Solutions 12e FINAL

The Lakeside Company: Auditing Cases SOLUTIONS MANUAL 12e Table of Contents John M. Trussel and J. Douglas Frazer A Note on Ethics, Fraud and SOX Questions 2 A Note on Research Assignments 3 Introductory Case 5 Case 1

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Case 2

22

Case 3

33

Case 4

44

Case 5

58

Case 6

74

Case 7

82

Case 8

92

Case 9

101

Case 10

110

Case 11

116

Case 12

125

Case 13

136 1

A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS The Lakeside Company: Auditing Cases, 12th edition, has been updated in light of the accounting scandals of the early 2000s, the passage of the Sarbanes-Oxley Act of 2002, and the renewed interest in ethics within the accounting and auditing profession. Sarbanes-Oxley issues have been incorporated in two ways. First, case content has been altered to include Lakeside’s consideration of financing expansion through an initial public offering, and the resulting impact such a decision would have on Lakeside and on Abernathy and Chapman, CPAs. Second, the discussion questions and exercises have been expanded to include consideration of Sarbanes-Oxley and new auditing and independence standards, both by adding a section in the end-of-chapter material and by reference in the other questions where appropriate. Ethics questions are now specifically identified with an ethics logo. The ethics questions are often open ended, and this solutions manual does not try to give exact answers to these questions. Rather, we intend to give some ideas for classroom discussion, and to help with student research on these questions. Fra Fra ud ud

Fraud questions are now specifically identified with a fraud triangle.

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A NOTE ON RESEARCH ASSIGNMENTS The "Apply Your Research" and "Consulting Partner Review" assignments included at the end of several cases do not lend themselves to definitive solutions that could be included in an instructor's manual. The assignments are simply not intended to be exercises in arriving at a predetermined answer. Rather, the applications of the suggested readings have the following objectives: -

To provide a means for improving the writing skills of students. From all reports, accounting majors too often leave college lacking in the basic ability to compose and construct sentences and paragraphs. Accounting and auditing (especially as one moves up in an organization) obviously require skills other than the purely quantitative. Memos, reports, footnotes, audit and accounting guides, etc., all require accountants and auditors to be effective communicators of the written word. Indeed, the instructor may want to team up with a member of the school's English or communications department to enhance the effectiveness of these assignments. The auditing instructor can then evaluate the technical and research portions of the assignment, while the English instructor would make suggestions as to grammar, syntax, construction of sentences and paragraphs, logic of the thought process, etc. As a preliminary step, the instructor may want to assign articles such as "Word Crunching: A Primer for Accountants" from the March 1990 issue of the Journal of Accountancy.

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To introduce students to accounting and business journals as well as other important publications. After college, students must be able to "keep current" or their effectiveness will quickly decline. In most cases, this continuation of their education is provided by the regular reading of publications such as The Wall Street Journal, Journal of Accountancy, CPA Journal, and Forbes. These assignments require the students to begin reading these journals prior to graduation. The students should become comfortable with their ability to understand and use the materials in professional publications. In addition, real-world aspects of many accounting issues are presented through these various readings.

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To develop the students' ability to derive viable solutions to auditing problems. Unfortunately, students in college often come to the belief that all auditing issues can be resolved simply by applying the pronouncements of various authoritative bodies. Textbooks too often present problems that have one ultimate answer. However, in many real cases, no definitive solutions actually exist. Thus, when faced with such problems, students must be capable of reviewing the available literature and then using that information as a basis for arriving at a workable 3

decision. -

To promote auditing research. In most of these library assignments, students are provided with one or more resources as starting points for their research. However, the instructor should always push the students to look for more and different types of information. The ultimate purpose of these assignments is to force the students into the library and online sources to do the searching for themselves. One excellent method of introducing the assignments is to use some class time to illustrate the various methods of research that are available to them, including electronic resources, such as the following: o http://www.sec.gov o http://www.PCAOBUS.org o http://www.AICPA.org o http://www.FASB.org o Your state society of CPAs also operates sites. If possible, a business librarian or a research librarian may be enlisted to discuss the various search techniques that can be used at the school's library for research purposes. Developing the ability to find information is one of the most important skills that can be achieved by an accounting major.

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INTRODUCTORY CASE SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) The staff auditor performs many of the detailed audit procedures, such as preparing and controlling accounts receivable confirmations. In general the work of the staff auditor is controlled by the audit program and supervised by the senior auditor. The senior auditor coordinates the audit at the client's location and performs many of the more difficult audit procedures, such as analytical review procedures. Usually the detailed work performed by the audit senior is more sophisticated and requires the experience gained by someone holding that rank. The audit senior is supervised by the manager. The manager and the partner have supervisory roles. Managers and partners often have more than one audit team under supervision at any given time. The partner is the person who has responsibility for determining whether the firm’s signature can be attached to audit report. (2) The partner-in-charge of an audit is the definitive decision-making position on the audit team. Although the manager and senior auditor make several decisions, they must get ultimate approval from the partner-in-charge of the audit. The consulting partner's role is to add a further degree of objectivity to the audit. The consulting partner reviews and critiques certain crucial decisions made by the audit team, such as the final audit report. The partners should be rotated to assure independence. Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and a Reviewing Partner. Both partners must be rotated every five years. (3) An accounting firm is a business like any other, and its management must recognize that a marketing strategy is probably necessary to generate a continual flow of sufficient operating revenues. However, in the accounting profession, disagreement exists as to the extent that such marketing should take. In the past, overt marketing was not permitted since it was considered to be unprofessional. This position was supported based on the reasoning that a firm 5

should be selected based solely on the quality of its service. No reliable system existed, though, for conveying such information to potential clients. Hence, firms with many clients tended to remain large, while smaller firms often found growth to be nearly impossible. In the free market system espoused by the United States, restrictions on such practices as advertising and solicitation were inevitably overturned. Over the past three decades, attitudes toward marketing have changed dramatically as competition has become much more intense. Advertisements by CPA firms in newspapers and magazines are now common. Newsletters such as that distributed by Abernethy and Chapman are also frequently used to increase a firm's name recognition in the business community. In the current world of business, some type of marketing strategy seems imperative if an accounting firm is to compete. Whether that marketing should extend to formal advertising is often a question of firm policy. Most importantly, the firm must ensure that potential clients know of its presence and the services that it offers. A client will probably not select a CPA firm based on advertising. However, the client may initially become aware of the firm only through some type of marketing. Interestingly, some members of the accounting profession view marketing as having had a negative impact on the profession as a whole. Price competition for new clients is often associated with the marketing of a firm. These critics assert that lowered fees result in sloppy and hurried audit work that can decrease the overall reputation of the profession. (Additional resources discussing this issue can be found in the "Suggested Readings" at the end of this case.) (4) A national or international CPA firm might consider acquiring Abernethy and Chapman for several reasons: -

Although only a regional firm, Abernethy and Chapman apparently has a client base that includes a number of large clients in several different industries. By acquiring the local firm, the larger organization will frequently be able to retain these customers, thus increasing its own client list.

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The larger firm may be interested in moving into this geographical region, and buying the local firm will provide an instant base on which to build a practice in the area.

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The larger firm may already have an office in this location and feels that combining the practices will reduce expenses.

Abernethy and Chapman might have several reasons for viewing an acquisition in a favorable light: 6

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Frequently, the purchase price will be a considerable amount of money because of the goodwill inherent in an established accounting firm. The offer to sell may be especially tempting if the partners are nearing retirement age and the future of the firm appears uncertain.

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The smaller firm may have trouble dealing with increased competition from bigger firms. Often clients may decide that a change to a nationally known CPA firm should be made to add extra stature to the audit report. If a local organization has only a few large clients, it cannot economically afford to lose a significant amount of revenue in this way. A merger may help the firm to keep its clients. -

The regional firm may also desire the additional backup services offered by large organizations. National CPA firms usually have experts in many industries as well as in specific audit areas who are available for consultation. In a smaller firm, this degree of assistance is not always available when a difficult accounting or auditing problem is encountered.

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PCAOB registration and SEC practice presents hurdles that might be overcome through a merger with a larger firm.

Many mergers have occurred in the auditing profession during recent years. Critics assert that this trend has reduced competition and will inevitably lead to a decrease in audit quality. Proponents counter by stating that mergers lead to more efficient operations and, thus, improve audit quality. Obviously, mergers will create a drastic change in the profession as more of the smaller firms disappear. Audit work in this country may possibly become concentrated within the largest CPA firms. Whether this result is good for the auditing profession may be merely a question of perspective. To the smaller firms struggling to survive and grow, the mergers are usually considered a threat as the bigger firms become more competitive. To the larger firms, the chance for continued growth and more efficient operations is always an important objective. See the Sarbanes-Oxley section below for a follow-up question related to the impact of SOX on the auditing profession. (5) Moving staff from one area of a CPA firm to another can cause the perception of an independence problem. For example, the appearance of independence may be in question if a member of the consulting staff helps to install a new accounting system for a client and then she moves to the audit staff to audit this same client. See the Sarbanes-Oxley section below for a follow-up question/answer related to 7

the impact of SOX, in particular the list of proscribed activities for registered CPA firms. SUGGESTED ANSWERS TO EXERCISE (1) The question requires students to address all the elements of a quality control system, as included in Statement on Quality Control Standards No. 2. In some cases, students should recognize the need for additional information. To: DeAnna Malott From: Date: Re: Quality Control Standards at Abernethy and Chapman Overview: I was employed by the firm of Abernethy and Chapman to review the quality control standards within the firm. The following represents my evaluation of these standards according to the six elements required by the AICPA. Evaluation: Standard Leadership responsibilities

Relevant ethical requirements

Existing Procedures

Recommendations

The case does The firm should have not explicitly policies in place that address this establish the “tone at standard. the top” for quality However, the firm within the firm. has some items in place, such as a partner dedicated to monitoring the system. Firm requires its The AICPA's Code of employees to Professional sever all Conduct does not financial ties to require all audit clients. employees to sever ties with all audit clients. For example, staff auditors not working on a particular 8

Additional Information Needed What specific policies does the firm have to demonstrate leadership responsibilities for quality within the firm?

The case does not mention spouses or dependents of the employees. Spouses and dependents must also be independent, as defined by

Acceptance and continuation of clients

Human resources

engagement need Section 100-not sever ties. In this Rule 101 of the case, the firm Code. In this exceeds the case, the firm minimum level of should conduct for strengthen its independence. requirements. The case does not How does the address other ethical firm meet other requirements. ethical requirements? This case does It is important to  not address this have many controls control standard. when considering a It does note that potential client, so the firm is that the potential attempting to risks of legal gain more clients exposure are not too through an great. (Note: This extensive topic is addressed in marketing Case 2.) program. The firm This appears to be a considers reasonable quality experience and control. technical competence in assigning personnel to audit engagements. The firm hires This seems to be a only college more than adequate graduates with a quality control major in procedure. In fact, accounting and many firms hire requires that professionals, such each as computer experts, professional sit who were not for the CPA accounting majors. exam within one year of employment. The firm requires Many states require 9

40 hours of continuing education per year; however, the case does not address the issue of the type of education (e.g., accounting and auditing versus other courses).  The firm promotion procedures consider seniority and technical competence, which seems to be an adequate control.

Engagement performance

that a minimum number of continuing professional education hours be in accounting- and auditing-related courses.

The case does not address the issue of assessment of technical competence. Many firms require a written assessment of performance after each engagement.

The firm requires The firm should have that a consulting a mechanism for partner be consultation with assigned to each authoritative audit literature and other engagement. sources, including The consulting outside experts, if its partner assures professional staff that the work lacks expertise in a performed by the particular area. engagement team meets applicable professional standards and regulatory requirements. This helps to ensure objectivity, as the consulting 10

It is not clear from the case how the team documents the work performed on an audit engagement. An evaluation of audit documentation is necessary for complete evaluation of the quality controls.

auditor is not a direct part of the engagement. The firm seems to have a clear chain of command and adequate supervision on the audit. The staff auditors report to the senior auditor, who in turn reports to the manager. The partner-incharge has an overall supervisory position. Monitoring

The firm has a partner, DeAnna Malott, assigned to monitor the quality control standards.

A comprehensive system of documentation of the quality controls should be developed.

