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Audit Evidence and Audit Programs

MULTIPLE CHOICE:
1. The permanent file section of the working papers that is kept for each
audit client most likely contains
a. Review notes pertaining to questions and comments regarding
the audit work performed.
b. A schedule of time spent on the engagement by eachindividual
auditor.
c. Correspondence with the client's legal counsel concerning pending
litigation.
d. Narrative descriptions of the client's internal control policies and
procedures
ANSWER: D
2. Of the following procedures, which is not considered part of obtaining
an understanding of the clients environment?
a. Examining trade publications to gain a better understanding of
the client's industry.
b. Confirming customer accounts receivable for existence and
valuation.
c. Touring the client's manufacturing and warehousing
facilities to gain a clearer understanding of
operations.

d. Studying the internal controls over cash receipts and


disbursements.
ANSWER: B
3. If working papers are to have the characteristics that will ensure that
they achieve their primary purposes, which of the following is the most
important?
a. Working papers must be of standard format and
standard content. b.Working papers must be properly indexed and crossreferenced to the draft audit report.
c. Working papers must provide sufficient, competent, and useful
information to support the audit report. d. Working papers must be
arranged in logical order following the audit program sequence.
ANSWER: C
4. Which of the following is not an example of analytical evidence?
a. Compared inventory turnover by major class with the prior year
on a monthly and quarterly basis.
b. Compared gross profit percentages by major product classes with
the prior year.
c. Examined invoices for plant asset additions to determine whether
the client had erroneously recorded ordinary repairs as plant
assets.
d. Examined monthly performance reports and investigated
significant variations from budgeted amounts.
ANSWER: C

5. Choose the best illustration of objective audit evidence from the


following
a. The paid invoice file containing invoices matched withreceiving
reports and purchase orders.
b. Management's assertion that payment procedures
requirematching of invoice with receiving report and
purchase order. c.Clerical staff assurances that management
policy regarding payment of invoices--matching of invoice
with receiving report and purchase order--is always followed.
d. The treasurer's statement of not remembering any exceptions in which
an invoice was submitted for payment that was not accompanied by a
matching receiving report and purchase order.
ANSWER: A
6. An initial (first-time) audit requires more audit time to complete than a
recurring audit. One of the reasons for this is that
a. New auditors are usually assigned to an initial audit.
b. Predecessor auditors need to be consulted.
c. The client's business, industry, and internal control are unfamiliar
to the auditor and need to be carefully studied.
d. A larger proportion of customer accounts receivable need to be
confirmed on an initial audit.
ANSWER: C
7. Which of the following is a basic tool used by the auditor to control the
audit work and review the progress of the audit?

a. Time and expense summary.


b. Engagement letter.
c. Progress flowchart.
d. Audit program.
ANSWER: D
8. An auditor wants to develop an audit test to evaluate
thereasonableness of the quantity of scrap material resulting from a
certain production process compared to industry standards. Which would
be the most competent type of evidence available to satisfy this
objective?
a. Documentary. b. Hearsay. c. Physical. d. Analytical.
ANSWER: D
9. As part of audit planning, CPAs should design audit programs for each
individual audit and should include audit steps and procedures to
a. Detect and eliminate fraud.
b. Increase the amount of management information available.
c. Provide assurances that the objectives of the audit are met. d. Ensure
that only material items are audited.
ANSWER: C
10. Of the following audit procedures, which best supports the valuation
objective?
a. Performing a lower of cost or market test of the client's
inventories.

b. Reviewing a contingent liability footnote for proper


wording.
c. Searching for unrecorded liabilities.
d. Observing the client's year-end physical inventory taking.
ANSWER: A
11. An assumption underlying analytical procedures is that
a. These procedures cannot replace tests of balances
and transactions.b. Statistical tests of financial information may lead
to the discovery of material errors in the financial statements. c. The
study of financial ratios is an acceptable alternative to the investigation of
unusual fluctuations.
d. Relationships among data may reasonably be expected to exist and
continue in the absence of known conditions to the contrary.
ANSWER: D
12. An auditor is examining accounts receivable. What is the most
competent type of evidence in this situation?
a. Interviewing the personnel who record accounts receivable. b.Verifying
that postings to the receivable account from journals have been made.
c. Receipt by the auditor of a positive confirmation. d. No response
received for a request for a negative confirmation.
ANSWER: C
13. With respect to the auditor's planning of a year-end examination,
which of the following statements is always true?

