might be understated in comparison with previous years. 3n addition, the auditor should perform a more e!tensive cutoff test using receiving reports of items received (ust before year end that should be recorded as payables according to the shipping terms.

7-#5. a. 1 2 # ) 0 5 7 9 < 1 = "ccount &alance "ssertion 1!istence A.>, ?ales C +2%?" +ompleteness 3nv" +ompleteness 3nv C A.&" +ompleteness 1!pense" 1!istence Asset" +ompleteness Diability C Doss" 1!istence A.>, ?ales C +2%?" +ompleteness 3nv" +ompleteness Eage 1!p. C ?alaries &ayable" +ompleteness +ash C A.&" 1!istence +ash" +ompleteness A.>" +ompleteness Deased Asset C Dease 2bligation" 1!istence Dease 1!pense" +ompleteness Amorti/ation 1!pense and 3nterest 1!pense" *aluation A.> C ?ales"

b. >ecording 628 destination sales would be acceptable to the auditor if that policy is followed consistently from year to year and the amount of such sales near year-end is fairly consistent. 3n that case, net income is not significantly affected, but accounts receivable and retained earnings will be overstated. >etained earnings will be overstated when this policy is first implemented and will carry forward to subse$uent years. c. 3tems 1 and 0 affect net income by the amount of the gross margin. 3tems 2, 7, C 9 affect only the balance sheet. 3tems #, ), 5, C 1= affect net income by the total amount of the transaction.event.error. 3tem < affects net income by the difference between lease e!pense and the total of amorti/ation and interest e!pense. 3f the company takes a physical inventory at the end of the year and then ad(usts the account balances to the physical count, then any of the inventory misstatements could affect reported income. 6or e!ample, on item 2, the company has received the goods but has not recorded either the inventory or the payable. The company has understated both assets and liabilities and there would apparently not be an income effect. :owever, if the company counts the inventory because it is on hand, and then ad(usts the inventory to what is on hand, the company would be making the (ournal entry below' 3nventory +2%? F !!,sss.oo F !!,sss.oo

Thus, if the company takes a formal inventory count, there will be a profit effect for all inventory that is not recorded appropriately.

7-#7. Procedure 2bservation 'ow (sed )examples* 2bserve client personnel taking a physical inventory. &hysical &hysically e!am selected inventory 1!amination items. 3n$uiry Ask whether there is any inventory 1. in on consignment, 2. out on consignment or stored in public warehouses, #. that is obsolete or slow moving. +onfirmation +onfirm inventory out on consignment or in a public warehouse. 1!amination of Analy/e sales.purchase contracts for -ocuments any special terms. >ecomputation >ecalculate $uantity times unit cost and foot the file. >eprocessing ?elect receiving documents near year end and trace to inventory records *ouching Trace a sample of inventory costs to vendor invoices. Analytical +alculate inventory turnover and &rocedures number of day4s sales in inventory. 7-#9. Evidence 1. *endor invoices a. Classi ication 1!ternal b. Reliabilit$ ,oderate to high :igh ,oderate depends on conditions under which generated" c. "ccount &alance , "ssertion 3nventory and e!penses' *aluation, completeness, rights C obligation Accounts &ayable' 1!istence, valuation, completeness, obligation ?ales and Accounts >eceivable' *aluation and completeness 1!penses cost of goods sold"' *aluation, completeness "ssertion)s* +ested +ompleteness, 1!istence, *aluation 1!istence, *aluation 1. >ights 2. +ompleteness #. *aluation 1!istence, +ompleteness, *aluation, >ights *aluation, 1!istence, +ompleteness *aluation +ompleteness *aluation, >ights *aluation

2. *endor 1!ternal monthly statements #. ?ales 3nternal invoices

). ?hipping 3nternal client3nternal' ,oderate ?ales and receivables' documents generated 1!ternal' :igh completeness, e!istence, for sales documents, e.g., valuation. packing slips", 3nventory' 1!istence and e!ternal bill of lading from independent trucking firm" 0. 8ank 1!ternal but :igh, but sub(ect to +ash' 1!istence, ?tatements usually obtained downgrade because it is completeness, valuation, from client" usually obtained from client rights 5. 1mployee 3nternal payroll time cards 7. >eceiving 3nternal reports for generated as goods the goods are received received" from vendors 9. ?ales +ontracts ,oderate to high. Although Eage e!pense' 2ccurrence, internal, it is influenced by a valuation completeness. number of dependent factors. Eages payable' 1!istence, valuation, completeness ,oderate depends on the 3nventory' 1!istence, $uality of controls and completeness, valuation to independence of the the e!tent it properly receiving function from identifies items received" other activities" ?ales' *aluation +ontingencies' 1!istence and disclosure

3nternal. e!ternal, :igh, if signed and may be authenticated by both parties generated internally, but contain signatures and other authentication of legal documents <. &urchase 3nternal.1!ternal :igh, if signed and +ommitme similar to sales authenticated by both parties nt contracts +ontracts identified above" 1=. Dease 3nternal.1!ternal :igh, if signed and agreesimilar to sales authenticated by both parties ments and purchase contracts identified

+ontingent liabilities' 1!istence, valuation, disclosure. 3nventory' *aluation. +apitali/ed lease assets C obligations' 1!istence, valuation, obligation +apitali/ed lease assets'

above" 11. 1stimated 3nternal Earranty ?chedules

,oderate to low depending on conditions under which prepared and availability of Earranty liability' independent data to support +ompleteness, valuation, schedule" disclosure ?ales' valuation. Accounts receivable' valuation.

1!istence, valuation, rights, disclosure Earranty e!pense' *aluation

12. &urchase order stored on client computer and received by 1-3

1#. +redit >ating >eports 1). *endor 3nvoice

1!ternal, but since :igh, but only if auditor is it is stored on able to determine that the the client4s data cannot be sub(ect to computer, it is management manipulation potentially or alteration. 3f not, the sub(ect to auditor must assess the manipulation reliability as low. and should be treated as internal unless the auditor can establish that the information is safe from client manipulation. Gote the same is true for an e!ternal document found in a client file. 1!ternal ,oderate to high. 1ven though e!ternal, there have been $uestions about the $uality of the companies providing the service. 1!ternal :igh, but only if auditor is able to determine that the data cannot be sub(ect to management manipulation or alteration. 3f not, the auditor must assess the reliability as low

Accounts or loans receivable' *aluation

3nventory rights and valuation, accounts payable e!istence and valuation

7-#<. a. +onfirmations are generally considered more reliable than in$uiries of the client because they represent independent evidence generated from outside the organi/ation and are thus free of bias that may affect responses to internal in$uiries. The opposite holds true when the respondent 1" has a bias towards a particular type of response, 2" does not have sufficient knowledge to render a meaningful and independent response, or #" does not take sufficient care to develop a meaningful response. +onfirmations would not be reliable when the response is not relevant to the assertion being tested. b. 1!amples of >eliable and Dess >eliable 1vidence 1!amples of Dess >eliable 1vidence An accounts receivable confirmation from a residential customer of a local electric utility *isual inspection of the electronics or other hightech e$uipment. ,anagement7s schedule of the book value of e$uipment ac$uired as part of an ac$uisition, ad(usted for a market rate of inflation