The case does not mention what types of documents are required to support these controls, but documentation is extremely important. For example, many firms require employees to submit a listing of all financial ties to companies so that the firm can monitor its independence.

Conclusion: The firm has many policies related to quality control standards. However, the firm has room for improvement in many of the areas, particularly in the acceptance and continuation of clients.

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SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS (1) Students should be encouraged to visit the (http://www.pcaobus.org) when answering this question:

PCAOB

website

Registration – CPA firms must be registered to be associated with public companies. The application for registration is an online process. There is a fee, it is small relative to other costs of maintaining the registered status and changing the nature of the firm to comply with PCAOB rules. Here is the fee structure from their website:

Inspection - The PCAOB operates a system of inspections and publicizes the results, per its authority under the SOX Act: The Act provides that an inspection shall include at least the following three general components: • An inspection and review of selected audit and review engagements of the firm, performed at various offices and by various associated persons of the firm; • An evaluation of the sufficiency of the quality control system of the firm, and the manner of the documentation and communication of that system by the firm; and • Performance of such other testing of the audit, supervisory, and quality control procedures of the firm as are necessary or appropriate in light of the purpose of the inspection and the responsibilities of the Board. Regular inspections are on a three-year cycle, although smaller firms may be less frequent. Special inspections can be required by the PCAOB. -

Maintenance of independence under PCAOB rules and SOX12

proscribed activities: Proscribed activities under SOX (section 201): Section 201: Services Outside The Scope Of Practice Of Auditors; Prohibited Activities. It shall be "unlawful" for a registered public accounting firm to provide any nonaudit service to an issuer contemporaneously with the audit, including: (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; (9) any other service that the Board determines, by regulation, is impermissible. The Board may, on a case-by-case basis, exempt from these prohibitions any person, issuer, public accounting firm, or transaction, subject to review by the Commission. It will not be unlawful to provide other non-audit services if they are pre-approved by the audit committee in the following manner. The bill allows an accounting firm to "engage in any non-audit service, including tax services," that is not listed above, only if the activity is pre-approved by the audit committee of the issuer. The audit committee will disclose to investors in periodic reports its decision to pre-approve non-audit services. Statutory insurance company regulatory audits are treated as an audit service, and thus do not require pre-approval. The pre-approval requirement is waived with respect to the provision of non-audit services for an issuer if the aggregate amount of all such non-audit services provided to the issuer constitutes less than 5% of the total amount of revenues paid by the issuer to its auditor (calculated on the basis of revenues paid by the issuer during the fiscal year when the non-audit services are performed), such services were not recognized by the issuer at the time of the engagement to be non-audit services; and such services are promptly brought to the attention of the audit committee and approved prior to completion of the audit. The authority to pre-approve services can be delegated to 1 or more members of the audit committee, but any decision by the delegate must be presented to the full audit committee. Partner rotation - The rotation of the lead partner and the reviewing partners are required by the SOX Act. Quality Control Standards – Registered firms must maintain the SEC practice requirements:

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AICPA Quality Control Standards for public company audits are summarized at: http://cpcaf.aicpa.org/Resources/

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CASE 1 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) Financial statements are frequently relied on by outside parties such as stockholders and banks when making decisions about an enterprise. Should equity securities be bought or sold? Should a long-term loan be given? However, financial statements are the representations of the management of the company. As such, these statements will not necessarily be fairly presented. Material misstatements may exist in the form of errors, irregularities, or illegal acts. The management might, for example, have an insufficient knowledge of generally accepted accounting principles to produce appropriate statements. Human error or bias is also possible in the gathering and reporting of financial information. In addition, the management may have fraudulently manipulated the data in hopes of achieving some objective. Outside parties are aware that the financial information produced by a company and its management may not always be reliable. Hence, to add credibility to this reporting process, independent experts are retained to audit the financial statements and test the underlying accounting records. These auditors then issue an opinion for the benefit of outside parties as to the fair presentation of the financial statements in conformity with generally accepted accounting principles. This added degree of assuredness allows decision-makers to rely on reported financial information. (2) A CPA firm could not be expected to maintain expertise in every potential industry that it might audit. In reviewing a potential client, the firm should evaluate its ability to gain the necessary industry expertise prior to the actual audit, but no requirement exists that this knowledge must be possessed prior to accepting the engagement. Each industry may have its own specific accounting practices. In addition, certain industries frequently offer unique auditing problems. Thus, without a thorough investigation, the auditor cannot ascertain the knowledge that will be needed in examining a potential client. In the consumer electronics business, for example, the methods of distribution as well as credit policies would be significantly different from those found in a car dealership. Damaged or obsolete inventory are other problems that might be more important in this specific industry. Hence, a knowledge of one type of operation does not necessarily mean that the auditor has the expertise needed to examine a client operating in a 15

different industry. Auditing standards require that auditor to have the expertise by the completion of the audit, but this expertise need not be in place at the beginning. It would be unethical to misrepresent a firm’s experience, but it need not be volunteered. (3) A profit-sharing bonus plan gives employees an added incentive to seek increases in company income; a larger profit figure will lead to a larger bonus at the end of the year. Consequently, employees may be tempted to inflate income artificially by creating false sales or deferring the recording of expenses. An auditor must always be alert for situations that can promote the possibility of such irregularities. A profit-sharing bonus plan may well have only positive effects on company employees. However, the auditor should not be so naive as to fail to recognize that some individuals may take advantage of such plans by manipulating the financial records. This problem may be especially significant in the Lakeside Company because the bonus plan is new and the stores are geographically located at a distance from the home office. New plans require adaptation by company controls and such separation always increases potential control concerns. In addition, Rogers has already mentioned that some of the internal control systems are no longer adequate. Thus, the possibility of inflated income figures is even more of a possibility. (4) Critics of the auditing profession have argued vehemently for a number of years that advisory services such as those discussed in this question taint the appearance (and possibly the reality) of independence. These services may appear, to the public, to give the audit firm a financial interest in the success of the company. This argument holds that the firm will now want the client to succeed as proof of the quality of the advice that was given. In addition, the audit team may be less judicious in investigating these systems since they are aware that members of their own firm designed and installed them. Audit firms counter by stating that adequate safeguards have been put into place to ensure continued independence. For example, advisory services are frequently rendered by a separate division of the firm so that no proximity exists between this function and the audit staff. In addition, firms are not allowed to give many types of advice that might jeopardize their independence. Finally, audit firms must make certain that their services are limited to making recommendations, and are not for carrying out management decisions. The firm cannot make decisions for the client.

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Sarbanes-Oxley specifically proscribes various activities that have traditionally been part of the CPA’s repertoire. Design of accounting systems is prohibited, although helping a client with selection and implementation of off-the-shelf packages would be acceptable. So, in this case, it depends on what the client means by “developing.” In the event that Lakeside goes forward with its public offering Abernathy and Chapman will need to decide whether to remain independent so they can continue as Lakeside’s auditor, or sacrifice independence to do systems consulting. Sarbanes-Oxley prevents trying to do both. (5) In his article "The Initial Audit Engagement Conference" in the Journal of Accountancy for September 1976, Bernard Valek lists a number of steps that can be performed in a plant tour to avoid later "surprises" as well as to assist the firm in establishing an appropriate audit fee. The first three are typical of a plant tour. The others go beyond the typical tour. Students should not be expected to anticipate each of these procedures but the question can be used to emphasize the importance of the auditor's complete understanding of the audit client. These steps include: *

Inspect inventory for possible obsolescence and an indication of the major product lines of the company.

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Verify the presence or absence of a perpetual inventory system.

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Review manufacturing facilities for indication of level of activity as well as any idle machinery.

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Review journals for careful preparation.

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Review general ledger activity for unusual entries.

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Review monthly financial statements for unusual variations.

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Review bank reconciliations, and compare to general ledger.

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Examine accounts receivable reconciliation to general ledger balance.

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Review client physical inventory method.

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Discuss with client the policy for valuing inventory and identifying obsolete inventory items.

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Discuss with client the procedures for obtaining a proper year-end cutoff. 17

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Review depreciation schedules, and recalculate a sample of the depreciation expense figures.

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Review income tax returns.

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Examine information relating to any capital stock or retained earnings transactions for the past year.

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Review minutes of board of directors' meetings and stockholders' meetings for unusual or material matters.

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Read lease agreements.

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Review past audit reports.

(6)

A company may not want its CPAs to audit a client's records because the auditors gain a substantial amount of competitive information during an audit. However, CPAs are bound by confidentiality under the AICPA's Code of Professional Conduct. Also, a CPA's knowledge of the industry gained from having several clients in the same industry provides him or her with insights he/she may not have otherwise had. SUGGESTED ANSWERS TO EXERCISES

(1) (a) and (b) The independent auditor must be able to review massive quantities of information and identify the fraud risk factors that may affect the amount of evidence to be gathered or the opinion to be rendered. This question calls upon the judgment abilities of the students. The format used by students for this memo is not important as long as it is clear and understandable. SAS 99 requires use of a brainstorming session in the planning stage to be sure that everyone associated with the audit understands the nature of the business and the potential risk of fraud. These sessions can also occur during the audit if additional evidence presents itself. Potential problems that students would be expected to identify are as follows. Additional fraud risk factors may also be identified by the students. Fraud Risk Factors Internal Control - The president of the company admits that the company's internal control is antiquated. Control problems may be heightened in that operations extend throughout two

Auditor Follow Up Since understanding the internal control is one of the prerequisites for ultimately determining the amount of substantive testing that will be required, the weakness of the various controls 18

Fraud Risk Factors states. Uncertainty Involved with the Sixth Store - A qualified opinion was issued by the predecessor auditor in connection with this store. Inventory - The mere size of the inventory of a business like Lakeside would make this account a critical audit area. Distributorship Sales - The case indicates that these sales have risen dramatically during the past two years.

Bonus System - This system has been recently installed by Lakeside, so very little is known about its effects upon the financial results of the company.

Related Party Transactions - The case indicates that Lakeside has begun to have financial dealings with the president of the company. Rental Agreements - Five of the stores have been leased and, apparently, Store Seven will be rented from Rogers. Rental agreements pose the question as to the need for capitalizing the lease. Accounts Receivable - All distributorship sales are made on credit. Loan Agreements - Lakeside has a number of loans outstanding. Inventory Returns - For distributorship sales, up to 20% of the inventory items

Auditor Follow Up may require the extensive gathering of evidence, or even preclude an opinion. Abernethy and Chapman must face the question as to whether this issue can be resolved during 2009. The auditor will face the problem of verifying the existence, cost, value, presentation, and ownership of the electronic equipment. Any sudden change or fluctuation in an account balance will always warrant the auditor's attention. In this instance, the auditor will be especially interested in verifying the validity of these sales figures. This factor alone can cause difficulty in the auditor's examination. In addition, any bonus system will provide an incentive for the employees to falsify the company's financial records. The auditor must be aware that employees can benefit from producing falsely inflated income figures. Obviously, nothing is wrong with this arrangement, but such related party transactions are often difficult for the auditor to verify. In addition, they require clear disclosure. Abernethy and Chapman will have to read the various agreements to see if any of them qualify as a capital lease under the criteria established by the Financial Accounting Standards Board. The size of the receivable account and the problem of determining collectibility will be a critical audit area for the auditor. The auditor will need to study each loan agreement to ascertain that the company is not violating any of the loan covenants. Not only is the potential size of this liability a problem, but the auditor's 19

Fraud Risk Factors can be returned within four months. As of the end of the year, Lakeside will have a large contingent liability associated with the inventory items sold during the last four months. Possible public offering of stock

Auditor Follow Up ability to estimate the amount must be a concern.

A public offering raises risk for manipulation of the financial statements in order to attract capital. In addition, the number of potential readers of financial statements has changed dramatically, making the risk associated with this audit much higher.