a. An engagement should not be accepted after the fiscal year-end. b.An


inventory count must be observed at the balance sheet date.
c. The client's audit committee should not be told of the specific audit
procedures that will be performed. d. It is an acceptable practice to carry
out substantial parts of the examination at interim dates.
ANSWER: D
14. A letter to the auditor in response to an inquiry is an example of
a. Physical evidence.
b. Confirmation evidence.
c. Documentary evidence.
d. Analytical evidence.
ANSWER: B
15. Which of the following statements about working papers is correct?
a. Working papers are not permitted to be used as a reference
source by the client.
b. The auditor should document the understanding of the client's
internal control obtained to plan the audit
c. Working papers may be regarded as a substitute for the client's
accounting records.
d. When reporting on comparative financial statements, the
independent auditor may discard working papers after two
years.
ANSWER: B

16. Which of the following factors is most important in determining the


competence of audit evidence?
a. The reliability of the evidence in meeting the audit objective. b. The
objectivity of the auditor gathering the evidence. c. The quantity of the
evidence obtained.
d. The independence of the source of evidence.
ANSWER: A
17. The procedures specifically outlined in an audit program areprimarily
designed to
a. Protect the auditor in the event of litigation. b. Detect errors or fraud.
c. Test internal evidence.
d. Gather evidence.
ANSWER: D
18. When reviewing audit working papers, the primary responsibility of
an audit supervisor is to determine that:
a. Each worksheet is properly identified with a descriptive heading.
b. Working papers are properly referenced and kept in logical
groupings.
c. Standard departmental procedures are adhered to with regard to
work paper preparation and technique. d. Working papers
adequately support the audit findings, conclusions, and report.
ANSWER: D

19. Auditors apply analytical procedures to the client's


operations in order to identify
a. Improper separation of accounting and other
financial duties. b.Weaknesses of a material nature in the client's internal
control.
c. Unusual transactions.
d. Noncompliance with prescribed control procedures.
ANSWER: C
20. Which of the following workpapers would one normally expect to find
in the permanent file?
a. A copy of a long-term bond indenture.
b. The working trial balance.
c. An analysis of additions and disposals relating to marketable
securities.
d. A workpaper analyzing customer replies to confirmation requests.
ANSWER: A
21. The in-charge auditor decides that work papers are complete
a. When satisfied that the audit objectives have been met and the
working papers support the conclusions. b. When working papers make
reference to the steps outlined in the audit program.
c. Only after the auditor who prepared the working papers has
signed and dated them.
d. When proper cross-references to other working papers are noted.

ANSWER: A
22. Of the following procedures, which does not produce analytical
evidence?
a. Compare revenue, cost of sales, and gross profit with the prior
year and investigate significant variations.
b. Examine monthly performance reports and investigate significant
revenue and expense variances.
c. Confirm customers' accounts receivable and clear all material
exceptions.
d. Compare sales trends and profit margins with industry averages
and investigate significant differences.
ANSWER: C
23. Audit evidence can come in different forms with different degrees of
persuasiveness. Which of the following is the least persuasive type of
evidence?
a. Documents mailed by outsiders to the auditor. b. Correspondence
between the auditor and vendors. c. Sales invoices inspected by the
auditor.
d. Computations made by the auditor.
ANSWER: C
24. Analytical procedures are
a. Substantive tests designed to evaluate a system of internal
control.

