Ch04-Audit Evidence and Audit Programs

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 each individual 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:

2.

Of the following procedures, which is not considered part of “obtaining an understanding of the client’s 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:

3.

D

B

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

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4.

Chapter 4 Audit Evidence and Audit Programs 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:

5.

Choose the best illustration of objective audit evidence from the following a. The paid invoice file containing invoices matched with receiving reports and purchase orders. b. Management's assertion that payment procedures require matching 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:

6.

C

A

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

Chapter 4 Audit Evidence and Audit Programs 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:

8.

D

An auditor wants to develop an audit test to evaluate the reasonableness 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: 10.

C

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:

11.

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A

An assumption underlying analytical procedures is that

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Chapter 4 Audit Evidence and Audit Programs a. b. c. d.

These procedures cannot replace tests of balances and transactions. Statistical tests of financial information may lead to the discovery of material errors in the financial statements. The study of financial ratios is an acceptable alternative to the investigation of unusual fluctuations. Relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary.

ANSWER: 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:

13.

C

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:

14.

D

D

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.

Chapter 4 Audit Evidence and Audit Programs ANSWER: 15.

A

The procedures specifically outlined in an audit program primarily designed to a. Protect the auditor in the event of litigation. b. Detect errors or fraud. c. Test internal evidence. d. Gather evidence. ANSWER:

18.

B

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:

17. are

B

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:

16.

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D

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.

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Chapter 4 Audit Evidence and Audit Programs ANSWER:

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:

20.

A

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:

22.

C

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:

21.

D

A

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.

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Chapter 4 Audit Evidence and Audit Programs ANSWER: 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:

24.

C

C

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: 26.

D

An auditor test counted a batch of inventory. example of what kind of evidence? a. Analytical. b. Documentary. c. Physical. d. Hearsay. ANSWER:

C

This is an

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27.

Chapter 4 Audit Evidence and Audit Programs

In evaluating the reasonableness of advertising expense, which of the following would be the best evidence? a. Oral evidence obtained through discussions with company marketing executives and representatives of the advertising 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 charges submitted by the advertising agency and paid by the company. ANSWER:

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:

29.

C

D

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

Chapter 4 Audit Evidence and Audit Programs

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:

31.

B

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 disbursements with budgeted amounts. ANSWER:

32.

44

C

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

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34.

Chapter 4 Audit Evidence and Audit Programs 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 expense-related 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: 37.

D

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

Chapter 4 Audit Evidence and Audit Programs

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:

39.

D

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:

40.

A

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: 42.

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B

During the working paper review, an audit supervisor finds that the auditor's reported findings are not adequately cross-referenced to supporting

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Chapter 4 Audit Evidence and Audit Programs

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 the relationship 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: 44.

Generally, what source of evidence should most impact audit conclusions? a. External b. Inquiry. c. Oral. d. Informal. ANSWER:

45.

A

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:

46.

A

B

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?

Chapter 4 Audit Evidence and Audit Programs a. b. c. d.

An increase in the discount offered for early payment. A more liberal credit policy. A change from net 30 to net 25. Greater cash sales.

ANSWER: 47. the

A

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:

50.

D

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:

49.

B

Which of the following is generally included or shown in 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 matters disclosed by the auditor's procedures were resolved or treated. ANSWER:

48.

48

D

The principal reason for developing a written audit program is to help assure that the a. Audit work is properly supervised.

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Chapter 4 Audit Evidence and Audit Programs b. c. d.

Audit work is properly planned and documented. Audit report contains only significant findings. Work of different auditors is properly coordinated.

ANSWER: 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:

52.

D

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:

54.

A

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:

53.

B

D

External auditors often confirm assertions contained in the organization'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.

Chapter 4 Audit Evidence and Audit Programs d.

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Confirmation by knowledgeable third parties is highly competent 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:

57.

PLANNING

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:

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:

60.

COMPETENCE (VALIDITY)

COMMISSION, OMISSION

Evidence consisting of everything that can be counted, examined, observed, or inspected is referred to as _____________ evidence.

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Chapter 4 Audit Evidence and Audit Programs

ANSWER: 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:

62.

of evidence that auditors' are often first procedures.

COMPLETENESS

MATHEMATICAL

A group of related transactions affecting essentially the same set of general ledger accounts is referred to as a _________________ . ANSWER:

65.

evidence may be the best form the objective, in concerning errors of omission the application of analytical

An auditor-prepared bank reconciliation is an example of _______________ evidence. ANSWER:

64.

DOCUMENTED

Analytical supporting suspicions aroused by ANSWER:

63.

PHYSICAL

TRANSACTION CYCLE

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. b. c. d. e. f.