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(2) INDEPENDENT AUDITOR'S REPORT To the Board of Directors: We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2011, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. During 2010, the Lakeside Company made a large investment in a retail store located in the eastern sector of Richmond, Virginia. This store has failed to reach a break-even sales point to date, and total recovery of the Company's investment is highly uncertain. In our opinion, the chances are reasonably possible that the asset's value has been permanently impaired and should be reduced to the net realizable value in conformity with generally accepted accounting principles. Management of the company has refused to recognize this impairment loss. In our opinion, except for the effects of not recording or disclosing the impairment of value of the asset, as discussed in the preceding paragraph, the aforementioned financial statements present fairly, in all material respects, the financial position of the Lakeside Company at December 31, 2011, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. King and Company (signed), Certified Public Accountants Date: (last day of audit fieldwork)

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SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS (1) The issuance of stock is regulated by the Securities and Exchange Commission and the accounting, auditing and reporting is regulated by the PCAOB since 2002. A summary of the regulations follows: Issuance of stocks are regulated primarily under the SEC acts of 1933 and 1934. Registration with the SEC is required, which includes financial reporting. The laws are summarized at: http://www.sec.gov/about/laws.shtml. The financial reporting and auditing for public companies has been regulated by the PCAOB since 2002. The PCAOB registers, inspects and disciplines the auditors of public companies. Its effect on the public companies is indirect, through the regulation of the auditors. Encourage students to visit the SEC EDGAR site to understand the nature of electronic, public financial information. (2) CPA firms wishing to be associated with public companies must be registered firms, accept the inspection process, and be subject to the discipline of the the PCAOB. CPAs in public practice ofhave three choices. It is not only public vs. private, because some CPA firms are choosing to give up the requirement for independence and perform accounting, tax, and consulting services that are not possible for registered CPA firms. Thus their clients have two CPA firms, one for the non-independent services and one for the audit. In the case of Abernathy and Chapman, they will need to choose the nature of their practice. This is a major strategic choice. Most CPA firms do not perform public company audits. Large international and national firms handle almost all of the companies on the exchanges.

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CASE 2 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) The question of materiality is certainly one of the most complex issues in all of auditing. No clear-cut guidelines have ever been established to aid the auditor in deciding whether a specific balance or transaction is "material." This lack of an official standard provides the auditor with the freedom to base all final decisions on professional judgment. Unfortunately, without a formal rule, the auditor has little guidance in applying judgment to a particular situation. Materiality has traditionally been held to be any factor that would influence the decisions of those parties relying on the financial statements. Identifying a proper basis of comparison is an important aspect in determining whether an uncertainty is material. Net income is the most obvious standard of comparison, although another consideration is which of the statements is affected (e.g., Balance Sheet, Income Statement, or both?). The situation questioned by King and Company involves an investment in fixed assets. Comparing the potential loss to total assets, investment in stores, and owners' equity would seem a reasonable basis for judging materiality. Another possible basis is the effect of the asset write-off on net income. In the Lakeside case, each auditor would have to decide independently as to whether Store Six represents a material contingency for this client. The potential closing of Store Six is certainly an unusual occurrence and for that reason should be evaluated against the client's $1,000,000 net worth and the $3.6 million in total assets reported in the case. In making these comparisons, the auditor needs to anticipate the potential loss. Although the total loss could amount to $186,000, Rogers has suggested less than $100,000 as a maximum figure. Unfortunately, estimates provided by the president of the client company are circumstantial evidence, having little power to persuade. In the view of the authors, this potential loss (of at least $100,000) for a company with a net worth of only $1,000,000 would certainly appear to be material. Other comparisons based on total assets or income would give similar results. (The issue of materiality is considered in more depth in exercise 3 below). (2) The CPA firm must talk with the predecessor auditor before accepting the engagement. The new auditors can learn about the integrity of the potential client's management as well as about any accounting or auditing problems that 23

might be encountered. If Rogers prohibits this meeting, Abernethy should carefully explain the necessity of the procedure. The client may not be fully aware of audit practices and fail to understand that such discussions are a normal part of investigating new clients. Should the client still insist that no communication be made with the previous auditor, Abernethy would normally have to reject the new engagement unless very unusual circumstances surrounded the client's request. (3) The information given by the predecessor auditor as to the integrity of the client's management must weigh heavily in the decision to seek a new client. Because of the potential legal liability faced by independent auditors, the decision to accept a client has become quite important. No auditor wants to perform an engagement for a company with a management that cannot be trusted. However, in evaluating the assertions of King and Company, Abernethy must realize that this firm has just been fired from the Lakeside audit. Some potential bitterness toward the client is certainly possible. Thus, auditors usually seek references from other than just the predecessor auditor before deciding whether to actively pursue a new audit client. (4) In a peer review, a team of outside auditors is hired by a CPA firm to review its system of quality controls, the policies and procedures utilized by that organization to ensure that its members are following all professional standards —audit, accounting and review, ethics, etc. This review helps to ensure that the firm is fulfilling its professional responsibilities. If the peer review team discovers practices that are unprofessional or inadequate, the firm can make immediate corrections to rectify the problems. Peer reviews originated in the 1970s when litigation of CPA firms became rampant, and congressional investigations of the profession indicated that drastic improvements were needed. The peer review process was instigated to provide firms with a means of getting outside consultation about their professional practices. Rather than discovering problems only after losing a lawsuit, the firms were periodically reviewed by these outside teams to catch problems before they grew to be too large. A peer review team looks at the means by which the public accountant ensures quality control within its practice. For example, the acceptance of new clients should be properly monitored by the firm. Adequate consultation needs to be made available to all staff members so that audit problems can be properly resolved. Hiring and promotion practices should be established and in place to provide sufficient staffing for all engagements. The peer review team looks at all areas of quality control to ascertain that problems do not exist that could lead to 24

substandard work. In addition, the team reviews the audit documents for a selected number of engagements to see if sufficient, competent evidence is being gathered and properly documented. (5) Audit documents (or “working papers”) are intended to provide a record of the auditor's examination and the evidence accumulated. Thus, all testing done in each audit area should be documented and included within the working paper file. In addition, the audit documents must verify that the examination was planned and the auditing staff was properly supervised. Any auditing or accounting problems encountered during the engagement have to be spelled out in the audit documents along with an explanation of the resolution of each issue. The permanent file will hold all data about the client that is not anticipated to change dramatically from year to year. It can be reviewed by the auditor prior to beginning the engagement to gain insight into the organization of the company. A permanent file will normally include items such as the articles of incorporation, organization chart, chart of accounts, contracts, other long-term legal agreements, and a written description of the company as well as its organization and history. The annual working paper ("current") file contains documentation of the evidence gathered during a specific audit. Thus, the results of confirmations, inquiry, observations, inspection, calculations, and all other testing are placed within these audit documents. The contents of this file must substantiate the audit opinion and also that the auditor followed generally accepted auditing standards on this particular engagement. (6) As a professional, the independent auditor has a responsibility to ensure that a prospective client understands the function of an audit prior to accepting an engagement. Not every member of the business community will have the background knowledge to comprehend the purpose of the attest function and the extensive testing procedures that it requires. In addition, many possible clients do not require the degree of assurance provided by an audit but are not aware of alternatives such as compilations and reviews. Since independent auditors have knowledge of the attest function and are offering these services to the public, responsibility for a full understanding by the client lies with the firm. In addition, the firm is required to reach an understanding of the audit function with the firm and the engagement letter is used to document this understanding. (7) The providing of adequate service to a client would always require that the CPA 25

firm suggest a review rather than an audit whenever it might meet the company's intended objectives. The client must understand, though, that a review is substantially less than an audit. Procedures are limited primarily to inquiries of the client's management along with analytical procedures applied to the financial statements. The report then states that the firm was not aware of any material modifications to the financial statements that require adjustment to be in conformity with generally accepted accounting principles (a limited or "negative" assurance). In a review, control risk is not assessed, tests of controls are not made, and adequate substantive testing procedures are not performed on which to base an opinion as to the fair presentation of the financial statements. Because these procedures are omitted, a review is less expensive than an audit. However, the banks and stockholders must be willing to accept the lesser degree of assurance being provided by the independent auditor. The client should be made aware of this option but also the potential problems of not having a complete examination. Of course, if Lakeside pursues the public offering, a review will not be adequate. (8) Many students may want to reject this engagement based on the internal control problems, the impairment of value issue, and Rogers' arguments with the predecessor auditors, but such situations are not uncommon occurrences in auditing. Public accounting is not a risk-free profession; no perfect audit client ever exists. Thus, a firm must be able to assess the problems involved and weigh them against potential rewards. Abernethy and Chapman has an opportunity here to pick up a new client in a new industry. In addition, Lakeside has demonstrated the possibility of significant growth in the future. However, the auditing firm needs to seek some resolution for the uncertainty before becoming involved. Since that problem is already obvious, an understanding should be reached with Lakeside prior to beginning the engagement. If this issue can be successfully resolved, the auditor should seek this new client.

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SUGGESTED ANSWERS TO EXERCISES Case 2 - Exercise 1 Abernethy and Chapman ANALYSIS OF POTENTIAL LEGAL LIABILITY Potential Client: The Lakeside Company Type of Engagement: Audit Form Completed By: Date: (1)

Is the potential client privately held or publicly held? Privately held

(2)

Evaluate the possible liability to the client that Abernethy and Chapman might incur, if the engagement is accepted. The basic liability to the client is for losses occurring as a result of any firm negligence. If Abernethy and Chapman performs the engagement as an average, prudent auditor would, no problem exists. If not, the client may sue for return of its audit fee as well as any other resulting losses. A special problem area exists in the Lakeside case: the client's weak internal control. Such weaknesses increase the likelihood of fraud or embezzlement. The control problems also make discovery of such defalcations more difficult. In addition, proving that the firm is innocent of negligence is often difficult to do if the client loses money through defalcations not discovered by the auditor.

(3)

List the third parties that presently have a financial association with the potential client and could be expected to see the financial statements. These parties are also called primary and foreseen beneficiaries. The current stockholders Cypress Products Two banks financing the inventory National Insurance Company of Virginia (mortgage loans) Possibly other creditors

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(4)

Discuss the possibility that other third parties will be brought into a position where they would be expected to see the financial statements of the potential client. These parties are also called foreseeable beneficiaries. As Rogers has expressed considerable interest in expansion, the CPA firm should anticipate that the financial statements could be presented to potential stockholders or lenders.

(5)

Evaluate the possible legal liability to third parties, both present and potential, that Abernethy and Chapman might incur if the engagement is accepted. As a privately held business, this audit does not fall under federal security laws. Thus, the auditor is bound by common law and is judged under such precedents as the Ultramares case, the CIT Financial Corp. case, and the Rusch Factors case. In the Lakeside audit, the CPA firm should have no liability to third parties unless the audit is performed in a grossly negligent manner or the firm is negligently responsible for careless financial misrepresentations. In a few jurisdictions, they may be held liable to foreseen or foreseeable beneficiaries for ordinary negligence. Abernethy and Chapman INFORMATION FROM PREDECESSOR AUDITOR

Potential Client: Lakeside Company Form Completed By: Predecessor Auditor: King & Company Date of Interview: (1)

Discuss the predecessor auditor's evaluation of the integrity of the management of the potential client. Predecessor auditor indicated no problems with the integrity of the Lakeside management.

(2)

Did the predecessor auditor reveal any disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters? If so, fully describe these disagreements.

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A major problem existed between Lakeside and the predecessor auditor involving an explanatory paragraph included in the 2008 report. This uncertainty issue revolved around the potential loss foreseen in the possible closing of one of Lakeside's stores. (3)

What was the predecessor auditor's understanding as to the reasons for the change in auditors? Predecessor auditor stated that the firm was discharged over the wording of the previous audit opinion.

(4)

Did the predecessor auditor give any indication of other significant audit problems associated with the potential client? The predecessor auditor also mentioned weaknesses in Lakeside's internal control and Rogers' unwillingness to improve these systems.

(5)

Did the predecessor auditor indicate any problem in allowing Abernethy and Chapman to review prior years' audit documentation for the potential client? If "yes," explain. Predecessor auditor stated that the audit audit documents could be reviewed.

(6)

Was the predecessor auditor's response limited in any way? No limitation was indicated.