b. Tests of control procedures designed to evaluate the validity of


management's representation letter. c. Substantive tests designed
to evaluate the reasonableness of financial information.
d. Tests of control procedures designed to detect errors in reported
financial information.
ANSWER: C
25. Which of the following statements relating to the
competence of evidential matter is always true?
a. Evidential matter gathered by an auditor from
outside an enterprise is reliable.
b. Accounting data developed under satisfactory conditions of
internal control are more relevant than data developed under
unsatisfactory internal control conditions. c. Oral representations
made by management are not valid evidence. d. Evidence gathered
by auditors must be both valid and relevant to be considered
competent.
ANSWER: D
26. An auditor test counted a batch of inventory. This is an example of
what kind of evidence?
a. Analytical. b. Documentary. c. Physical. d. Hearsay.
ANSWER: C
27. In evaluating the reasonableness of advertising expense, which of the
following would be the best evidence?

a. Oral evidence obtained through discussions with


companymarketing executives and representatives of
theadvertising agency retained.
b. Documentary evidence obtained by vouching charges to the
account and by retracing charges from source documents to the
account.
c. Analytical evidence developed by comparing the ratio of
advertising expenses to sales with historical data for
the company and industry.
d. Arithmetical evidence developed by re-computing
chargessubmitted by the advertising agency and paid by
the company.
ANSWER: C
28. Which of the following is not a consideration in the development of
audit programs?
a. Internal control over the recording of plant asset additions and
repairs and maintenance expenditures is found to be weak.
b. The client constructed a major addition to its central
manufacturing facility during the year under audit.
c. The client is a private university located in the Midwest.
d. The client's board or directors is elected by the
stockholders at the annual meeting.
ANSWER: D

29. Audit working papers are used to record the results of the auditor's
evidence-gathering procedures. When preparing working papers,
the auditor should remember that working papers should be
a. Kept on the client's premises so that the client can have access to
them for reference purposes.
b. The primary support for the financial statements being examined.
c. Considered as a part of the client's accounting records that are
retained by the auditor.
d. Designed to meet the circumstances and the auditor's needs on
each engagement.
ANSWER: D
30. The main advantage of properly indexed working papers is to
a. Reduce the size of the file.
b. Better organize the working papers.
c. Allow division of labor within the audit team. d. Facilitate the
efficient use of audit staff.
ANSWER: B
31. Which of the following is not a typical analytical procedure?
a. Study of relationships of financial information with relevant
nonfinancial information.
b. Comparison of financial information with similar information
regarding the industry in which the entity operates. c.Comparison of

recorded amounts of major disbursements with appropriate


invoices.
d. Comparison of recorded amounts of major disbursementswith
budgeted amounts.
ANSWER: C
32. Which of the following is an example of inferential evidence?
a. The auditor observes the taking of the client's physical inventory
and performs test counts.
b. The auditor inspects marketable securities for
existence.
c. An auditor, who notes that customer accounts receivable have
increased significantly in the current year as a percentage of
sales, suspects that a larger proportion of the accounts will
prove uncollectible.
d. The auditor counts cash on hand at year-end.
ANSWER: C
33. Which of the following would be least likely to be comparable between
similar corporations in the same industry line of business?
a. Earnings per share.
b. Return on total assets before interest and taxes. c. Accounts
receivable turnover.
d. Operating cycle.
ANSWER: A

34. Which of the following is not an example of confirmation evidence?


a. Requesting the client's outside legal counsel to evaluate the
possible outcome of pending litigation.
b. Questioning the client's employees about existing internal control
policies and procedures.
c. Requesting the client's customers to verify year-end accounts
receivable balances.
d. Requesting payees to respond in writing to the terms contained
in notes payable appearing in the client's ledger.
ANSWER: B
35. A CPA, in performing an independent audit, would most likely use
recalculation as a substantive test for which of the following expenserelated accounts?
a. Purchases of supplies.
b. Interest expense.
c. Advertising expense.
d. Repairs and maintenance expense.
ANSWER: B
36. During the course of an audit engagement, an auditor prepares and
accumulates audit working papers. The primary
purpose of the audit working papers is to
a. Aid the auditor in adequately planning his work. b. Provide a point of
reference for future audit engagements. c. Support the underlying

concepts included in the preparation of the basic financial


statements. d.Support the auditor's opinion.
ANSWER: D
37. Which of the following is not an appropriate auditing procedure
supporting fairness of financial presentation?
a. Inspecting plant asset additions for existence.
b. Recalculating accrued interest on notes payable.
c. Examining invoices in support of legal fees recorded during the
fiscal year.
d. Reviewing the client's production quality control program.
ANSWER: D
38. Sales commissions as a percentage of sales declined
significantly during the year under audit. Of the following possible causes,
the most likely is
a. Sales increased during the year.
b. The sales force was reduced at the end of the year.
c. Sales commission rates were increased at the beginning of the
year.
d. Fictitious sales were recorded at year-end to inflate
earnings.Commissions were not recorded on these
sales.
ANSWER: D