1!amples of >eliable 1vidence Accounts receivable confirmation response from a ma(or customer who has a long history of doing business with the client and has a reputation for outstanding controls 3ndependent testing of the $uality of electronics or other high-tech e$uipment >eview of an independent, certified appraisal as to the values to be assigned to property, plant, and e$uipment as part of an ac$uisition

+omparison of previous years data on a +omparison of previous year4s data as a basis for company that had been audited for estimating e!penses on a first-year audit the last 1= years as a basis for client that had never been audited before. estimating the likelihood that miscellaneous e!penses might be misstated >eview of invoices to determine the price of ,anagement7s schedule of construction costs to e$uipment purchased. make an addition to an e!isting factory. The characteristics that distinguish between the reliable and less-reliable audit evidence include' 3ndependent, outside, ob(ective documentation, such as vendor invoices versus management7s schedule without further testing" of construction cost

c.

The ability of a third party to generate a meaningful response to a confirmation re$uest. The likelihood of a meaningful response is related to the third party7s independence, e!istence of a good control structure, and an information system from which to generate data to respond to the re$uest. >eliability of data used as a basis for making a pro(ection utili/ing analytical procedures. &reviously audited data are more reliable than similar data that had never been sub(ected to audit testing. 3ndependent appraisal information from certified appraisers as opposed to internally generated and potentially biased" management estimates.

&hysical e!amination is considered strong evidence because the auditor directly obtains the information. The auditor does not have to rely on an intermediate party or on documents that could be altered by the client. The evidence is limited, however, in that it does not address many assertions. 3t is difficult to tell whether an inventory part, for e!ample, is really obsolete without gathering sales data e!cept in the rare cases in which goods are visibly damaged, dusty, or in some state of disrepair". &hysical e!amination of inventory is of limited use when the auditor does not have the e!pertise to identify the products, such as auditing (ewelry, petroleum products, or advanced electronic e$uipment. The auditor would have difficulty determining whether a product was fully operational or whether there was only a ;shell; present without developing some means to independently test the products.

d.

+haracteristics of internal documentation that would likely lead the auditor to evaluate its reliability as high would include' -ocumentation developed as part of a strong control system, with sufficient checks and balances and supervisory review that the auditor has a strong sense that errors or fictitious documents would be prevented or detected Dack of strong economic incentives for management to develop fictitious documents or to manipulate the financial reporting system to overstate income. 3nternal checks on the evidence that e!ist outside the accounting system so that misstatements or errors in the documents would be discovered. 1mployees, for e!ample, are likely to follow-up on any mistakes in recording their weekly or monthly paycheck. -ocumentation sub(ect to review by parties outside the organi/ation or outside the department that originally developed the documentation strong segregation of duties". -ocumentation reviewed by internal legal counsel or to which outside parties are also signatories. The validity of the documentation easily corroborated by the auditor.

e.

Analytical procedures and tests of details are both aimed at detecting misstatements in an account balance. Analytical procedures are effective in determining potential misstatement of an account balance either overstatement or understatement". Tests of

details are primarily oriented to providing information to determine whether an account is overstated. Tests of details are considered to be more reliable because the auditor is e!amining detailed documentation and other evidence in support of the account balance. The auditor can statistically select items to e!amine and draw statistical inferences about the results. 2n the other hand, analytical review procedures depend heavily on the plausible relationships established in the analytical model and the $uality of the independent data used to make the estimates. f. Analytical procedures are particularly effective in two situations' 1. There is a logical relationship between the account being estimated and some other account being audited. The data from the audited account can be used directly to estimate the account being tested by the analytical procedures. 2. The account, particularly liability accounts, may be understated. 3t is often difficult to test the completeness assertion if the client does not have strong controls to ensure that all transactions are recorded. Analytical procedures can be effective in pointing to the possibility that material amounts are not recorded. Analytical procedures can also be effective in identifying situations in which relationships between accounts don7t seem to be logical. 8y identifying such relationships in which an account appears to be either over- or understated, the auditor can systematically go through a process of hypothesi/ing the most likely cause of misstatement and then go about testing the most likely e!planations in order. 8y focusing on the most likely e!planations of une!pected results, the auditor can test in a most efficient manner. g. ?ituations in which an auditor might use recomputation would include' 1. Testing e!tensions on inventory price by $uantity e$ual e!tended cost". 2. 6ooting various files or detail of accounts to determine whether they agree with the amount recorded in the general ledger. #. >ecomputing the detail of sales invoices, including the e!tensions, totals, and amount of sales ta! liability. ). >ecomputing employee pay and withholding amounts. 0. >ecomputing the client7s estimate for doubtful accounts or warranty liabilities. 3t is important that recomputation take place because it is the only way to ensure that an account balance is presented correctly. 6or e!ample, audit work that determines that inventory is correctly priced and includes the right $uantities does not substantiate the amounts included in the balance sheet until the auditor tests e!tensions and foots the account. The auditor-prepared spreadsheet can be either a recomputation or an independent estimate. 3t could be used as a recomputation if the auditor submits the client7s estimated data to be run by the spreadsheet. 2n the other hand, the auditor could use the

spreadsheet and independently generated data to make an independent estimate of an account balance that could be compared with the client7s estimate of the account balance. 7-)=. a. >elationships between accounts' "ccount "udited 1. ,arketable 1$uity ?ecurities a -. Related "ccount a .. "udit Relationship and Evidence -ividend income 3nvestment securities have dividend terms that can be verified by e!amination of a standard dividend-reporting service. %ain or loss on sale of %ains or losses on sales can be verified as part securities of the audit process of identifying current ownership and valuation of the securities. Hnreali/ed gain or loss The analysis to determine the year-end market on securities. ad(ustment leads to a debit or credit to the unreali/ed gain or loss account if any entry is needed". 2. 8ond &ayable 3nterest e!pense, including proper amorti/ation of discount or premium An amorti/ation schedule can be established when the liability is recogni/ed. 3nterest payments are specified by the bond terms. A microcomputer spreadsheet could be set up to calculate total interest e!pense associated with the liability for the life of the bond. -epreciation schedules are established when the property is ac$uired and can be verified by recomputation. 2nce depreciation has been established, the auditor can estimate the current year7s depreciation by taking previous depreciation and ad(usting for additions new e$uipment" and disposals. -epending on the use of accelerated methods and age of e$uipment, such estimates can be $uite accurate. ). 1$uity ,ethod 3ncome from 1$uity 3nvestments 3nvestments The client will record its share of the investee4s income or loss as an increase.decrease in the investment account and as income.loss on the income

#. &roperty, plant, and e$uipment

-epreciation and accumulated depreciation.