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Case 2 - Exercise 2 [Note: The auditor will perform a number of steps in reviewing the audit documents of the predecessor auditor. The major objective is to examine the types of information that would be available to an auditor in an ongoing engagement. Through this review, the auditor can gain satisfaction as to the validity of beginning account balances as well as accounting principles applied in the previous audits. By relying on the work of the predecessor auditor, the extensive review necessary in an initial audit can be held to a minimum]. Abernethy and Chapman Review of Predecessor Auditor's Documentation Client: The Lakeside Company Predecessor Auditor: King & Company Prepared by: Date: Prepare a list of the specific contents of the predecessor auditor's documentation that should be examined by Abernethy and Chapman. Indicate each area that should be reviewed and the purpose of studying these particular areas of the audit documentation. Use the following format. Area that Should be Reviewed Proposed Adjusting Entries Tests of beginning balances in accounts including inventory, land, buildings, equipment, paid-in-capital, and retained earnings. Ascertain the specific accounting principles applied in the previous fiscal year. Review internal control evaluations.

Review the analysis of contingencies. Any problem areas (such as slow collection of accounts receivable) that were singled out in the previous year.

Purpose of Review To determine the type and materiality of the proposed adjustments To determine that satisfactory evidence has been obtained to verify beginningof-year balances, since ending balances are audited by successor auditor. To determine if client consistently applies accounting principles in the current year. To determine if there were any internal control weaknesses/deficiencies noted or if there are any particularly strong areas of control noted. To determine if adjustments or disclosures need to be made for contingencies in the current year. To determine if the problems continue to exist in the current year.

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(3) Note: Student answers will vary greatly due to the nature of the assignment. Consider asking several students for their materiality level to see the range of answers. This should lead to a good discussion about auditor judgment. Preliminary Judgment about Materiality Client: Lakeside Company Balance Sheet Date: December 31, 2012 Prepared by: Determine the preliminary judgment about materiality for the client as a whole. Express your answer as a dollar amount. Determine the appropriate level of materiality based on all analyses completed for the client thus far. Fully support and discuss the materiality level that you determine. Quantitative Considerations: Because materiality is relative, it is necessary to have bases for establishing whether misstatements are material. A base is a critical item of which users tend to focus while making decisions. The base will vary depending on the nature of the client’s business. Typical bases may include net income before taxes, net sales, total assets and stockholders’ equity. Percentages typically range from 1%-10% depending on the base. Base (from previous year) Net income before taxes Total assets Net sales

Dollar Amount of Base $408,000

Percentage Range 3%-6%

Base x Percentage

$3,628,000 $10,754,000

1%-3% 1%-3%

$36,280-$108,840 $107,540-$322,620

$12,240-$24,480

Qualitative Considerations: Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. For example, misstatements that involve fraud may be more important to users than misstatements due to unintentional errors. Fraud reflects on the integrity of management and other employees of the client. Item to be Considered Outdated accounting systems New client Previous year qualified opinion

Impact on Materiality Reduce the level Reduce the level Reduce the level

Preliminary Judgment about Materiality: Combine the quantitative and qualitative considerations into one overall materiality level. Materiality level:

$50,000 31

Discussion: Discuss how you arrived at this dollar amount for the preliminary judgment about materiality. That is, how did you combine the qualitative and quantitative considerations to arrive at this dollar amount? The preliminary judgment about materiality is set at $50,000. Since there are three qualitative considerations that reduce the level, we chose the lower of the ranges of the quantitative considerations. The average of the lower ranges is $52,020 [($12,240 + $36,280 + $107,540) / 3 = $52,020]. We rounded to a conservative $50,000 for ease of application. The bases were chosen based on the nature of the client’s business. Typical users of the financial statements of a company in consumer electronics industry will likely focus on profits, net sales and total assets. The percentage ranges are typical for the bases. Assets and net sales are typically the largest bases and thus have smaller percentage ranges than does net income before taxes. (Some students may have chosen total liabilities or total stockholders’ equity since banks are a major user of the financial statements). At a $50,000 materiality level, then a total impairment of the carrying value of Store 6 ($186,000) would be material, as would an impairment of half the carrying value. The firm should discuss with Rogers the strong possibility of a write down of Store 6, should an impairment test warrant one. (Note: In Case 9, the students are required to perform an impairment test for Store 6). (4) This answer assumes that King and Company, the predecessor auditor, has no reason to believe that their previous report is not still appropriate. Furthermore, that firm has reviewed the current financial statements and obtained a representation letter from Abernethy and Chapman, the successor auditor, stating that the current year's audit has not revealed anything that would have a material effect on the prior year's audit.

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INDEPENDENT AUDITOR'S REPORT To the Stockholders: We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2012, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Lakeside Company as of December 31, 2011, were audited by other auditors whose report dated [give date], on those statements included a qualified opinion because of inadequate disclosure of an impairment of value. The impairment of value concerned the Company's investment in one of its stores. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 2012 financial statements referred to above present fairly, in all material respects, the financial position of the Lakeside Company as of December 31, 2012, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Abernethy and Chapman Certified Public Accountants Date: (last day of audit fieldwork)

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CASE 3 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) Although this question can be answered by a simple reading of Exhibit 3-1, it does force the student to consider the contractual obligations being assumed by both parties. One portion of this letter that might warrant discussion is the CPA firm's declaration that absolute assurance is not being given in regard to major misstatements. The students can be queried as to the reasons for including this statement. In addition, the students can be asked to discuss the method by which the client company can draw the distinction between reasonable assurance and absolute assurance. As a different line of questioning, the students can discuss other responsibilities that could have been accepted by either party. The engagement letter is required. Responsibilities of the CPA firm found in the engagement letter: *

To perform an audit in order to express an opinion on the client's financial statements,

*

To make a search for material misstatements,

*

To report any internal control weaknesses,

*

To report any potential fee changes,

*

To provide the final audit report by February 22, 2013.

Responsibilities of the client: *

To pay the audit fee,

*

To provide a year-end trial balance by January 17, 2013, and an interim trial balance by October 17, 2012,

*

To provide audit documents to the CPA firm as specified.

(2) In performing analytical procedures, auditor expectations should be derived from a wide variety of sources. For cost of goods sold, Abernethy and Chapman 34

should consider each of the following in arriving at an anticipated total: -

Past figures. If cost of goods sold has always been a certain percentage of Lakeside's sales, that same relationship would be expected to continue unless other factors have changed. Had Lakeside, for example, switched from cheaper products to more expensive ones, the relationship between cost of goods sold and sales would possibly be affected. Or, if Lakeside has dropped the Cypress line in order to sell the products of some other manufacturer, a similar change might have been anticipated. However, without an adjustment of this type, cost of goods sold as a percentage of sales would be expected to remain stable.

-

Industry averages. By studying trade publications, Abernethy and Chapman can determine an industry average for cost of goods sold as a percentage of sales. Although Lakeside's results could not be expected to be exactly the same as this average, the auditors should not anticipate a significant variation to occur without some adequate explanation.

-

Competitors. If available, the financial statements of competing companies can be used to determine the normal relationship of cost of goods sold to sales. Although no two companies are ever alike, important comparisons such as this one should be made between similar companies.

-

Budgeted figures. If Lakeside has an annual budget, the numbers estimated by the company at the beginning of the period can be used by the auditor in establishing an expected cost of goods sold.

(3) -

Lakeside holds an inventory of high-technology items: consumer electronic equipment. Obsolescence of a portion of this merchandise is an ever-present danger because of new innovations. The inventory can also be easily damaged, a problem that is not always visually obvious.

-

Lakeside distributes merchandise to retail stores. A generous return policy is provided; thus, an estimate must be made of the sales returns that will be received by the company after the audit is concluded.

-

Lakeside sells on credit throughout two states. collections from accounts receivable may be difficult.

-

Lakeside rents a number of its stores. The auditor must determine whether capitalization of these leases is required.

-

Lakeside has a large amount of debt. The auditor has to ensure that all 35

Hence, estimating

debt is being properly reported and disclosed. The interest expense associated with these liabilities must also be correctly calculated and recognized. In addition, the auditors need to verify that all loan covenants are being met. -

Lakeside is considering going public. A company attempting to raise significant capital may be tempted to overestimate assets and revenues. The auditor needs to be particularly careful on accounts that lend themselves to significant estimate.

(4) The auditor must be satisfied that sufficient, competent evidence has been obtained to substantiate an opinion concerning the fair presentation of the client's financial statements. The decision as to the sufficiency of this evidence is left solely to the judgment of the auditor. Only through years of experience can the auditor develop the ability to make this determination. Although specific guidelines for this decision are not available, all significant problems must be resolved and all suspicious occurrences should be investigated. Evidence needs to be accumulated for each significant area of the financial statements to substantiate the assertions made by the client about its reported balances. Where inherent risk and control risk are judged to be high, the auditor must take steps to reduce detection risk to an acceptable level. In such cases, several steps are possible: performing additional substantive testing, using more experienced staff personnel, performing testing procedures closer to the balance sheet date, or relying on more effective testing procedures. Another factor that influences the auditor's decision is the quality of evidence being accumulated. Some information may come directly to the auditors from outside parties, data that is usually considered to be of a higher quality than evidence prepared by the client company. Less evidence is required if it is judged by the auditor to be of a high quality. Although each of these factors is considered, the ultimate decision still must rest with the auditor's judgment. This individual is taking responsibility for the audit opinion as well as accepting the risks involved in circulating this report. Thus, the auditor must be satisfied that, based upon the wisdom gained through years of audit experience, sufficient evidence has been obtained. (5) Any discussion as to the "quality" of evidence being gathered by analytical procedures must be based on the objective of the testing. Analytical procedures performed in the planning stage are not primarily designed for the purpose of indicating the fair presentation of financial information. Instead, they are used in the assessment of risk, to alert the auditor to potential problem areas that may 36

require additional substantive testing. In that respect, analytical procedures serve a vital audit purpose. Students should always be reminded, though, that this testing is only one component of the overall substantive testing being performed by the independent auditor. Furthermore, analytical procedures provide circumstantial evidence which, taken alone, is not a high quality type of evidence.

substantive procedures - analytical procedures and tests of detail (6)

Knowledge of the consumer electronics business is just one aspect of Cline's expertise that will allow him to evaluate the fair presentation of Lakeside's financial statements. Overall knowledge of the client company and the industry in which it operates should also allow the auditor to -

identify areas that may need special consideration; assess conditions under which accounting data are produced, processed, reviewed, and accumulated within the organization; evaluate the reasonableness of estimates; evaluate the accuracy of management representations; make judgments about the appropriateness of the accounting principles applied and the adequacy of disclosures.

Knowledge of a business and the industry in which it operates may be obtained from examining the client company's accounting records and inquiry of the client personnel. This information can be supplemented through review of the prior years' audit documents, AICPA Accounting and Audit Guides, industry publications, financial statements from other companies in the same industry, college textbooks, magazines, and other trade periodicals. Since the students may not be familiar with the AICPA Industry Audit Guides, the instructor may want to bring an example or two to class for this discussion. Examples of the industries covered by these audit guides include: -

Airlines Finance Companies Investment Companies Providers of Health Care Services

(7) A number of the current concerns faced by auditing firms as well as the auditing profession as a whole relate either directly or indirectly to increased price competition. Through class discussion of this particular question, students should be able to ascertain at least three of these problems: 37

*

Price competition forces narrow time constraints on the work of the independent auditor. In order to finish an audit engagement in a short enough time so that a reasonable profit can be made, a danger exists that the auditor will (1) accept less than sufficient evidence, (2) fail to recognize critical audit areas, or (3) not be able to acquire the depth of knowledge necessary for essential audit judgments. Thus, the argument is frequently raised that price competition leads to a decrease in overall audit quality.

*

Because the initial year of an audit will often require significantly more time than examinations of subsequent years, price competition can lead a firm to actually lose money in the first year of an engagement. Therefore, the CPA firm must work to keep a client for several years to offset this initial loss and produce a reasonable profit. The necessity of retaining an engagement for a number of years may force the firm to be subservient to management's demands to avoid being fired. This argument has lost much of its impact over the last few years as client companies have established audit committees comprised of outside members of the board of directors to ensure the independence of the auditing firm.

*

Many auditors also feel that price competition is generally detrimental to the public accounting profession. The main thrust of this argument is that price competition encourages companies to select their independent auditors based primarily on cost rather than on the quality of audit work. This type of selection process would favor firms offering cheap rates over auditing firms offering quality services.