39. Which of the following is responsible for the fairness of the


representations made in financial statements?
a. Client's management.
b. Independent auditor.
c. Audit committee.
d. AICPA.
ANSWER: A
40. An audit program provides proof that
a. Sufficient competent evidential matter was obtained. b. The work was
adequately planned.
c. There was compliance with generally accepted standards
of reporting.
d. There was a proper study and evaluation of internal control.
ANSWER: B
41. Which of the following ultimately determines the specific
audit procedures necessary to provide an independent
auditor with a reasonable basis for the expression of an opinion?
a. The audit program.
b. The auditor's judgment.
c. Generally accepted auditing standards.

d. The auditor's working papers.


ANSWER: B
42. During the working paper review, an audit supervisor finds that the
auditor's reported findings are not adequately cross-referenced to
supporting documentation. The supervisor will most likely instruct the
auditor to
a. Prepare a working paper to indicate that the full scope of the
audit was carried out.
b. Familiarize him/herself with the sequence of working papers so
that he(she) will be able to answer questions about the conclusions
stated in the report. c. Eliminate any cross-references to other
working papers
since the system is unclear.
d. Provide a workpaper indexing system that shows therelationship
between findings, conclusions, and the related facts.
ANSWER: D
43. Which of the following would be the most relevant form of evidence
to evaluate the reasonableness of account balances?
a. Analytical. b. Documentary. c. Physical. d. Hearsay.
ANSWER: A
44. Generally, what source of evidence should most impact
auditconclusions?
a. External b. Inquiry. c. Oral. d. Informal.

ANSWER: A
45. Most of the independent auditor's work in formulating an opinion on
the financial statements consists of
a. Studying and evaluating internal control.
b. Obtaining and examining evidential matter.
c. Examining cash transactions.
d. Comparing recorded accountability with assets.
ANSWER: B
46. During an audit of the accounts receivable function, you found that
the accounts receivable turnover rate had fallen from 7.3 to 4.3 over the
last three years. What is the most likely cause of the decrease in the
turnover rate?
a. An increase in the discount offered for early payment. b. A more liberal
credit policy.
c. A change from net 30 to net 25.
d. Greater cash sales.
ANSWER: B
47. Which of the following is generally included or shown in the auditor's
working papers?
a. The procedures used by the auditor to verify the personal
financial status of members of the client's management team.
b. Analyses that are designed to be a part of, or a substitute for,
the client's accounting records. c. Excerpts from authoritative

pronouncements that support the underlying generally accepted


accounting principles used in preparing the financial statements.
d. The manner in which exceptions and unusual mattersdisclosed by
the auditor's procedures were resolved or treated.
ANSWER: D
48. To test for unsupported entries in the ledger, the direction of audit
testing should be from the
a. Ledger entries.
b. Journal entries.
c. Externally generated documents.
d. Original source documents.
ANSWER: A
49. Which of the following does not describe one of the functions of audit
workpapers?
a. Facilitates third-party reviews.
b. Aids in the planning, performance, and review of audits.
c. Provides the principal evidential support for the auditor's report.
d. Aids in the professional development of the operating staff.
ANSWER: D
50. The principal reason for developing a written audit program is to help
assure that the

a. Audit work is properly supervised.


b. Audit work is properly planned and documented. c. Audit report
contains only significant findings. d. Work of different auditors is
properly coordinated.
ANSWER: B
51. One of the primary roles of an audit program is to:
a. Serve as a tool for planning, directing, and controlling audit work.
b. Document an auditor's understanding of the internal control.
c. Provide for a standardized approach to the
audit engagement. d.Delineate the audit risk accepted by the auditor.
ANSWER: A
52. The principal purpose for cross-indexing audit working papers is to
a. Give the working papers a professional appearance. b. Explain the use
of tick marks.
c. Provide explanation of the audit steps performed. d. Provide a trail for
the auditor and the reviewer.
ANSWER: D
53. Audit information is generally considered relevant when it
is:
a. Derived through valid statistical sampling.
b. Objective and unbiased.