"ccount "udited

a -. Related "ccount a .. "udit Relationship and Evidence statements. The best evidence is audited financial statements of the investee.

0. +apitali/ed Deases 5. +apitali/ed Dease 2bligations

Dease Amorti/ation 3nterest 1!pense

?imilar to goodwill amorti/ation described above. An amorti/ation schedule can be established when the lease is capitali/ed. The process of capitali/ing the lease generates an interest rate to be used as part of the amorti/ation of the lease obligation. A spreadsheet can be developed and carried forward for each audit. 1stablishment of the note results in a stated interest rate as for bonds" that can be used to estimate interest rate e!pense for each period. The Earranty 1!pense account is normally debited for all warranty work performed during the year and is then ad(usted for changes in the liability account at the end of the year.

7. Gotes &ayable 3nterest 1!pense

9. 1stimated Earranty Diability >eserve" <. &referred ?tock

Earranty 1!pense

&referred -ividends &referred -ividends specifically provides for including dividend stated dividends that can be used to e!pense for calculate actual payment of dividends or redeemable calculate dividends in arrears. preferred stock".

b. 3t is generally easier to test balance sheet accounts at year-end because there are fewer items that make up the account balance than there are transactions affecting that balance and usually the asset and liability accounts have other outside sources of evidence that the auditor can use to test the account balances. 6or certain accounts, such as fi!ed assets, if the opening balances have been audited, the auditor will focus on the ma(or changes in the balance during the year. 7-)1. 1. Testing 3nventory for overstatement also tests 1" +ost of %oods ?old for understatement completeness" if inventory sold has not been charged to +ost of %oods ?old, 2" Accounts &ayable for overstatement e!istence" if inventory has been

added to the records that should not have been included, #" 3nventory ?hortage completeness" for inventory that is missing due to theft, and )" Tools or 2ther 6i!ed Assets for understatement completeness" due to a misclassification. 2. Testing >evenue for understatement also tests 1" Accounts >eceivable for understatement completeness" due to unrecorded credit sales, 2" +ash for understatement completeness" due to unrecorded cash sales, and #" Hnearned >evenue for overstatement e!istence" due to a failure to recogni/e earned revenue. #. Testing Accounts >eceivable for overstatement also tests 1" ?ales for overstatement e!istence" due to recording credit sales that have not taken place, 2" +ash for understatement completeness" due to failure to record a cash collection, #" ?ales Ta!es &ayable for overstatement e!istence" due to charging sales ta! to a ta! e!empt organi/ation, )" the Allowance for -oubtful Accounts for overstatement valuation" due to a failure to write off a known uncollectible customer4s balance, and 0" >eceivables from 2fficers and 1mployees for understatement completeness" due to misclassification. ). Testing Accrued ?alaries for understatement also tests 1" ?alaries 1!pense for understatement completeness" due to failure to accrue year-end salaries and 2" +ash for overstatement e!istence" due to failure to record the payment of salaries 0. Testing >epairs and ,aintenance 1!pense for overstatement also tests 1" &roperty, &lant, and 1$uipment for understatement completeness" due to e!pensing a cost that should have been capitali/ed and 2" another e!pense account for understatement completeness" due to misclassification. 5. Testing the ade$uacy of the Allowance for -oubtful Accounts also tests 1" 8ad -ebt 1!pense for understatement completeness" and overstatement e!istence", 2" Accounts >eceivable for overstatement e!istence" due to failure to write off uncollectible accounts, and #" +ash for understatement completeness" due to failure to record a collection of an account previously written off. 7-)2. +$pe o "udit Procedure a. Analytical procedures b. >eprocessing c. >ecomputation d. *ouching "ssertions +ested *aluation +ompleteness, *aluation *aluation 1!istence, *aluation

+$pe o "udit Procedure e. 1!amination of -ocumentation f. 1!amination of documents g. &hysical 1!amination h. 1!amination of documents i. +onfirmations (. Analytical &rocedure k. >ecomputation l. 3n$uiry of +ompany &ersonnel m. 3n$uiry of +ompany &ersonnel n. 2bservation o. 3n$uiry of +ompany &ersonnel p. 1!amination of -ocuments $. +onfirmations 7-)#. a.

"ssertions +ested 1!istence, *aluation 1!istence, *aluation 1!istence, *aluation *aluation, +ompleteness 1!istence, *aluation *aluation, completeness *aluation +ompleteness, -isclosure, *aluation -isclosure, *aluation +ompleteness, 1!istence, *aluation *aluation - but only indirectly +ompleteness, 1!istence, *aluation +ompleteness, *aluation, -isclosure

The auditor should initially evaluate the considerations pertinent to testimonial evidence, including whether' The in$uiry will receive a conscientious review and response The individual is knowledgeable and has a sufficient basis on which to respond The individual is not biased toward giving a particular response i.e., the individual does not stand to benefit from a particular response" The personal integrity of the individual responding 3n addition to these factors, the auditor should consider potential management motivation to be elusive or less than candid in its responses because of a motivation to make the results of either its department or the organi/ation as a whole look better than they actually were. The auditor should also consider the e!tent to which oral representations made by management can be corroborated through other evidence.

b.

1!amples of Testimonial 1vidence' Alternative ?ources or +orroborative 1vidence .. Corroborative Evidence 1. Gone

-. "lternative /ources o Evidence 1. ?ubse$uent payment of account balance by customer. >eview customer7s orders, invoices, and independent shipping documents evidencing shipment of items.

2. >eview and analy/e sales after year-end 2. >eview industry trade (ournals for economic to determine if there is any change in trend. data regarding industry as a whole and for an evaluation of company products. >eview recent sales and sales after year-end to determine whether they are made at lower or close-out prices. -iscuss prospects for the product line sales with sales manager or field representatives. >eview other business (ournals for analysis of company, its prospects, and products. >eview governmental correspondence if there is any evidence of product problems. >eview and analy/e merchandise returns to determine whether there is any apparent trend or problem with the product line. #. +onfirm intent with a management representation letter. >eview board of directors minutes to determine whether investments were approved as short-term or long-term investments significant long-term investments were likely approved by boardI short-term investments likely did not re$uire board approval". ). >eview correspondence from the 6ood and -rug Administration 6-A" verifying approval. 3f still $uestionable, confirm with the 6-A by sending a confirmation, or by contacting the 6-A directly. #. >eview past history of management actions to determine whether such securities have traditionally been treated as short-term investments.

). >eview for shipments of the product. >eview trade (ournals for any reports on the progress of 6-A approval for the product.