After the students have been allowed to discuss the problems associated with price competition, the instructor may want to ask whether these problems outweigh the advantages of having the auditing profession participate in the free market system. Since most business students in the United States appear to advocate free markets within the country, some interesting discussion can be stimulated as to whether the auditing profession should be exempt from price competition. (8) According to the audit risk model, planned detection risk (PDR) equals acceptable audit risk (AAR) divided by the product of inherent risk (IR) and control risk (CR). Holding inherent risk and acceptable audit risk constant, there is an inverse relationship between control risk and planned detection risk. Thus, an increase (decrease) in control risk leads to a decrease (increase) in planned detection risk. Also, as planned detection risk decreases (increases), the amount of substantive tests and other audit procedures increases (decreases). That is, if the auditor determines the level of detection risk to be low, he or she wants the chance of not detecting an error too small. In order to have a small chance of not 38

detecting an error, the auditor must do more testing. For example, given AAR=10% and IR=80%, and assuming an 80% CR (high), then using the audit risk model, planned detection risk is a relatively low 15.6% [.10/(.80x.80)], but assuming a 20% CR (low), then planned detection risk is a relatively high 62.5% [.10/(.80x.20)]. (9) According to SAS 99, the assessment of the risk of fraud begins with a meeting of the entire team for such purpose. This brainstorming session needs to encourage the involvement of all team members and cannot be just a staff training session. The objective is to solicit the ideas from all team members and to sensitize the entire team to the particular problem areas that this client presents. The process begins with such a session, but does not end there. During the audit the entire team needs to consider how the information being developed relates to the areas already identified, noting new areas that need attention, or adjusting expectations on the areas already identified. The areas identified by fraud risk are primarily in the areas of inherent risk and control risk . Increased fraud risk represents an increase in inherent risk (the risk that errors exist) or will also increase the control risk (the risk that the client’s internal control system will not detect the error or irregularity). (10) The registration process is not difficult. Maintaining the status of a registered CPA firm is more difficult and requires that the firm be willing to adjust its operations including independence and staffing quality control standards to meet the higher expectations of the PCAOB. They may also be required to change the nature of their practice, at least as far as publicly traded clients because of the list of proscribed activities. Abernathy and Chapman have sufficient time to become registered and therefore need only be concerned about accepting Lakeside as a client if there is some obstacle to their registration. If Lakeside asks if they are currently registered, then the answer has to be, “no, but we are pursing registration.” SUGGESTED ANSWERS TO EXERCISES (1) Performing analytical procedures is one aspect of an auditing course that traditionally generates a lot of student interest and enthusiasm. One method of approaching this question is to have the class list the potential problems that were discovered and then discuss the relative severity of each. The students can be asked to consider the appropriate response that should be made by the audit team to each of the elements listed. By discussing the various possible responses, students are better able to recognize the attest function as a fluid 39

process that must be flexible enough to adapt to a specific set of circumstances. It should be noted to students that, in practice, several years (rather than two) would be analyzed for trends. a)

Ratio analysis from 2010 to 2011.

Ratio Current # Days inventory on hand Receivable collection period (days)

2010 1.35 93

2011 1.35 101

21

25

Debt-to-total-assets

74.4%

74.5%

Times interest earned

3.6 times

2.8 times

Profit Margin Return on Assets

2.79% 8.47%

2.27% 6.73%

Return on Equity

33.2%

26.4%

Significance No significant change Increase may indicate obsolete or slow-moving inventory on hand Slight increase may indicate relaxing of credit policies and/or possible understatement of allowance No significant change; however, the high ratio indicates significant leverage and potential solvency problems if additional debt is needed Decline indicates reduced ability to meet interest payments through operations No significant change Declining return results from a combination of declining net income and increasing total asset base. Decline in return results from a combination of declining net income and increasing equity base.

Conclusion: Lakeside had no significant changes in its liquidity or solvency levels; however, the company appears to be experiencing a decline in its profitability level. The audit staff should pay particular attention to revenueenhancing or expense-reducing areas, such as fictitious sales or improper capitalization of expenses to halt this downward trend. b)

Ratio analysis: comparison to industry.

Ratio Current

Industry Avg. 2.16

Lakeside 2011 1.35

Days inventory on hand

69

101

Receivables collection period

15

25

Debt-to-total-assets

52%

74.5%

Times interest earned

9.2 times

2.8 times

40

Significance Lakeside is below the industry average. This may indicate short-term solvency (liquidity) problems. Lakeside is well above the industry average. This may indicate short-term solvency problems. Lakeside is well above the industry average. This may indicate short-term solvency problems. Lakeside is significantly above the industry average; this may indicate long-term solvency problems. Lakeside is significantly below the industry average; this may indicate solvency problems.

Ratio Profit Margin

Industry Avg. 4.2%

Lakeside 2011 2.27%

Return on Assets

8.1%

6.73%

Return on Equity

19.3%

26.4%

Significance Lakeside is only slightly below the industry average. Lakeside is only slightly below the industry average. Lakeside is above the industry average. Its large amount of debt is leveraging up the return on equity.

Conclusion: Lakeside is well below the liquidity level of the industry, and the company is in a significantly worse solvency level than the industry. Auditors should be aware of methods to enhance the liquidity and solvency levels, such as unrecorded liabilities. Lakeside profitability is about the same as the industry average, except for return on equity, in which it is well above the industry (primarily due to the high level of leverage). c.

Scan the financial statements and the trial balances.

Procedure Scan the income statement [Note: Instructors may want to suggest that students prepare a common size income statement.]

Results The company's stores continue to report an overall loss, which is increasing in amount.

Scan the balance sheet [Note: Instructors may want to suggest that students prepare a common size balance sheet.] Scan the cash flow statement

Significant increases in shortterm borrowings.

Scan the trial balance

Something appears to be wrong with the information generated by Store Three. The sales for that store have increased by approximately 94% since the previous year. At the same time, the cost of the goods sold has dropped from 58.5% of sales (which is consistent with the other stores) to only 50.3% of sales. Also, the inventory held by this store has risen by over 50%. Sales Commissions for District D in 2012 appear to be slightly out of line. All of the other commissions are approximately 5.7% of sales, while this account is nearly 7% of the applicable sales figure. Rent expense on vehicles and

Scan the trial balance

Scan the trial balance

Cash flow from operations declined significantly in 2011.

41

Significance These losses suggest the possibility that the stores will eventually be discontinued by Lakeside or drastically altered in some manner. The short-term nature of the borrowing could result in shortterm solvency and liquidity problems. The cash flow problems combined with the solvency problems may indicate a problem with the company's ability to continue as a going concern. These fluctuations could indicate recording errors or an employee attempting to inflate the earnings being reported for Store Three. This problem is more germane than might be encountered normally because of the profitsharing bonus system that rewards employees for reporting high income figures. Although not necessarily a material figure, the potential error should be investigated so that Lakeside can make the appropriate corrections if needed. Such a decrease often serves to

Procedure Scan the trial balance

Results equipment has decreased in 2012. The Repairs and Maintenance account has increased by over 150% since 2011.

Scan the trial balance

The "Gain on Disposition of Fixed Asset" balance of $14,000 warrants investigation.

Scan the trial balance

The Allowance for Doubtful Accounts balance shows a debit balance on September 30, 2012, compared to a credit balance one year earlier.

Scan the trial balance

The company's two bank credit lines now have a total balance that exceeds the $750,000 maximum that was indicated in an earlier case.

Scan the trial balance

The long-term notes payable have increased by $50,000. The auditor would certainly be interested in the application of those funds as well as the loan agreement signed by the company. Sales returns have increased significantly for both the company stores and the distributorship.

Scan the trial balance

Scan the trial balance

The equipment account shows

42

Significance indicate that the company has acquired new property. This significant increment may indicate a posting error that will require correction. Conversely, actual repairs may have been made by Lakeside. In that situation, the auditor needs to verify that all capitalized costs have been segregated and properly accounted for within the company records. Often a company will fail to remove the appropriate cost and related accumulated depreciation when a plant asset is sold. The auditor should also ascertain that the current year depreciation expense has been properly recognized. Finally, the sale of an asset can lead to the acquisition of a new asset as a replacement. The independent auditor should follow up on this possibility to assure that any replacement is appropriately capitalized. The auditor should determine if the client has written off an especially large group of accounts. Perhaps bad debt experience is changing and a larger allowance is required. The auditor should verify that no loan covenants have been broken. In addition, because of disclosure requirements as well as the effects on the interest expense account, the auditors will need to review any new borrowing agreement. The auditor should determine the application of those funds as well as the loan agreement signed by the company.

The auditors need to ascertain the reasons for such an increase. Any change in the trend for sales returns would lead the auditors to reevaluate year-end accruals. If the company has acquired

Procedure

Results an increase from the previous year.

Scan the trial balance

The estimated bonus expense has increased.

Significance additional equipment during the year, the auditor needs to verify that capitalization and depreciation were given proper treatment. That increase is probably due to the profit-sharing plan having been in effect for all nine months of 2012, but the increase should be investigated.

Exercise 3-2 Note: Refer the students to Case 1 and Case 2. Student answers will vary greatly due to the nature of the assignment. Consider asking several students for their inherent risk level to see the range of answers. This should lead to a good discussion about auditor judgment. Exercise 3-2 Overall Inherent Risk Level Client: The Lakeside Company Balance Sheet Date: December 31, 2012 Prepared by: Inherent risk (IR) is a measure of the susceptibility of material misstatement before considering the effectiveness of the internal control. Determine the appropriate level of inherent risk for the audit engagement as a whole, using qualitative terms (high, moderate or low inherent risk). Complete the following table. Factor Nature of client’s business Results of previous audits Initial versus repeat engagement Quantity of related party transactions Quantity of nonroutine transactions Quantity of estimates and judgment required for accounts

Discussion Consumer electronics industry is subject to swings in the economy and is very competitive. Qualified opinion rendered by predecessor auditor. Initial engagement Many transactions with the owner’s separate business. Transactions are fairly routine. Bad debts require estimates. Few other accounts do. 43

Low

Moderate High X

X X X X X

Factor Potential for fraudulent financial reporting (fraud risk factors) Potential for misappropriation of assets (fraud risk factors) Other factors (list) Other factors (list) Conclusion: Overall inherent risk level

Discussion Many risk factors for fraudulent financial reporting were identified in case 1. As noted in Case 1, accounting systems are outdated, resulting in high potential for misappropriation

Low

Moderate High X

Discussion for overall level is below.

X

X

Discussion: Discuss how you arrived at this overall level of inherent risk. As noted in the table above, the client has many factors that lead to a high evaluation of inherent risk, including the nature of the industry, the results from previous audits, and others.

44

CASE 4 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) Statement on Auditing Standards 78, "Consideration of Internal Control in a Financial Statement Audit: An Amendment to SAS No. 55," identifies the five elements of internal control as the Control Environment, Risk Assessment, Control Activities, Information and Communication, and Monitoring. Cline's questions appear to be designed to determine the degree of information that has been established to date about each of these elements. Question (3) asks about the information that the auditors could have looked at within the Lakeside Company in order to respond adequately to these queries. Auditors must be able to gather sufficient data in the early stages of an audit to assess the various risks involved in the examination. In studying the control environment of a company, SAS 78 recommends that a number of factors should be assessed including those listed below. For several of these factors, the types of information that the Abernethy and Chapman auditors might use to make their evaluation is also discussed. A quick look at the control environment will probably lead the auditors to the decision that Lakeside has not established the environment needed for adequate internal control. 