c. Factual, adequate, and convincing.


d. Consistent with the audit objectives.
ANSWER: D
54. External auditors often confirm assertions contained in
theorganization's financial statements and accounting records with third
parties. Which of the following best explains why confirmation produces
evidence of high quality?
a. Written assertions from knowledgeable third parties provide sufficient
evidence to achieve most audit objectives. b. Confirmation by
knowledgeable third parties is usually the most relevant evidence
available.
c. Confirmation by knowledgeable third parties is usually the least
costly evidence available.
d. Confirmation by knowledgeable third parties is highlycompetent
because of its independent source.
ANSWER: D
55. As a category of evidence, documents may be external or internal.As
an auditor reviewing your client's accounts
receivable, which of the following is an example of internal documentary
evidence?
a. The carrier's bill of lading.
b. Sales invoice copies.
c. A customer's purchase order.

d. A vendor's month-end statement.


ANSWER: B
COMPLETION:
56. Audit programs can be developed only after the auditor has completed
the audit _______________ process.
ANSWER: PLANNING
57. An auditor who gathers increased quantities of evidence for larger
account balances is observing the standard relating to of audit
evidence.
ANSWER: SUFFICIENCY
58. An auditor who gathers increased amounts of external evidence
under conditions of weak internal control is observing the standard
of of audit evidence.

ANSWER: COMPETENCE (VALIDITY)


59. In performing substantive audit tests, focusing on the existence or
occurrence objective helps locate misstatements due to while the
completeness objective directs audit attention to misstatements due
to .
ANSWER: COMMISSION, OMISSION
60. Evidence consisting of everything that can be counted, examined,
observed, or inspected is referred to as _____________evidence.
ANSWER: PHYSICAL

61. The audit trail consists of that stream of evidence that enables the
auditor to trace a transaction or event forward from its inception to
the appropriate ledger account, or conversely, vouch a transaction
backward from the ledger
account to the inception of the transaction or event. For the audit trail to
exist, transactions must be .
ANSWER: DOCUMENTED
62. Analytical evidence may be the best form of evidence supporting
theobjective, in that auditors' suspicions concerning errors of
omission are often first aroused by the application of analytical
procedures.
ANSWER: COMPLETENESS
63. An auditor-prepared bank reconciliation is an example
of_______________ evidence.
ANSWER: MATHEMATICAL
64. A group of related transactions affecting essentially the same set of
general ledger accounts is referred to as a _________________.
ANSWER: TRANSACTION CYCLE
65. The focal point of the current file is the ____________
_______________ ______________ often referred to as a table of
contents.
ANSWER: WORKING TRIAL BALANCE
MATCHING:

66. For each of the listed auditing procedures, indicate, by letter, the type
of evidence it represents.
a. Physical evidence
b. Confirmation evidence
c. Documentary evidence
d. Analytical evidence
e. Mathematical evidence
f. Hearsay evidence
____ 1. Audited client-prepared bank reconciliation
____ 2. Vouched debits to repairs accounts by
examining vendorsinvoices
____ 3. Observed the clients year-end physical inventory
____ 4. Compared accounts receivable turnover with industry
average
____ 5. Prepared ten-year income summary expressing all
components as a percentage of sales
____ 6. Obtained letter from clients outside legal counsel
regarding pending litigation
____ 7. Inquired of corporate treasurer as to reason(s) for
acquiring marketable securities

____ 8. Calculated year-end interest accrual and compared


with general ledger balance
____ 9. Obtained replies directly from customers concerning
the correctness of clients recorded year-end accounts receivable
balances
____ 10.Examined securities purportedly owned by the client and held by
local brokers
____ 11.Compared operating cash flows with net income and
identified causes of significant disparities.
SOLUTION:
1. e
2. c
3. a
4. d
5. d
6. b
7. f
8. e
9. b
10. a