7-)). a. "ssertion b. Most Persuasive /ource o Evidence +ested 1. 1!istence and 1. +onfirming with the business organi/ation under the assumptions valuation of that receivables The business organi/ation has an information system that provides a better basis to ensure a knowledgeable response. The business is familiar with making such responses and recogni/es that it is part of business. The business generally is free from bias in making the response, which comes from the accounts payable department not from management. The above conditions are usually true, but it should be recogni/ed that they may not hold true across all businesses and thus it is a mistake to assume that business confirmations are always more reliable. 2" 3nventory turnover and sales analysis by product line are more reliable because visual inspection of electronic products yields little information either operationally or functionally, about the status of the product. The auditor needs sales data to better determine whether a product can be sold at e!isting sales prices for the $uantities on hand. *isual inspection provides direct evidence of the e!istence of the inventory whereas the analytical procedures provide only indirect evidence. #". 2bserving the counting of the client7s inventory is more persuasive because a" the auditor obtains the information directly including procedures utili/ed to gain assurance that inventory owned by the client is counted" and b" although the warehouse is independent, there have been $uestions about the conscientiousness with which they respond to such re$uests. 3n addition, some warehouses do not have strong control structures set up whereby they could easily respond to such re$uests. )". -irectly receiving a cut-off bank statement from the bank is the most persuasive because it contains information such as canceled checks for verifying the client7s year-end account balance ,ost auditors also confirm the year-end balance with the financial institution because they seek information regarding bank loans to

2" *aluation of inventory

1!istence of inventory #". 1!istence of inventory

)". 1!istence and valuation of the cash account

a. "ssertion +ested

b. Most Persuasive /ource o Evidence the client and other contingent liabilities. 8ut if the ob(ective is to test the e!istence and valuation of cash, the bank cut-off statement provides the most persuasive evidence.

0". 1!istence of inventory

0". &hysically e!amining the sheet metal is more persuasive because it is easier to identify, the $uality is usually stamped directly on the metal, and there generally are no ma(or obsolescence problems with sheet metal. The opposite of each item applies to the e!amination of sophisticated electronics e$uipment. 5". +onfirmation of the year-end bank balance is more persuasive. 6irst, a factual determination of the actual balance can be made. ?econd, the bank is an independent party with strong controls and regulation aimed at not misstating a client balance. 2n the other hand, although the outside legal counsel is independent, it is a client advocate and therefore its estimates may be affected by its optimism in effectively presenting the client7s case. 1stimates received from outside attorneys are more likely to reflect minimum losses than e!pected losses. 7". 3t is not clear which is more persuasive. The first approach can be persuasive if it included a step to independently determine that the data entered into the client7s spreadsheet is accurate and that the model had proved to be a good predictor of the actual warranty liability over a period of time. :owever, information that these two assumptions hold is not presented, and barring those assumptions, the second approach appears to be more persuasive. The second choice implies that the auditor independently gathered reliable data and tested the accuracy of the estimate over time and within the statistical parameters allowed by regression analysis. 9". >e$uesting vendor statements is the most persuasive if the auditor has sufficient information to ensure that all ma(or vendors are contacted, assuming that most vendors respond to the auditor7s re$uest. ,ost auditors use the first approach e!amining open items and a sample of payments after year-end", which provides persuasive evidence if the client pays its bills on a regular and timely basis and has sufficient controls to ensure that all bills are identified for payment and if management is not motivated to understate accounts payable because of financial difficulty.

5". 1!istence of cash versus the completeness of a contingent liability

7". 1!istence and valuation of the liability account

9". +ompleteness of the recording of accounts payable

<". +ompleteness of a liability savings deposit is a liability of the financial institution although it is an asset for the client" 1=". 1!istence and valuation

<". The testing of the client7s procedures is probably the most persuasive because a" an independent department investigates and resolves all customer in$uiries, and b" strong regulatory controls ensure that the accounting systems to record savings deposits are strong. 2n the other hand, research has shown that individual customers do not do a good (ob as measured by the accuracy of their responses" in confirming their savings or checking balances. This observation holds because the customers a" must first complete a bank reconciliation to accurately respond b" have come in many cases to rely on the accuracy of the bank and do not have their own independent recording systemI and c" have a natural bias not to report overstatements but to report understatements. 1=". The auditor is confirming an asset account in this situation versus confirming a liability in <". The confirmation with the borrower is the more persuasive evidence because it tells the auditor something about the customer7s current acknowledgment of the debt.

7-)0. a. ?pecial risks that might concern the auditor regarding this account include A significant related-party transaction e!ists and may be more pervasive than (ust the year-end account balance. Three ma(or customers are e!periencing financial difficulties and thus might not be able to repay their loans. The client continues to sell products to the three customers e!periencing difficulties adding to receivables that may ultimately not be collectible. The account balance has grown rapidly and substantially during the year. Assertions and audit procedures - Gotes >eceivable "ssertions "uditing Procedures to "ddress "ssertions

b.

Existence All 1!amine notes receivable evidencing ownership, terms, and recorded notes parties involved. represent bona fide receivables". 3n$uire of management about the continued ownership of the notes i.e., they have not been sold or are contingently due to some other parties". Also, obtain a confirmation from the bank to identify any discounted notes. +onfirm with the customers the e!istence and terms of the notes.

"ssertions

"uditing Procedures to "ddress "ssertions 1!amine subse$uent payments on notes.

Completeness: All 1!amine the notes as stated above. notes are properly recorded in the 3n$uire of management as to the e!istence of any other notes. correct time period. Rights: The company 1!amine the notes as stated above. has the right to future payments to be received on the notes and can legally sell or otherwise reali/e the value of the notes. Valuation: The notes 2btain customer acknowledgment of the debt see confirmation are properly valued procedure identified with e!istence assertion". at their net reali/able value. >eview credit status with 1agle >iver credit manager to assess credit risk. -etermine whether it has current financial statements of the companies. >eview outside credit analysis of companies by e!amining their -un and 8radstreet report or similar credit analysis. >eview notes for continuing payment to determine whether company is meeting periodic interest payments. >eview accounts receivable for the same customers to determine whether the company is currently paying its accounts receivable. -iscuss with management the ade$uacy of any allowance developed for the notes. -ocument your understanding of the valuation issues and assessment of collectibility problems. >eview the value of any collateral for the notes. Presentation and disclosure: The notes are properly disclosed on the >eview financial statements, including footnotes, for proper disclosure. -etermine whether any additional disclosure is needed.

"ssertions face of the financial statement. Any additional disclosure deemed necessary regarding collectibility problems is ade$uately disclosed in a footnote.