Integrity and ethical values. The auditors should inquire as to policy statements and a code of ethics. They should also be aware of any actions by Lakeside's management to remove or reduce incentives and temptations that might prompt its employees to engage in dishonest, illegal, or unethical acts. Commitment to competence. Lakeside should have a training program to ensure that its employees have the knowledge and skills necessary to accomplish tasks. The auditors should inquire as to any such programs. Board of directors or audit committee participation. Abernethy and Chapman will need to determine the oversight role (if any) played by the board of directors. By looking at the minutes of the meetings, the auditors should be able to determine whether the board is actually serving in a control capacity. The case mentions that the board of directors had to approve of the hiring of new independent auditors. Thus, a separate audit committee probably does not exist. In addition, Rogers' assurance that the board would approve this request would seem to imply that the board does not provide significant control over the management of the company. Management's philosophy and operating style. By talking with Rogers and the other members of management, the auditors should be able to determine 45







the actual priority placed on internal control by the company. Documentation of this should also be available for inspection. Rogers seems to understand that better systems are needed but he has invested neither the time nor the money to develop such policies and procedures. This lack of support may indicate that the management is not serious about establishing adequate control within the company. Because of the company's growth, improvements in the future may be forthcoming, but at the present time the management appears (from what has been said) to have let the company outgrow its control policies and procedures. Organizational structure. If Lakeside has a chart presenting the various officials and their jobs, the auditors can assess whether control policies would be easy to circumvent. Although Exhibit 3-2 shows the company divided into clearly distinct areas, the Assistant to the President does seem to be in a position to operate without proper control supervision. In addition, the President seems to hold a significant amount of power in this company, with very little control having been established. Assignment of authority and responsibility. This factor includes how authority and responsibility for operating activities are assigned and how reporting relationships and authorization hierarchies are established. Since Lakeside is not a huge organization, Rogers tends to intervene in many of the operating activities. However, as Lakeside continues to grow, this may become a major concern to the auditors. Human resource policies and practices. These policies and practices relate to hiring, orientation, training, evaluating, counseling, promoting, compensating, and remedial actions. The auditors should inquire and observe Lakeside's policies, including any standards for hiring the most qualified individuals, training, and performance appraisals.

Risk assessment is the second component of internal control. The auditors will determine and evaluate how Lakeside identifies, analyzes, and manages risks relevant to the preparation of the financial statements. The auditors will want to pay particular attention to several changes occurring at Lakeside and how the management deals with these changes. These changes include the expansion of the company's stores, the concentration on the Cypress product line, and the relatively new bonus system. Next, the auditors will look at the actual control activities in place to see that specific control objectives are being met. Within this testing, the auditors should look at the following as goals of the company's internal control: 



Performance reviews. Independent checks on both performance and proper valuation of recorded amounts should be conducted. The auditors will want to verify that reconciliations and other comparisons are made at important junctures in the various systems. Information processing. The auditors will want to verify that Lakeside has both general controls and application controls. They will especially verify that proper authorization of transactions exist. The auditors can examine the 46





documentation produced for a variety of transactions to ensure that each was authorized by the appropriate individual within the company. Further, the auditors will verify that Lakeside properly designs and uses adequate documents. By walking through the various systems, the auditors can determine if adequate documentation is required at each point and if those documents are preprinted and prenumbered to ensure that the proper information is gathered and retained. Physical controls. By physical observation of the warehouse, the stores, and other assets, the auditor can determine if Lakeside has adequate safeguards over its assets. Segregation of duties. By looking at the organization of a company, the auditors can determine if the necessary separation of responsibilities is in place to facilitate adequate control. For example, since Lakeside has a chart showing the various officials and their jobs, the auditors can assess whether a true system of checks and balances has been established. Although Exhibit 4-1 shows the company divided into clearly distinct areas, information in Exhibits 4-3 and 4-4 indicates, for example, that the Assistant to the President has a great many responsibilities, some of which raise the possibility of control problems.

Next, the auditors will have to examine any information that helps to ascertain the efficiency of the company's information and communication system. In the case presented, little data is provided to evaluate the information system except that Rogers feels the systems are outdated for a company of this size. Therefore, the auditors should assess the design of the system and the people who operate the accounting system. For example, the auditors might want to select a number of transactions and trace them from the point of origination through the accounting system to see that the recording process is performed properly. This testing is designed to determine if the system is capable of performing the following tasks in an effective manner:     

Identify and record all valid transactions. Describe, on a timely basis, the transactions in sufficient detail to permit proper classification. Measure the value of transactions. Determine the time period in which transactions occurred. Present the transactions appropriately in the financial statements.

The final component of internal control is monitoring. Monitoring is the process that assesses the quality of internal control performance over time. Lakeside does not appear to have an extensive monitoring system, such as an internal audit function. Without an internal auditor, no independent party within the company serves to monitor and oversee the company's internal controls. The internal audit function can be extremely important in a company, especially where stores and sales representatives operate at a geographic distance from the home office. 47

(2) An evaluation of the overall control environment is not possible from Exhibits 4-3 and 4-4. However, the auditors can see that responsibilities have been developed and divided within the company. Each individual or department seems to have a well-defined job within the two systems. Thus, some evidence exists to indicate that management is aware of the importance of internal control. Such systems simply cannot be created without adequate support by the company's management. In terms of risk assessment, Lakeside does not appear (from Cases 2 through 4) to have a formal method of systematically assessing risks (Weakness). The auditors should recommend a system of identifying risks, their significance, their likelihood of occurrence, and how they might be managed. This is especially true with Lakeside's growth of stores, concentration of suppliers (Cypress only), and installation of a bonus system. In addressing control activities, the auditors can see, as indicated in the answer to Exercise (2), that the company seems to use adequate documents and authorization procedures (Strength). In addition, although the Assistant to the President has many different duties (Weakness), the company seems to have made an attempt to segregate responsibilities in an appropriate manner. Both of the information systems that are presented also seem well designed, especially for a small but growing company. However, the company still uses some manual systems that can be slow and offer the opportunity for many human mistakes to be made (Weakness). The answer to Exercise (2) goes into more detail concerning control strengths and weaknesses in this area. The monitoring activities seem to be somewhat lax. However, with Lakeside still being relatively small, Rogers' oversight somewhat compensates for the lack of monitoring. With the growth of Lakeside, this is becoming less true. (3) After a preliminary assessment of control risk, the auditors have three possible actions: a) Because of potential strengths found within internal control, the auditor may feel that control risk can be assessed at below the maximum level. If so, the auditors must then be able to identify specific control procedures that will likely prevent or detect material misstatements. The auditors must perform tests of these controls to evaluate their effectiveness to determine if a reduction in the assessment of control risk is justified. 48

b) Because of weaknesses found within internal control, the control risk may have to be assessed at the maximum level. This evaluation will probably force the auditor to reduce detection risk by such means as performing additional substantive testing, using more experienced staff personnel, carrying out procedures closer to the balance sheet data, and/or relying on more effective testing procedures. c) Although potential strengths may be identified within internal control, the auditors may still opt to assess control risk at the maximum level. This decision would be made if additional substantive tests appear to be easier and cheaper to make than performing the necessary tests of specific control policies and procedures. Sarbanes Oxley requires expanded internal control auditing because the Management Assessment of Internal Control needs to be separately audited by a registered CPA firm, regardless of its effect on the audit of the financial statements. (4) The auditor will normally begin verifying control policies and procedures by making inquiries of the employees as to the performance of their duties. The answers provided indicate to the auditor whether each individual understands the duties that have been assigned as well as their purpose. A proper knowledge of a job usually means that employees are more likely to comply with the system and fulfill their responsibilities. In addition, the auditor is often able to observe the work of these individuals during the audit fieldwork. From these observations, an evaluation can also be made as to the quality of the work being performed. Although inquiry and observation are important steps in testing control procedures, the auditor needs to obtain more substantial evidence. A welldevised system of controls should require each employee to leave physical proof whenever a task has been completed: a tickmark must be used, the person must sign a form, a code number must be entered, etc. Thus, the auditor should be able to trace this physical evidence through an entire system noting whether the policies and procedures are operating efficiently. For important measures that might reduce the assessment of control risk, the auditor may want to verify effectiveness by examining a large number of documents. Frequently, an auditor evaluates control procedures within an entire system through a "test of transactions." Transactions are traced through an accounting system to make certain that the recording has been made properly and that each control procedure is functioning as intended. (5)

49

This new information provides an increased risk on the motivation/incentive for fraud to occur, and an increase in opportunity through collusion affecting segregation of duties, in terms of the fraud triangle. It does not mean that fraud has occurred, and does not have the rationalization necessary for fraud to occur . The auditor faced with this information should document the discussion, and make sure the audit team is aware of the conversation. It is not the job of the staff auditor to initiate an investigation at this early point in the audit. SUGGESTED ANSWERS TO EXERCISES (1) a) The following page presents a flowchart for the revenue recognition system. Numerous acceptable variations of this flowchart may be created. This problem is not intended to suggest a rigid format for the flowchart but rather to give the student experience in constructing and reading one. When evaluating a student's work, several questions should be asked:   

Does the flowchart truly mirror the system? Is the flowchart understandable? Is the flowchart overly complex, containing too many symbols and explanations?

One technique that might be used with this assignment is to divide the class into teams of three or four students each. Then select a flowchart at random from each team and ask the team members to critique it. This process, which can be done inside or outside of class, will compel the students to view the flowchart as an instrument intended to communicate the design of a system.

50

51

(1) b) Revenue and Cash Receipts Cycle Distributorship Cash Receipts Treasurer’s Office: Checks arrive from customers along with a copy of the invoice slip. The checks are received by the Treasurer's Office where each check is immediately stamped "For Deposit Only." The checks are listed on a bank deposit slip and on a fourpart cash remittance list. This listing includes the customer, the amount paid, and the invoice number. The checks and the bank deposit slips are taken by the Treasurer's Office to the bank. The second copy of the bank deposit slip is validated and returned to the Treasurer's Office where it is placed in a permanent file by date along with the fourth copy of the cash remittance list. The bank returns the first copy of the validated bank deposit slip directly to the Assistant to the President where it is placed in a temporary file by date. Assistant to the President: The sales division sends the first copy of the cash remittance list to the Assistant to the President. He compares the bank deposit slip that he has received from the bank against the total of the cash remittance list for that same date with a spot check of individual items. The list of collections is then used to update the Accounts Receivable Subsidiary Ledger before being placed in a temporary file by date. Upon receipt of the monthly bank statement, the cash remittance lists and the validated bank deposits are removed and used to prepare the monthly bank reconciliation. The reconciliation, the bank statement, the validated deposit slips, and the cash remittance lists are then placed in a permanent file by date. Sales Division: The invoice slips and the first three copies of the cash remittance list are sent by the Treasurer's Office to the Sales Division. The second copy of the sales invoice and the fourth copy of the bill of lading had originally been filed by that department when the goods were shipped. Each invoice slip is matched with the corresponding sales invoice and bill of lading. The appropriate discount is calculated and recorded on each copy of the cash remittance list. Each invoice slip is then attached to the appropriate sales invoice and bill of lading and placed in a permanent file by invoice number. The third copy of the cash remittance list is placed in a permanent file by date. 52

Controller’s Office: The second copy of the cash remittance list is sent to the Controller's Office where the cash receipts and the sales discounts are refooted. From this information, a daily journal entry is made in the cash receipts journal. Subsequently, the second copy of the cash remittance list is filed permanently by date. Case 4 - Exercise 2a INTERNAL CONTROL - PRELIMINARY ANALYSIS CLIENT: The Lakeside Company SYSTEM: Cash Receipts DATE: PREPARED BY: List each document found in this system, the number of copies, and whether it is prepared internally or externally. *0

Invoice Slips (one copy per payment) - prepared internally but returned directly by outside party. It is the bottom portion of the number 4 copy of the sales invoice.

*1

Validated Bank Deposit Slips (two copies per day) - prepared internally but validated by outside bank and mailed directly to the Assistant to the President.

*2

Cash Remittance List (four copies per day) - prepared internally.

*3

Sales Invoice (second copy) - prepared internally.

*4

Bill of Lading (only fourth copy is a part of this system) - prepared internally, two copies sent to customer.

*5

Bank Statement (one copy per month) - prepared externally.

*6

Bank Reconciliation (one copy per month) - prepared internally.

Answer each of the following questions. For each "No" answer, comment on whether an internal control weakness is indicated.

53

QUESTION (1) Is each document within this system prenumbered? (2) Is the authority for completing each document clearly delineated? (3) Are all documents subsequently reviewed by an independent party within the company?

YES

NO

X

X

X

(4) Are appropriate procedures clearly spelled out for completing and reviewing each document?