11. d
67. For each of the listed procedures, indicate, by letter, the
assertion(s) being tested.
a. Existence or occurrence
b. Completeness
c. Rights and obligations
d. Valuation or allocation
e. Presentation and disclosure
____ 1. Confirmed customer accounts receivable
____ 2. Vouched property additions to underlying
documentation consisting of vendors invoices and
work orders
____ 3. Inquired of corporate treasurer as to reasons for
buying and holding securities
____ 4. Selected a sample of bills of lading representing
shipments to customers and traced to sales invoices
to determine that all shipments have been billed to
customers
____ 5. Examined vendors invoices recorded after year-end to

determine whether any of these invoices represent


liabilities of the client as of year-end
____ 6. Obtained confirmation of marketable securities from
clients brokers
____ 7. Evaluated the reasonableness of the clients
depreciation policy
____ 8. Obtained letter from clients outside legal counsel
regarding pending litigation
____ 9. Inspected recorded addition to client materials
handling facilities
____ 10. Investigated decrease in revenue from scrap sales as
revealed by the application of analytical
procedures
SOLUTION:
1. a,d
2. d
3. e
4. b
5. b,c

6. a,c,d
7. d
8. e
9. a
10. b
PROBLEM/ESSAY
68. For each of the following ledger accounts, give an example of
substance underlying the account balance:
1. Cash in bank
2. Sales revenue
3. Inventories
4. Accounts payable
5. Notes payable
6. Capital stock
7. Marketable securities
8. Operating expenses
9. Wages and salaries expense
10. Property, plant, and equipment
SOLUTION:
1. Bank statement, canceled checks, deposit tickets

2. Sales invoices, shipping documents, cash register tapes 3. Goods in


warehouses, goods out on consignment
4. Vendors records of accounts receivable, vendors
invoices
5. Payees confirmation of amounts owed to them, copy of
note in clients files
6. Records maintained by registrar and transfer agent
7. Securities in vault or in safekeeping, brokers
advices, brokers confirmations
8. Vendors invoices, canceled checks, clients
workpapers supporting such charges as depreciation,
amortization, and product warranty
9. Payroll summaries, time cards, clock cards, canceled
checks, human resources records
10. Plant assets at various locations, vendors invoices
69. Audit evidence must be sufficient and competent. To be competent,
the evidence must be both valid and relevant.
Required:
a. What is meant by sufficient audit evidence?
b. Define the concepts of validity and relevance as they

relate to audit evidence.


SOLUTION:
a. Sufficient audit evidence is evidence that is adequate to support the
auditors opinion on the financial statements. A matter of audit judgment,
sufficiency is usually based on materiality and the adequacy of existing
internal control.
b. Validity of audit evidence is a function of three qualities:
1) The independence and competence of the source of
the evidence (e.g., external evidence possesses
greater validity than internal evidence);
2) The conditions under which the evidence was
obtained (e.g., evidence produced by strong
internal control possesses greater validity
than evidence gathered under weak internal
control); and
3) The manner in which the evidence was obtained
(e.g., evidence obtained directly by the auditor
possesses greater validity than evidence obtained
indirectly).
Relevance means that the evidence pertains to specific audit

objectives. Observing the taking of the inventory, for example, provides


evidence concerning existence of the inventory, but is not relevant to
determining ownership.
70. The following operating data has been provided to Erica Chavez by
her audit client, Grimes Hardware. Sales commissions
average 6 percent of sales:
2002 % 2003 % Change (%)
Sales $18,000 100% 22,000 100% 22%
Cost of sales 10,000 11,000
Sales commissions 1,080 1 100
Gross profit 6,920 9,900
Operating expenses 3,200 3,600
Income before taxes 3,720 6,300
Income taxes 1,200 2,000
Net income $2,520 4,300
===== =====
Required:
a. Complete the vertical and horizontal analysis by calculating the correct
percentages.
b. Why are both vertical and horizontal analysis important inputs to
analytical procedures?