"uditing Procedures to "ddress "ssertions

0ther: -etermine >eview audit documentation for completeness. sufficiency of audit work and reach -ocument, via memo, the assessment of audit work and financial conclusions. statement presentation of the notes receivable. 7-)5. a. The primary purpose of documentation is to document the work performed and evidence gathered during the course of the audit engagement. The documentation is organi/ed in a specific manner to accumulate all evidence regarding particular accounts in one place where it can be analy/ed and reviewed by senior audit e!ecutives. The documentation, as a whole, should be conclusive regarding the accounts audited and the conclusions reached by the auditor on the fairness of the financial statement presentations. b. The audit documentation is owned by the auditor. c. A review of prior year documentation can provide important information that can be used in the current years audit engagement. ?ome of the information that might be obtained includes' ,a(or ad(ustments as a result of the audit representing areas of misstatement and therefore providing some indication of audit risk. Time budget and actual time spent by audit area providing information on overall allocation of audit time and areas that demanded additional time because of problems encountered in the audit. Assessment of control risk and ma(or deficiencies in the client7s overall control structure. The e!istence of control risk provides input in determining whether the audit should focus primarily on minimi/ing detection risk, and thus developing procedures consistent with this assessment. &revious audit personnel7s assessment of risks and problems encountered in the audit.

d.

3dentification of potential ad(ustments not made. The auditor may choose not to make some ad(ustments to the financial statements because the amounts are not material and the client does not wish to have the ad(ustments recorded. :owever, some of these misstatements, when coupled with current period misstatements, could amount to material misstatements on the income statement. The auditor should consider both beginning and end-of-period misstatements in determining potential materiality. 2ther items of continuing audit significance, some of which are identified in the permanent file, others in memos by audit e!ecutive personnel.

1. @es, it is permissible to furnish a copy of previous documents to clients as a guide for developing documents for the current year. The overall approach for performing an audit is not a mystery to the clientI in fact, the auditor describes the overall audit approach as part of the process of obtaining new clients and shares the overall audit approach with the audit committee each year. The auditor may have some legitimate concerns. The auditor should not identify all the specific items that will be e!amined as part of the audit approach or share memos describing audit conclusions with the client. 3f the auditor has a serious $uestion regarding management integrity and the client is perceived as high risk, the auditor may choose not to share documents with the client because the papers might be used to assist the client in preparing fictitious documentation. 2. The auditor should do some testing to gain assurance that client prepared documentation is ade$uate. 2ne procedure is to e!amine the (ournal containing all the original entries for selected periods of time to determine whether all items over F0,=== were completely and correctly listed on the document.

7-)7. 1. The document should contain an indication that it was prepared by the client &8+". 2. Got all columns were footed or crossfooted. They should be because the client prepared the document. #. Total cost is not cross-referenced to the trial balance. ). -epreciation of the additions was not recalculated. 0. There is no indication whether the life, salvage value, and depreciation method for the additions are proper. 5. The beginning cost balances were not traced to the prior year4s documents. 7. The e!planation of J - verified" is too general. 3t should indicate that source documents were e!amined. 9. The disposal of the lathe was not audited. <. There is no indication that the gain or loss on disposals was audited. 1=. An inde!, the initials of the preparer, and the date of preparation are missing.

11. The heading does not indicate the nature of the document. 12. There is no conclusion. 1#. There should be columns for the depreciation method, lives, and salvage values. 1). Total cost is not cross-referenced to the trial balance. Cases: 7-)9 a. The proper valuation of the allowance for doubtful accounts is management4s best estimate of the amount of the accounts receivable that will not be collected. This is somewhat sub(ective and, since it is an estimate it normally will not be as precise as those accounts based on recorded transactions. b. The company should utili/e the following information' Aging of the receivables &ast collection e!perience +hanges in credit policies +hanges in the economy as it affects the customers ?ubse$uent collections c. The auditor should' 3n$uire as to the credit policies and approach management takes to make its estimate and determine if it is a reasonable approach. Analy/e the relationship between the provision for doubtful accounts and actual write-offs over the last few years. >eview an aging of the accounts receivable and' o +ompare with the prior year aging for any significant changes o >eview subse$uent collections o 3n$uire about customers with old balances o >eview customer correspondence files to identify reasons for late payments o 2btain credit reports for large overdue balances +onsider changes in the economic climate affecting the client4s customers. d. ?ales to less credit-worthy customers will normally lead to larger write-offs and, thus, a larger allowance. e. A change in the economic climate will impact the estimateI historical e!perience will be less useful in making the estimate.

7-)<. 1. 3n$uiry of client personnel. 3f Addeco admitted to the problem, it would save time and focus the investigation in certain areas. 2. 1!amination of internal and e!ternal documentation. 6rom the internal side, invoices for the services performed should be e!amined and the date of service should be investigated. +onfirmations with customers or other e!ternal documents will provide a more reliable source of evidence, if they are available. 3n a case like this where the clients of Adecco are large companies, it is fair to assume they have an ade$uate level of documentation, including dates, since they have to determine when to include the e!penses in their financial statements. 7-0=. An extra shipment of $9 million of dis s. The primary evidence is found by reviewing receipts for merchandise returned after year-end. The auditor e!amines records of goods returned after year-end to determine whether the returns were material and the previous sale should be reversed. The auditor also discovers evidence on the e!tra shipment because the F< million sale would result in a F< million receivable. 3f the auditor attempts to confirm the receivable with the customer, it is likely that the customer would indicate that the sale was not appropriate. !hipments were made from a factory in !ingapore. The client is asserting that title had passed and sales and receivables should be recogni/ed. +onfirmation of the terms of the sale with customers would indicate the validity of the assertion. "eturned goods were recorded as usable inventory. The auditor should perform analytical procedures and compare the percentage of returned goods with that of previous years and industry averages. 3n addition, the auditor should take a sample of goods received during the year and trace the items sampled into the recording process to determine the accounting used. The auditor should in$uire of inventory control personnel to determine the appropriate method to be used and to compare current inventory levels with previous levels to determine whether there has been an inventory buildup. #ust$in$time warehouses and the recording of sales. The auditor should e!amine sales taking place near the end of the year to determine whether shipments were going to customers. The auditor could also review the taking of inventory in the warehouses and determine why some goods might not be included in inventory. 6inally, if the goods were sitting in ,ini?cribe7s warehouses, it is most likely that a customer would not confirm the e!istence of the sale.

7-01. a. The auditor could have used risk analysis to determine the likelihood that a material misstatement might have e!isted as follows' The auditor should have noted increased pressure to improve reported earnings due to the merger of the two firms. This should have heightened awareness to a" accounts that re$uire a great deal of (udgmentI and b" accounts that are comple! to estimate or audit. The auditor could have compared the company4s results with that obtained for the industry as a whole. As an e!ample, the auditor would have noted that the company was accelerating revenue recognition or delaying the write-off of old accounts. The auditor should have reviewed the client4s internal control system, especially monitoring controls, to determine if there were sufficient controls whereby management reviewed unusual entries or items that varied from the e!pected. The auditor should always be alert to unusually large sales transactions that take place near the end of each $uarter.

b. Audit procedures and audit evidence gathered" that would have detected the misstatement. 1inancial /tatement Misstatement 3rregular +harges Against ,erger >eserves "udit Procedures to %etect Error or Misstatement >eserves should be set up at the time of a merger in anticipation of future e!penses directly associated with the merger. The client should have an information system in place to track all changes against these reserves. Any unusual entry to the reserves should be investigated. Thus, it would be unusual to debit reserves and credit revenue. The auditor should select a sample of all debits to the reserves and trace to supporting documents (ustifying the (ournal entry. The basis for the entry should be determined by e!amining underlying documents. Those that are not supported should have been reversed. 6irst, analytical review procedures should be used to identify unusual increases in revenue, or increases in revenue that would be higher than e!pected given a" the number of membersI and b" industry trends.