X

(5) Is the record-

X

COMMENT Exhibits 4-3 and 4-4 indicate that the sales invoices (including the sales invoice slip) and the bills of lading are prenumbered. None of the other documents shown in this system would normally be prenumbered. Exhibit 4-4 indicates that all documents within this system are clearly assigned to a specific department. A number of the documents are reviewed prior to the beginning of this system such as the sales invoice and the bill of lading. The validated bank deposit slips are reviewed by the Assistant to the President while the cash remittance list is reviewed by the Controller's Office. The bank statement is reviewed by the Assistant to the President. Finally, the bank reconciliation is prepared by the Assistant to the President but does not appear to be reviewed. The failure to review this document would constitute an internal control weakness. All instructions on the flowchart appear to be reasonably complete, although any set of written instructions could be put into more detail. One problem does exist: None of the instructions give guidance when discrepancies are found. For example, according to the flowchart, a major problem exists in the sales division at point B. According to the explanation, no instructions exist when the collection is less than the amount of the invoice. Rather than rebilling the additional amount, the invoice information is placed in a permanent file. Although this rebilling process may be handled through the Assistant to the President or some other party, this procedure is not indicated by the flowchart. The Treasurer's Office, which serves the

54

QUESTION keeping function independent of the custody function at all points throughout the system?

YES

(6) Are all mathematical computations independently verified? (7) Does recordkeeping begin at the origin of the transaction? (8) Are all transactions authorized? (9)

NO

X

COMMENT custodial function for the cash funds, also records the initial receipt of cash. That type of organization is typical of small companies but does offer the opportunity for theft or cash manipulation. In addition, the Assistant to the President maintains the Accounts Receivable Subsidiary Ledger and reconciles the bank statements. Although not specifically a control weakness because this individual does not have access to the cash account, these combined responsibilities do offer the opportunity for successful theft through collusion. All computations are independently verified except for the cash discounts. The flowchart is unclear as to the procedure to be applied when the sales division calculation does not agree with the customer's payment. The record-keeping function appears to begin immediately upon receipt of the cash.

X

X

All transactions seemed appropriately authorized.

to

Indicate any other specific internal control features that have been built into this system. Other control procedures that might be mentioned by the students: Checks are immediately stamped "For Deposit Only" Spot checks made of cash remittance list totals to bank statement deposits are made to counter potential "lapping" activities.

(10) Indicate any other specific internal control weaknesses that appear to be present in this system. Other control weaknesses that might be noted by the students: Invoice slips and related documents are permanently filed by invoice number in 55

be

the sales division rather than by customer name without any apparent cross-referencing. In case of a later dispute, locating the invoice might be difficult. Case 4 – Exercise 2 (b) Abernethy and Chapman INTERNAL CONTROL – Control Risk Matrix – Revenue Cycle Client: Lakeside

Controls

Sales orders recorded on prenumbered forms Credit is approved by Rogers C

C

Recorded sales are supported By authorized shipping and orders Price list controls the prices and are checked independently.

C

Miller has access to orders, billing and accounting

D

C

Deficiencies

C

D

56

Timing: C

C

Statements are mailed monthly

Classification:

Accuracy:

Posting and Summarization:

Internal Control

Completeness:

Occurrence:

Revenue Transaction-Related Audit Objectives

D

C

No review by independent parties

D

D

Assessed Control Risk M H H C = control, D = deficiency H = high risk, M = moderate risk, L= low risk

D

L

H

L

Note: each deficiency needs to be evaluated by identifying compensating controls, potential misstatements, materiality and the effect on audit evidence. Case 4 - Exercise 3 The Lakeside Company Internal Control Weaknesses - Revenue Recognition Procedures December 31, 2012 Improvements that could be made in the revenue recognition system for the distributorship sales division are listed below. As a small organization, the controls that might actually be implemented are limited to those procedures that would be cost effective. Listed below are several possible improvements that could be considered: *7

Establish a separate credit department to investigate new clients and set credit limits based on this information.

*8

Prohibit Rogers or other company personnel from giving credit except under specified conditions.

*9

Use a sales order form that is different from the sales invoice. The two documents serve different purposes and are most useful if designed to meet those specific needs.

*10

Have a separate shipping department to provide control over the inventory being removed from the company.

*11

Establish a separate accounts receivable department to monitor all changes in each customer's individual account.

*12

Establish a separate billing department to prepare the sales invoices and ensure their accuracy.

*13

When goods are shipped, a signed receipt should be received as proof of 57

the transfer.

SUGGESTED ANSWERS TO SARBANES – OXLEY QUESTIONS (1) The board of directors needs to be organized so that it can fulfill its purpose. The primary improvement is to increase its independence and operation. The President of the Corporation should be the Chairman of the Board of Directors, and there should be sufficient independent board members to manage and create a truly independent audit committee. Under Sarbanes-Oxley the audit committee is the primary interface with the registered CPA firm. Other structural changes may involve management and their duties. Unlike the previous non-public audits, violations of segregation of duties, or lack of audit trail might trigger a significant deficiency or material weakness notification. Therefore, while in the past, expanded substantive testing was possible in the event of internal control deficiencies, SAS 112 requires the communication of all such problems in the context of the audit or the management report on the internal control system. (2) The audit or internal control is still relevant in the determination of the audit risk model and the determination of detection risk relative to the audit of the financial statements; however, Sarbanes-Oxley requires that public company management report separately on the internal control system over which they are responsible. Further, the registered CPA firm must audit that management report. The result is that Abernathy and Chapman must evaluate the effectiveness, and test the effectiveness of the internal control system regardless of its impact on the financial statement audit. In most cases this would involve increased auditing and therefore higher fees.

58

CASE 5 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) SAS 31, "Evidential Matter," states that: "The measure of the validity of [evidential matter] for audit purposes lies in the judgment of the auditor...." (para. .02) Thus, the quality of oral evidence is an evaluation made by the auditor that would be influenced by a number of factors: the perception of management's integrity, the rank of the individual providing the information, the ability to corroborate the evidence by other sources, and the purpose for which evidence is being gathered. However, in all cases, statements made by the employees of a client are only circumstantial evidence. In a comparison with other forms of evidence (such as observing physical existence and receiving confirmations directly from third parties), it provides less assurance. In this case, Mitchell is attempting to gather additional evidence concerning Lakeside's systems, especially the design and operating efficiency of control procedures and policies. Oral evidence serves an important role in such testing but still has to be complemented by other testing: a review of completed internal documents, flowcharts, organizational charts, job descriptions, systems manuals, etc. Conversely, oral information provides less evidence in the substantive testing of account balances. Whereas company employees should be able to furnish relevant information as to the functioning of control procedures within the various accounting systems, the auditor must rely almost exclusively on other types of testing to determine the fair presentation of the client's financial statements. (2) Accounts receivable generate a constant flow of cash into a company, offering a temptation to any employee who might be inclined to steal. Over the years, ingenious individuals have devised a multitude of plans for diverting this monetary inflow to themselves. Some of the more common schemes include the following: *14

Money that comes to the company from a customer is stolen by an employee with the balance then being written off the records as an uncollectible account. This diversion of funds is especially likely when an old account is collected, one that can be removed from the books without arousing suspicion.

*15

Lapping can occur. One or more accounts receivable are collected by the company but the money is stolen by an employee. However, since the 59

collection is not recorded, another invoice will eventually be sent to these customers who would then alert the company to the earlier payment. To prevent the processing of this second bill, subsequent cash collections from other customers are applied to the balances of the original customers. This series of events can be repeated indefinitely. Money is stolen on a daily or weekly basis to cover each previous theft. *16

A customer can pay the total amount of an invoice. An employee removes cash equal to the 2% discount that is allowed when payment is made within ten days. If the company does not have a specific policy for rebilling a customer for incorrect discounts, the difference may simply be recorded as a discount that has been taken.

(3) A company's net income can always be inflated by creating fictitious credit sales. For example, an invoice is prepared for a fake customer with the amount being recorded as an increase in both accounts receivable and sales. In the Lakeside audit, the client company wants to grow. Bank loans or new equity investments may be needed for this purpose. Increased income would make this type of financing easier (and, perhaps, cheaper) to negotiate. False sales might also be created for a different reason: The regional sales representatives are paid a commission based on sales. Thus, to inflate their own income, they might attempt to falsify sales records. Students may also suggest that fictitious sales will inflate the profits of the individual stores and, thus, increase the bonuses paid to the manager and assistant manager. However, this case indicates (as does the balance sheet in Case 3) that all credit sales are made by the distributorship side of the business. The stores do not sell on credit so that fictitious sales cannot be created through the recording of extra accounts receivable. (4) In talking with client personnel, an auditor must be constantly alert for any indication of potential problems. "Red flags" are often encountered in these discussions that need to be investigated to ensure that material misstatements do not exist. During Mitchell's conversation with Miller, a number of comments are made that should concern the auditors: *17

*18

Access to the accounts receivable subsidiary ledger is available to all employees within the company. Therefore, the possibility exists that an individual could make an adjustment to a balance without Miller noticing. The receivable of a friend or relative, for example, could be reduced. Aging of the receivables is performed only once a year. Although Miller 60

*19

*20

*21

*22

*23

*24

*25

claims that he can monitor the age of individual accounts, the company needs to be aware of changes that occur over time. For example, the increase in the age of the receivables during the current period seems to have gone unnoticed. Consequently, the company's assets are tied up for a longer period of time and the chance of accounts becoming uncollectible increases. The company needs to be in a position to take corrective action as soon as this type of problem begins to occur. Miller controls the accounts receivable subsidiary ledger with virtually no company oversight or control. For example, no reconciliation with the general ledger is made except for the auditor's testing once a year. Errors and evidence of irregularities could exist and not be discovered for months. Complaints about billings are handled by Miller rather than by someone independent of the system. The handling of complaints is an important method of control, especially in an accounts receivable system, since regular interaction with outside customers occurs. This control mechanism is neutralized, however, if Miller is assigned to look into and resolve the problems. No formal system exists for setting credit limits and granting credit. Rogers appears to handle this aspect of the company based almost on intuition. Thus, potentially excellent customers may have their credit limited while risky customers are given excessive credit. A formalized system needs to be developed with some oversight included. Credit is based solely on reports that are filed by the sales representatives. These individuals have a direct interest in getting additional sales since they are paid on commission. Thus, they have reason to want each report to sound as if the customer is worthy of credit. Additional independent information should be accumulated to help the company decide on the granting of credit. The credit files are never updated. Therefore, the company learns that a customer is no longer a good credit risk only by incurring a loss, the writing off of a balance as a bad debt. Therefore, customers in financial difficulties can run up large debts that will never be paid. The company needs to establish a periodic review of credit information to ensure that each customer is still worthy of credit. The age of the accounts receivable is up significantly from the previous year without any good explanation. Miller blames the change on Christmas, but the effects of that holiday would have also been encountered in the preceding year. The possibility exists that bad accounts or false accounts are now included within the receivable balance. Miller indicates that the company might have previously been holding accounts rather than writing them off as bad on a timely basis. The auditor must be concerned that this practice is still being followed. Companies will often attempt to manipulate net income by varying the point at which accounts are determined to be bad. No justification seems to exist for using 0.7% of net sales as the estimation of bad accounts. The auditor cannot corroborate a number that appears to have been selected at random. A new attempt must be made to derive an 61

*26

*27

*28

*29

estimation that is a reasonable representation of the company's uncollectible accounts. The company waits until an account is 15 days old before a second invoice is mailed. This delay is, perhaps, one of the reasons that the age of the accounts has increased. Many customers may be waiting for the pressure of the second bill before making payment. Miller writes off accounts as uncollectible with no apparent company control. Since bad accounts may indicate errors or irregularities, they should always be reviewed and approved by some independent party within the organization. Miller produces and mails the final invoice for overdue accounts. Since Miller has a great many responsibilities in this system, this last billing should be made by some other individual. Therefore, if the account has been paid (and stolen or incorrectly recorded), the information comes back to this independent person. Prices and extensions of invoices are sometimes checked after the invoice has been mailed to the customers. This system is obviously inefficient. Payments may be made incorrectly, and customers can become aggravated by later adjustments being made.