c. Assuming sales commissions have been accurately


computed based on 2003 sales, what are the possible explanations for
any abnormalities produced by your percentage calculations?
SOLUTION:
a.
2002 % 2003 % Change (%)
Sales $18,000 100% 22,000 100% 22%
Cost of sales 10,000 56 11,000 50 10
Sales commissions 1,080 6 1,100 5 2
Gross profit 6,920 38 9,900 45 43
Operating expenses 3,200 17 3,600 16 13
Income before taxes 3,720 21 6,300 29 69
Income taxes 1,200 7 2,000 9 67
Net income $2,520 14 4,300 20 71
===== == ===== ==
b. Trend analysis (the Change column) examines changes in data over
time. Given the assumption that past trends may be expected to continue
into the future, significant changes warrant further investigation.Vertical
analysis (the first two percentage columns), by expressing all
components as percentages of a common base (sales in this case),
permits the auditors to compare percentages with previously developed
auditor expectations. If, for example, the auditor has previously

determined that commissions average 6% of sales, he/she may wish to


investigate the lower rate reflected in 2003 results.
c. If sales commissions are accurate and represent 6 percent of sales, the
sales base must be overstated in order to produce a commission rate of
only 5 percent. Sales may have been fabricated, or 2004 sales may have
been recorded in 2003. The material decline in cost of sales as a
percentage of sales suggests that recorded sales transactions were not
accompanied by cost of sales entries.
71. The following financial data have been extracted from the records of
Blackwell Wholesale Tires:
2003 2002
Sales $15,660 14,980
Cost of sales 7,800 7,400
Ending inventory 6,200 4,300
Accounts receivable-trade 2,200 1,300
Total current assets 12,300 10,100
Total current liabilities 7,300 4,980
Customer payment terms:
2/10;n/30
Industry averages:
Gross margin 51%
Current ratio 2:1

Inventory turnover 2.5


Accounts receivable turnover 11.0
Required:
Based on the above data, in which areas do you recommend
concentrating audit resources for the 2003 audit? Support your answer by
citing the relevant data.
SOLUTION:
2003 2002
Sales $15,660 14,980
Cost of sales 7,800 7,400
Gross margin 7,860 50% 5,580 49%
Inventory and accounts receivable appear to warrant emphasis for
Blackwell Wholesale Tires. Although the gross margin has not changed
materially in 2003 relative to 2002 and approximates the industry
average for both years, inventory turnover has declined significantly and
is well below the industry average (1.25 v. 2.5). This suggests the
possibility of inflated inventory quantities, incorrect inventory prices,
obsolete inventory, or some combination of these. Accounts receivable
turnover for 2002 was approximately equal to the industry average; but
for 2003 turnover has declined to approximately 7 times versus 11 times
for the industry. Given payment terms of 2/10;n/30, one would expect a
turnover between 11 and 12 times, or approximately 30 days sales in
accounts receivable. A turnover of 7 times equates with approximately 50
days sales in accounts receivable. Failure to properly investigate
customer credit, or weak collection procedures, or inflated accounts
receivable are possible explanations for the decline in turnover. Although

the current ratio appears adequate when compared with the preceding
year and with the industry average, the quick ratio (current assets minus
inventory divided by current liabilities) has declined from 1.16 in 2002 to
.84 in 2003. This suggests a short-term liquidity problem, especially if
inventories are overstated and/or customer accounts receivable are
delinquent.
71. Identify the deficiencies in the following audit workpaper:
TRAMWAY ENTERPRISES
Bank Reconciliation
12/31/2003
Balance per bank $5,774 *
Add deposit in transit 1,223 &
6,997
Deduct outstanding checks:
4455 $67 &
4477 180 &
4478 1,023 &
4479 33 &
1,303
Adjusted balance $5,594
=====

Balance per ledger $6,300


Adjustment to correct (706)
Adjusted balance as above $5,594
======
SOLUTION:
1. Initials of preparer and reviewer and dates of
preparation and review are missing.
2. Name of bank account being reconciled is omitted.
3. Subtraction error. Adjusted balance should be $5,694
rather than $5,594.
4. Audit adjustment of $706 not explained.
5. Audit legends not explained