6alse +oding of ?ervices sold to +ustomers

"udit Procedures to %etect Error or Misstatement ?econd, a sample of revenue recorded should be taken, particularly during periods of unusual increases in revenue, and traced back to the underlying supporting document to determine if they are recorded properly. -elayed recognition of Take a sample of recorded Acharge-backsB and trace cancellation of back initial notice from the bank to see if the items memberships and ;charge- are recorded on a timely basis. backs; a charge-back is a Take a sample of bank charge back notices and trace re(ection by a credit card- to the recording of the charge-back noting whether issuing bank of a charge to they were recorded on a timely basis. 3f not, make an a member7s credit card estimate of unrecorded charge-backs to determine if account". the amount might be material at year-end. +ompare the percentage of charge-backs recorded during this year with a" previous year resultsI and b" industry averages. Kuarterly recording of fictitious 1!amine all unusually large increases in revenue at revenues the end of a $uarter. Take a sample of all (ournal entries into the revenue account that come from other than the sales (ournal. 1!amine the (ournal entries in detail L including e!amination of underlying support for the (ournal entries. 3f suspicious, send a confirmation of the sales and services provided to selected customers. c. The auditor4s assessment of management integrity and management motivation should affect all audits. 3n the above situation, the auditor had a great deal of reason to $uestion management4s motivation due to a merger and management4s reputation to use accounting as a tool to increase reported earnings. %iven the suspicions by the auditor, the auditor should have' Assessed risk of potential misstatement as higher than usual. 3dentified the accounts that are most susceptible to management manipulation. -eveloped a plan to compare recorded results with previous results and with industry averages and then investigate any unusual items. -etermine whether sufficient controls e!isted to prevent errors or other misstatements. 3nvestigated account balances that showed any a" unusual activity during the end of any $uarter, or b" unusual increases in amounts. 3nvestigated any account balance where the entries into the account are susceptible to management (udgment, e.g. the charges against merger reserves.

1inancial /tatement Misstatement

234. a. +ontinued decline in market share, and a market shift or an increase in or acceleration of market shift" away from sales of trucks or sport utility vehicles, or from sales of other more profitable vehicles in the Hnited ?tates. Account' ?ales revenue Assertion' 1!istence. There e!ist incentives for management in geographic regions e!periencing slowdowns to inappropriately record ne!t year4s sales in this year4s income statement. Therefore, auditors should ensure that sales by geographic region are recorded accurately and actually e!ist in the year in which they are recorded. b. +ontinued or increased price competition resulting from industry overcapacity, currency fluctuations or other factors. Account' 3nventory. Assertion' *aluation. &rice competition may drive down the market value of inventory. The auditor should ensure that inventory is written down to reflect lower of cost or market values. c. Dower-than-anticipated market acceptance of new or e!isting products. Account' 3nventory. Assertion' *aluation. Dack of market acceptance of a produce may drive down the market value of inventory. The auditor should ensure that inventory is written down to reflect lower of cost or market values. d. ?ubstantial pension and postretirement healthcare and life insurance liabilities impairing our li$uidity or financial condition. Account' &ension liabilities. Assertion' *aluation, presentation and disclosure. The auditor must ensure that pension obligations are valued appropriately and are ade$uately disclosed in the footnotes. e. Eorse-than-assumed economic and demographic e!perience for our postretirement benefit plans e.g., discount rates, investment returns, and health care cost trends". Account' &ension liabilities. Assertion' *aluation, presentation and disclosure. The auditor must ensure that pension obligations are valued appropriately and are ade$uately disclosed in the footnotes. f. The discovery of defects in vehicles resulting in delays in new model launches, recall campaigns or increased warranty costs. Account' 3nventory, warranty e!pense. Assertion' *aluation, completeness. The auditor must ensure that inventory values reflect reductions to reflect defect issues. The auditor must ensure that 6ord completely reflects all

appropriate e!penses associated with the defect and warranty issues because there is an incentive on the part of management to minimi/e the recognition of such e!penses. g. Hnusual or significant litigation or governmental investigations arising out of alleged defects in our products or otherwise. Account' Ditigation liabilities. Assertion' &resentation and -isclosure. The auditor must ensure that management ade$uately discloses litigation because they have an obvious incentive not to do so. 2345 1. ?tudents should reflect on and discuss this issue in small groups. 3ndividual answers to this $uestion will of course differ by individual. The purpose of this $uestion is to get students thinking about the pressures that a staff auditor may face in conducting high $uality evidence gathering and documentation procedures. 2. 1li/abeth4s misrepresentation of her work is important to the 6irm because it provides inappropriate assurance regarding the client4s account balance. 3f there are errors, 1li/abeth4s inade$uate procedures and inaccurate documentation will fail to alert the attention of higher level members of her audit team, thereby increasing the audit risk that her 6irm assumes. #. 1li/abeth did do some things right once her misrepresentation was discovered. ?he readily confessed to her actions, e!pressed remorse, and promised not to engage in ghost tickmarking in the future. ?he could have become defensive, argumentative, and evasive about the situation but she did not. Hltimately, it was her positive attitude about the situation that saved her from getting fired in actual practice. 3n fact, in the actual practice situation, one reason that 1li/abeth was retained by the 6irm rather than fired" was that she had always been a good performer with a good attitude in the past. ?he was viewed as an asset to the 6irm, so her supervisors were willing to give her the Abenefit of the doubtB in this situation. ). -o you agree with the outcomeM -o you think the 6irm was too lenientM Too harshM Answers to this $uestion will of course differ by individual and group. 3nstructors should encourage groups to report out to the larger class in a discussion to highlight the rationale that individuals.groups used to arrive at their conclusion. 3n prior use of these materials, groups were about evenly split between whether the outcome was too lenient versus too harsh. As an e!ample of one way to answer this $uestion by applying the ethical decision making framework from +hapter #, consider the following steps' N 3dentify the ethical issue s". The issue involves 1li/abeth4s decision to engage in ghost tickmarking. N -etermine who are the affected parties and identify their rights. The parties affected by 1li/abeth4s actions include'