Physical evidence Confirmation evidence Documentary evidence Analytical evidence Mathematical evidence Hearsay evidence

Chapter 4 Audit Evidence and Audit Programs

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____ 1. Audited client-prepared bank reconciliation (mathematical ____ 2. Vouched debits to repairs accounts by examining vendors’ invoices documentary ____ 3. Observed the client’s year-end physical inventory physical ____ 4. Compared accounts receivable turnover with industry Averaage ____ 5. Prepared ten-year income summary expressing all components as a percentage of sales ____ 6. Obtained letter from client’s 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 client’s 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. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

e c a d d b f e b a d

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Chapter 4 Audit Evidence and Audit Programs

67. For each of the listed procedures, indicate, by letter, the assertion(s) being tested. a. b. c. d. e.

Existence or occurrence Completeness Rights and obligations Valuation or allocation Presentation and disclosure

____ 1. Confirmed customer accounts receivable A,D ____ 2. Vouched property additions to underlying Documentation consisting of vendors’ invoices and work orders D-VALUATION ____ 3. Inquired of corporate treasurer as to reasons for buying and holding securities E-PRESENTATION ____ 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 B-COMPLETENESS

____ 5.

Examined vendors’ invoices recorded after year-end to determine whether any of these invoices represent liabilities of the client as of year-end B,C – COMPLETENESS…RIGHTS… ____ 6.

Obtained confirmation of marketable securities from client’s brokers A,C,D – EXISTENCE…RIGHTS…VALUATION

____ 7.

Evaluated the reasonableness of the client’s depreciation policy D – VALUATION …

____ 8.

Obtained letter from client’s outside legal counsel regarding pending litigation E – PRESENTATION …

____ 9.

Inspected recorded addition to client materials handling facilities A - EXISTENCE

____ 10. Investigated decrease in revenue from scrap sales as revealed by the application of analytical procedures B – COMPLETENESS SOLUTION: 1.

a,d

Chapter 4 Audit Evidence and Audit Programs 2. 3. 4. 5. 6. 7. 8. 9. 10.

d e b b,c a,c,d d e a b

PROBLEM/ESSAY 68. For each of the following ledger accounts, give an example of substance underlying the account balance: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Cash in bank Sales revenue Inventories Accounts payable Notes payable Capital stock Marketable securities Operating expenses Wages and salaries expense Property, plant, and equipment

SOLUTION: 1. 2. tapes 4. 5. 6. 7. 8. 9. 10.

Bank statement, canceled checks, deposit tickets Sales invoices, shipping documents, cash register 3. Goods in warehouses, goods out on consignment Vendors’ records of accounts receivable, vendors’ invoices Payees’ confirmation of amounts owed to them, copy of note in client’s files Records maintained by registrar and transfer agent Securities in vault or in safekeeping, brokers’ advices, brokers’ confirmations Vendors’ invoices, canceled checks, client’s workpapers supporting such charges as depreciation, amortization, and product warranty Payroll summaries, time cards, clock cards, canceled checks, human resources records 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.

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Chapter 4 Audit Evidence and Audit Programs

Required: a. b.

What is meant by “sufficient audit evidence?” 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 auditor’s 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 Sales $18,000 Cost of sales 10,000 Sales commissions 1,080 Gross profit 6,920 Operating expenses 3,200 Income before taxes 3,720 Income taxes 1,200 Net income $2,520 =====

% 100%

2003

%

22,000 11,000 1 100 9,900 3,600 6,300 2,000 4,300 =====

100%

Change (%) 22%

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Chapter 4 Audit Evidence and Audit Programs 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 Sales $18,000 Cost of sales 10,000 Sales commissions 1,080 Gross profit 6,920 Operating expenses 3,200 Income before taxes 3,720 Income taxes 1,200 Net income $2,520 =====

% 100% 56 6 38 17 21 7 14 ==

2003

%

22,000 11,000 1,100 9,900 3,600 6,300 2,000 4,300 =====

100% 50 5 45 16 29 9 20 ==

Change (%) 22% 10 2 43 13 69 67 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

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Chapter 4 Audit Evidence and Audit Programs

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 Cost of sales 7,800 Ending inventory 6,200 Accounts receivable-trade 2,200 Total current assets 12,300 Total current liabilities 7,300 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

14,980 7,400 4,300 1,300 10,100 4,980

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:

Sales Cost of sales Gross margin

2003

2002

$15,660 7,800 7,860

14,980 7,400 5,580

50%

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

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Chapter 4 Audit Evidence and Audit Programs

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 Add deposit in transit

$5,774 * 1,223 & 6,997

Deduct outstanding checks: 4455

$67 &

4477 4478

180 & 1,023 &

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Chapter 4 Audit Evidence and Audit Programs 4479

Adjusted balance Balance per ledger Adjustment to correct Adjusted balance as above

33 & 1,303 $5,594 ===== $6,300 (706) $5,594 ======

SOLUTION: 1. 2. 3. 4. 5.

Initials of preparer and reviewer and dates of preparation and review are missing. Name of bank account being reconciled is omitted. Subtraction error. Adjusted balance should be $5,694 rather than $5,594. Audit adjustment of $706 not explained. Audit legends not explained.