1" The audit firm as a whole. The firm has a right to demand and e!pect high $uality performance. 2" 1li/abeth4s supervisors. The auditors in charge of and responsible for" the (ob have the right to honesty and high $uality work. #" The client and its stakeholders. The client hires auditors to help them be sure that their financial records are accurate. 3f the audit firm does not catch an error, then the financial statements may be misstated. N -etermine the most important rights. The most important rights are those held by the client and its stakeholders. They are paying for high $uality service, and if 1li/abeth4s actions had not been discovered, they would not have received such service. N -evelop alternative courses of action. ?tudent groups that believe the audit firm was too lenient generally argue that 1li/abeth deserved to be fired outright for her actions, because of her dishonesty and the costs that it imposed on the audit firm and her colleagues e.g., e!tra levels of review over the course of the year". ?tudent groups that believe the audit firm was too harsh generally argue that 1li/abeth made one isolated mistake and she deserves the benefit of the doubt and a chance to redeem herself. ?tudent groups in the Atoo harshB camp are usually especially annoyed that the firm initially did not consider firing 1li/abeth, and then later did consider firing her. N -etermine the likely conse$uences of each proposed course of action. +onse$uences will depend on whether students believe the firm was too lenient or too harsh. Assume that students decided the firm was too lenient. 3n this case, the conse$uences will fall s$uarely on 1li/abeth4s shoulders, as she will get fired and will have to start her career at another (ob, and with a potentially tarnished reputation. Gow assume that students decided the firm was too harsh. 3n this case, the client does not suffer negative conse$uences because 1li/abeth4s supervisor detected and corrected her mistakes. Thus, the negative conse$uences accrue to the firm and her supervisors, who bear the incremental costs in terms of time re$uired to more closely supervise 1li/abeth. N Assess the possible conse$uences, including an estimation of the greatest good for the greatest number. -etermine whether the rights framework would cause any course of action to be eliminated. ?ome student groups will conclude that the best course of action is for the firm G2T to fire 1li/abeth, but to hold a training session anonymously describing the situation and warning other auditors in the office of the impropriety of ghost tickmarking. These students will argue that this will assure the greatest good in terms of improved performance by all auditors of the office, and the ability for others to learn from 1li/abeth4s mistake. N -ecide on the appropriate course of action. Answers and ideas vary widely across student groups. Answers generally include 1" immediately firing 1li/abeth, 2" not firing 1li/abeth and simply counseling her and not noting the matter in her personnel record, #" not firing 1li/abeth but noting the matter in her personnel record, i.e., the actual outcome

of the case, )" not firing 1li/abeth but using the situation to motivate staff training, and 0" firing 1li/abeth and using the situation to motivate staff training and to send a strict AmessageB throughout the office. 2346. 1. The &+A28 report summari/ed a problem with -eloitte4s evidence collection, evaluation, and documentation at a particular issuer client. Articulate why you believe the &+A28 was dissatisfied with the 6irm4s performance. The &+A28 was concerned because -eloitte clearly did not challenge the issuer4s lack of willingness to write the physical plant asset down to net reali/able value. 1vidence of that lack of willingness is clear based on the shoddy audit documentation that the &+A28 uncovered, e.g., lack of calculations that would enable the audit team to calculate net reali/able value and lack of auditor generated evidence with accompanying over-reliance on client-generated documentation. The &+A28 is concerned because the plant asset is recorded at historical cost, which is apparently significantly higher than what would be recorded at net reali/able value. Thus, the issuer4s assets are overvalued on the balance sheet, which may affect users4 decisions based on the financial statements. And given that the write-down would have increased the issuer4s net loss by a substantial amount, the &+A28 seems to have (ust cause for concern. %ecause of power supply issues in a country, the output of the issuer&s plant in that country was severely curtailed in '((). The issuer entered into discussions with the government to sell the facility and determined that, at the low end of the range of potential sales prices, the boo value of the facility could be impaired by an amount up to four percent of the issuer&s net loss for the year ended *ecember )+, '((). The issuer determined, however, that it was not necessary to record an impairment loss at the end of '((), in part because the issuer contended that, absent the power supply shortage, the facility could operate at full capacity. The ,irm&s wor papers included issuer$generated support for the determination not to record an impairment loss, but that support did not include detailed calculations of the estimated future cash flows or probability$weighted cash flows, nor did it address when, or if, the plant would be able to return to near capacity. !uch analyses, or other detailed information addressing the value of the plant, would be necessary for the ,irm to perform an appropriate evaluation of management&s assertion that it was not necessary to record an impairment loss at the end of '((). 2. Hse the decision analysis framework from +hapter # to determine the appropriate steps that the 6irm could have taken that would have ultimately been acceptable to the &+A28. 3n ?tep 2ne, the auditor structures the problem, considering the relevant parties to involve in the decision process, identifying various feasible alternatives, considering how to evaluate the alternatives, identifying uncertainties or risks, and determining how to structure the problem. To illustrate these tasks, the audit engagement team should have structured the problem to address

both the client4s valuation estimates, and the team4s own independent valuation estimates. Toward that end, the team should have relied on valuation e!perts within -eloitte, or should have hired outside e!perts in valuing power plant assets. The team should have identified various alternatives, including that 1" the issuer4s valuation is correct and no write-down is necessary, or 2" the issuer4s valuation is incorrect, and a write-down is necessary. The team should have identified the risks, primarily that the plant assets would be over-valued on the balance sheet. The team should have structured the problem to provide evidence that it sought and evaluated independent evidence about the issuer4s plant asset. 3n doing so, they should have identified and followed appropriate %AA& for the potential write-down and they should have structured the problem to include some type of valuation process. 3n ?tep Two, the auditor assesses the conse$uences of the potential alternatives. +onsiderations at this stage include determining the dimensions on which to evaluate the alternatives and considering how to weight those dimensions. 3n this case, there are two potential alternatives. The dimensions on which to evaluate the alternatives include valuation estimates and considerations of appropriate %AA& for writing down physical assets. 3n ?tep Three, the auditor assesses the uncertainties in the situation. 6or e!ample, the auditor tries to assess the likelihood of various conse$uences associated with potential alternatives. ?ome conse$uences are more likely than others, and some are more costly than others. 3n this case, the primary uncertainty whether or not the issuer would ultimately be able to operate the power plant at near full capacity, and whether they would ultimately sell the plan to the government of the country in which the plant is located. The issuer4s contention that they should not write down the asset because it could operate at full capacity seems hollowI the audit team must determine whether such operation might actually be feasible in the short term. 3n ?tep 6our, the auditor evaluates the alternatives against some decision rule. 6or auditors, decision rules are often articulated in terms of generally accepted accounting principles. 3n our e!ample, the primary criterion is simple' follow %AA&, which will almost certainly lead to a write-down. 3n ?tep 6ive, the auditor considers the sensitivity of the conclusions reached in steps two, three, and four to incorrect assumptions. 6or e!ample, in this case, the assumptions involve uncertainty estimates of the future operational use of the plant. &erhaps the issuer can show that the plant re-started full operations shortly into the subse$uent year, and that might provide evidence that a write-down is unnecessary because the plant was only inoperable for a very short period of time. Absent such evidence, the issuer will have difficulty asserting that the plant asset should be recorded at historical cost. 3n ?tep ?i!, the auditor gathers information in an iterative process that affects considerations about the conse$uences of potential alternatives and the uncertainties associated with those (udgments. 3mportantly, the auditor considers the costs and benefits of information ac$uisition, knowing that gathering additional evidence re$uires time, effort, and money. %iven that audits are a for-profit enterprise, cost-benefit considerations in evidence gathering are particularly important. A good auditor knows Awhen to say whenB and decides to stop collecting evidence at the right time. 3n contrast, some auditors stop evidence collection too soon, thereby yielding

inade$uate evidence on which to make a decision. ?till others continue evidence collection even though the current evidence is ade$uate, thereby contributing to inefficiency and reduced profitability in the audit. 3n this case, -eloitte clearly stopped evidence collection too soon, which caused the &+A284s ob(ection. 6urther evidence collection is clearly needed to support or refute the client4s preference for not recording a write-down. The auditor iterates through steps one through si! repeatedly until satisfied that a decision can prudently be made. 3n ?tep ?even, the auditor needs to make the difficult determination of whether they have sufficiently analy/ed the problem, and whether the risk of making an incorrect decision has been minimi/ed to an acceptable level by collecting ade$uate, convincing evidence. Hltimately, they must make and document the decision that they have reached.

1ord Motor Compan$ and +o$ota Motor Corporation: " 1ramewor7 or "udit Evidence -. Consider 1ord8s inventor$ account on the balance sheet9 along with the accompan$ing ootnote. :hat are the most important assertions that management is ma7ing with regard to its inventor$; The following assertions are most important for the inventory account' -xistence.occurrence. The assets, liabilities, and e$uity interests are able to be accounted for, either physically or via verification in the accounting system. 6or 6ord, management is asserting that the inventory physically e!ists. "ights.obligations. The entity holds or controls the legal ownership to assets, and liabilities are the legally owed by the entity. 6or 6ord, management is asserting that the inventory is actually owned by 6ord, i.e., they have title to the inventory. /aluation.allocation. Assets, liabilities, and e$uity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation ad(ustments are appropriately recorded. 6or 6ord, management is asserting that inventory is properly valued at F1=,121,===,===. 0resentation.disclosure. Assets, liabilities, and e$uity interests are appropriately classified on the financial statements, and are ade$uately described in the footnotes to the financial statements. 6or 6ord, management is asserting that inventory is properly presented as an asset on the face of the balance sheet, and that the footnote describing 6362 and D362 valuation methodologies is accurate and appropriate. Gote that we do G2T list completeness as an important assertion for the inventory account. ,anagement4s motivation in the case of 6ord is to overstate, rather than understate, its asset accounts. Therefore, it is unlikely that 6ord management would inappropriately omit any assets such as inventory. .. 1ord9 in particular9 is wor7ing to change models rom /(V8s to more uel e icient9 smaller cars. 'ow might that change a ect the valuation o its bigger pic73ups and /(V8s; 6ord runs a risk that the ?H*4s and large si/ed pick-ups cannot be sold current retail prices, and more importantly, may re$uire either' The company has a longer holding period on the vehicles, thus increasing the cost of financing inventory, and.or The company will have to sell the vehicles either at a lost or at a large discount from current e!pected selling prices.

1ither of these would suggest that the company has a lower of cost or market valuation problem and the auditor will have to e!plicitly address the potential that a large portion of inventory may need to be written down to reflect a significant decrease in the current market value of its assets. 5. :hat assertions are implied in the Propert$9 Plant9 and E<uipment account; 'ow would valuation be a ected i the compan$ decided to downsi=e and eliminate a line o pic73up truc7s; The assertions are the same as indicated above'

+ompleteness 1!istence *aluation or Allocation &resentation and -isclosure.

6or 6ord, in particular, management has announced a plan to significantly reduce the scope of operations. 3t is doing so by closing plants, discounting non-profitable lines, and consolidating manufacturing into lower cost areas either lower wages or lower costs of operations". 3f management decides to close a production line, then the auditor must develop impairment testing to ascertain the likely sales price of the plant. 3f the selling price including the cost of e$uipment associated with the product line" is less than the current carrying value of the assets, the company must write down the plant and e$uipment to their best estimate of current market value of the assets. 6. Examine the assets on the balance sheet o 1ord Motor Compan$. #denti $ the assets that are sub>ect to )a* air value ad>ustments9 )b* impairment tests9 or )c* other ad>ustments to either net reali=able value or lower o cost or mar7et value; :hat are the implications or audit evidence that will be gathered or those accounts; The overwhelming response should be that virtually all of the items on the asset side of the balance sheet are sub(ect to one of those three situations noted above' ,air /alue Adjustments +ash 1$uivalents ,arketable ?ecurities Doaned ?ecurities 1mpairment Tests Get 3nvestments in 2perating Deases >etained interest in sold receivables 3nventory &roperty, &lant, and 1$uipment %oodwill -iscontinued Assets or Assets :eld for >esale 2ther Assets -stimates 6inance >eceivables 2ther >eceivables The main point we want the students to understand is that ever$ asset on the books of 6ord ,otor +o. is sub(ect to potential write-downs due to either changes in fair value, changes in the value of the assets, or changes in estimated cash to be received from the assets, e.g. net receivables. Thus, the auditors will look beyond historical cost in auditing each of these items. 4. Consider 1ord8s debt account on the balance sheet9 along with the accompan$ing ootnote. :hat are the most important assertions that management is ma7ing with regard to its debt;

2ompleteness. All assets, liabilities, and e$uity interests that should have been recorded have been recorded, i.e., nothing is left out of the financial statements. 6or 6ord, management is asserting that they have not omitted any debt that should have been recorded as a liability. "ights.obligations. The entity holds or controls the legal ownership to assets, and liabilities are the legally owed by the entity. 6or 6ord, management is asserting that it legally owes the debts listed on the balance sheet. /aluation.allocation. Assets, liabilities, and e$uity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation ad(ustments are appropriately recorded. 6or 6ord, management is asserting that it owes F159,0#=,===,===. 0resentation.disclosure. Assets, liabilities, and e$uity interests are appropriately classified on the financial statements, and are ade$uately described in the footnotes to the financial statements. 6or 6ord, management is asserting that debt is properly presented as a debt on the face of the balance sheet, and that the footnote describing the additional lines of credit.li$uidity sources is accurate and appropriate. Gote that we do G2T list existence as an important assertion for the debt account. ,anagement4s motivation in the case of 6ord is to understate, rather than overstate, its liability accounts. Therefore, it is unlikely that 6ord management would inappropriately include more debt than necessary on the balance sheet.