(5) First, because of weaknesses found during the preliminary evaluation of the internal control, control risk may be assessed at the maximum level. Since maximum control risk is being assumed, the auditor has no reason to test the operating efficiency of the control procedures. Second, although potential strengths may be identified by the preliminary evaluation of internal control, the auditors may still opt to assess control risk at the maximum level. This decision would be justified if additional substantive tests appear to be easier and cheaper to perform than the testing of the operating efficiency of specific control policies and procedures. Thus, once again, the testing of the control procedures becomes unnecessary. In the new Sarbanes-Oxley environment, testing cannot be omitted for public companies. (6) Inherent risk is the susceptibility of an account balance or class of transactions to a material misstatement. A number of factors affect this assessment: the quantity and size of transactions occurring over time, the past history of the company in this area, the likelihood of theft, the necessity of performing complicated calculations in order to generate reported figures, problems inherent to a 62

particular industry, the need for making estimations, the results of analytical procedures, and the possibility of obsolescence. For example, in the Lakeside audit, inventory would be an account that would probably have a high inherent risk. The company has numerous transactions in both buying and selling inventory. Computations of discounts and freight charges could be difficult, as would be the application of a cost flow assumption. The possibility of theft, breakage, returns, and obsolescence of inventory would all be high and require periodic estimations. The auditor's assessments of both inherent risk and control risk have a significant impact on detection risk and, therefore, substantive testing procedures. If the inherent risk and control risk are both determined to be low, detection risk need not be kept low. Thus, less substantive testing (both in quantity and quality) is needed. Conversely, if the inherent risk and the control risk are judged to be high, the auditor must reduce detection risk. As discussed above, this risk can be brought down to an acceptable level by such means as performing additional substantive testing, using more experienced staff personnel, carrying out procedures closer to the balance sheet date, or relying on more effective testing procedures. (7) In positive confirmations, debtors are asked to respond in all cases whether or not they are in agreement with the information given. When using the negative form of request, debtors are asked to respond only if they disagree with the information. Since positive confirmations require a response in every case, they provide better evidence than do negative confirmations. Hence, positive confirmations are more appropriate when the internal control is weak, accounts are large or old, or related parties are involved. Increased audit evidence is needed in each of these cases. Negative confirmations are not as costly and are most often used when less evidence is required. (8) The selection of a specific account for confirmation is an indication that the auditor desires additional evidence or assurance about that particular balance. A number of situations exist that would suggest the need for confirmation of a specific account: a) The balance appears to be with a related party; b) The account is quite large in relation to other accounts receivable;

63

c) The account is far overdue, indicating a possible bad debt to be written off or that payment has not been properly recorded; d) The activity within the account has been unusual. For example, later invoices were paid while earlier charges were ignored. (9) The debit entries made to Lakeside's Accounts Receivable control account produce an audit trail made up of the following documents or records: *30

Sales Journal - indicates the original journal entry recorded for each sales transaction. An auditor matches the debits in the general ledger account to these journal entries to ascertain that no posting errors have been made.

*31

Sales Invoice - serves within the Lakeside system as both an invoice indicating the amount billed to the customer and a sales order. The auditor can use the various copies of the sales invoice to verify that: -

credit was approved for the sale, quantities and types of items billed agree with the quantities and types of items shipped to the customer, prices included on the invoice are appropriate, that the bill is mathematically correct.

*32

Bill of Lading - records the quantity and description of the items being shipped. The auditor compares it with the sales invoice to make certain that the items ordered and billed are in agreement with the items that were shipped.

*33

Accounts Receivable Subsidiary Ledger - indicates the receivable balance from each individual customer. An auditor compares individual entries made to this subsidiary ledger with entries in the control account in the general ledger. Indicates proper functioning of system.

*34

Inventory Price List - used to price sales invoices. An auditor can use this listing to verify correct pricing of the sales invoices.

*35

Inventory Sales Journal - records inventory sales as a basis for perpetual inventory. An auditor verifies that the items recorded as being sold agree with the sales invoice. Although this verification relates to the inventory system rather than to receivables, the journal is mentioned in Exhibit 3-4 and does indicate an appropriate interface between the two systems.

Although the following documents are not part of the audit trail leading to the 64

recording of the Accounts Receivable debits, they are certainly relevant to any testing made in connection with the fair presentation of those debits: Invoice Slips, Cash Remittance Lists, Validated Bank Deposit Slips - some or all of these documents can be used by the auditor to verify the actual amount of cash received. The question of collectibility is best answered by actual collection of the receivable. Thus, the auditor will compare the debit entries in the receivable account to the subsequent cash collections. This question also asks about the reliability of the evidence gathered from this audit trail. Lakeside's audit trail is composed entirely of internally generated documents. For example, even the original customer order is taken by telephone and recorded by Lakeside employees. Thus, the reliability of the documents that comprise this trail, such as bills of lading or sales invoices, would be closely tied to the auditor's evaluation of internal control. If controls are perceived as strong, the reliability of these documents is much higher than if controls are weak. Because the audit trail is composed solely of Lakeside documents, the student should be aware that testing this trail provides the auditor with only a portion of the necessary evidence. Collection of the accounts receivable, for example, and auditor confirmations would also provide evidence as to the fair presentation of the accounts receivable. (10) Miller is uncertain how the 0.7% figure was determined. He says that the previous auditors determined this figure several years ago, and that the company has always used this figure. Obviously, this is not a reasonable method for estimating bad debts. The figure should be evaluated by Lakeside's management at least annually for its reasonableness. This evaluation should include a review of the history of uncollectible accounts, the current credit policy, and the current aging of accounts receivable. (11) Mitchell probably should not recommend that Accounts Receivable be confirmed as of an interim date (November). The internal control for the revenues and cash receipts cycle appear to be poor and cannot be relied upon to provide reliable financial information for the month of December; thus, Accounts Receivable should be confirmed at year-end. (12) Consistent with our answer in #11 above, Miller has not designed an effective system. It is not unusual for a company to grow, and what worked before can no 65

longer be relied on to handle the increased volume. Miller seems to exhibit a lax attitude in several of his answers and therefore, since he is responsible for the system, we must conclude that he has not made good decisions.

SUGGESTED ANSWERS TO EXERCISES Note: Although no specific question relates to the following matter, students may detect that a contradiction exists between a statement made by Miller in Case 5 and the system memorandum presented in Exhibit 4-3. Miller indicates that he verifies the prices and extensions reported on sales invoices. Exhibit 4-3 states that this control procedure is performed by the Controller's Office. Although this discrepancy could mean that Miller's assertion is incorrect, it probably signifies that the system has been altered subsequent to the development of the memorandum. Discussion of this contradiction is a good lesson in the importance of constantly updating the firm's knowledge of the client's systems and internal control. Case 5 - Exercise 1 Abernethy and Chapman Internal Control Questionnaire - Accounts Receivable Client: The Lakeside Company Prepared by: Date: Questions 1

Does an independent party on a regular basis reconcile the subsidiary ledger?

2

Are appropriate, established criteria in

Comments on Current System The subsidiary ledger is reconciled annually by the independent auditors.

The criteria for writing off accounts

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Significance

Suggestions

During the year, virtually no control is maintained over Miller's handling of the subsidiary ledger. The possibility that errors or irregularities will be discovered on a timely basis becomes remote if not impossible. In addition, Miller has the opportunity for manipulating the records to cover thefts and other defalcations.

On a periodic basis, a member of the administrative staff should verify that the subsidiary ledger for accounts receivable agrees with the general ledger control account.

For the auditor, a problem exists as to

Establish a formal system for writing off

Questions place for writing off doubtful accounts?

Comments on Current System are nebulous and seemingly based solely on the judgment of Miller.

Significance

Suggestions

the consistency of removing bad debts from one year to the next. Once again, no control appears to exist over Miller's judgment.

bad accounts. This system need be no more than a list of steps to be taken prior to the decision to remove an account. Company needs to ensure a review of these accounts. Once a system has been established for the write-off procedure (see Question 2), an independent employee should be required to review every account prior to removal to make certain that all proper steps have been followed.

3

Are accounts to be written off properly reviewed and authorized by an independent party?

No independent party authorizes the write-off of bad accounts.

The removal of bad accounts can be used to cover cash thefts. Also, writeoffs may be approved without sufficient attempts being made at collecting the receivables.

4

Is an appropriate follow up made on accounts that are written off?

Follow-up of bad debts is not addressed in the case; Mitchell does not ask this specific question.

If no follow-up is made, the company reduces the possibility of making any future collection. Additionally, attempting to collect an old account receivable is a control mechanism to ascertain that the balance has not actually been paid and the money stolen or the collection recorded incorrectly. Finally, if no follow-up is carried out, the opportunity exists for employees to steal the money if it should be received at a later date.

The receivable can be turned over to an outside collection agency or, as an alternative, a member of Lakeside's staff can be assigned to look into the bad accounts periodically.

5

Does the company periodically reevaluate the method in use for estimating

No reevaluation of the method for estimating bad accounts has been

No proof exists that the bad debt expense and the allowance for

Client should schedule recent bad accounts to arrive at a new estimation of

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Questions bad accounts?

Comments on Current System made by the client company.

Significance

Suggestions

doubtful accounts is fairly presented.

the bad debt percentage.

6

Are customers billed regularly by a party separate from the subsidiary ledger?

The first three invoices are mailed by the sales division; any further billing is made by Miller, who is in charge of the subsidiary ledger.

By having Miller send the last invoices, the opportunity for manipulation is increased. In a small company such as Lakeside, this situation is not unusual, but it should be accompanied by additional control and reconciliation features.

Control can be established by allowing Miller to continue the billing, but with the addition of the control procedures suggested in several of the other questions.

7

Is an independent verification made of complaints from customers concerning their bills?

The responsibility for looking into complaints is vested in Miller.

Again, all of the responsibilities are in the hands of one person with no independent control being applied. This lack of control reduces the possibility that errors will be discovered. Basically, an opportunity to establish control over Miller's work is being missed.

Lakeside should have complaints sent to an employee who can then discuss the matter with both Miller and the customer to make certain that the issue is properly resolved.

8

Was the company’s policy of granting credit changed over the past year?

According to the client, no formal change in the policy of granting credit has been made. However, the increases in the size of the receivables, the increase in the average age of the balances, and the apparent write-off of additional uncollectible accounts indicate the possibility that some, perhaps informal,

Any shift in credit policy requires auditor attention as to the effect on the allowance account and bad debt expense. Abernethy and Chapman may want to review the new customer accounts opened during the current year for any indication of a change in credit policy. This issue may be especially significant in the

Lakeside should adopt a policy to guide Rogers in his credit decisions. In addition, outside verification of credit ratings on a periodic basis would help reduce the risk of high bad debt losses.

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Questions

9

Can a credit sale possibly be made without prior credit approval?

10

Are credit files complete and periodically reviewed?

Comments on Current System modification has occurred. Because the credit policy has never been formally established, the auditor may have trouble distinguishing an actual change. No indication is given in the case as to whether sales invoices are verified after the shipment to ascertain appropriate credit approval. The system is designed so that credit approval is necessary before the sale is made, but no control mechanism is identified to assure that the system is working properly. Credit files contain only the sales representative's credit reports and do not appear to be reviewed periodically.

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Significance

Suggestions

Lakeside audit since credit reports are filed by the sales representatives who are paid on commission, thus benefiting from an increase in sales. To the auditor, the possibility of a sale being made without credit approval casts further doubts on the reliability of the system of controls. As a part of the tests of controls, the auditor will want to review a sample of sales invoices for proper credit approval.

At the point in the accounting system at which the extensions and prices are verified, the presence of credit approval should also be checked.

As indicated above, the credit granting policy is informal and based almost solely on Rogers' judgment. Thus, the efficiency of the system is unknown, and review of the system by the auditor is quite difficult.

As a part of the design of a comprehensive credit system, Lakeside should determine the desired contents of a credit file including items such as outside credit reports, financial statements, correspondence, etc. Periodically, these files need to be reviewed by an independent Lakeside employee to verify that all information is complete and up-todate. Each customer's file is also reevaluated at regular time intervals to judge whether

Questions

Comments on Current System

Significance

Suggestions credit should continue to be offered.

11

Are invoices verified as to agreement with goods shipped and price of goods?

Verification of goods and prices is made by Lakeside employees. Miller implies that his checking of prices and extensions are not made on a timely basis. In addition, this verification is another responsibility pertaining to accounts receivable concentrated in Miller's hands.

Verifying extensions and prices after the invoice has been sent to the customer is not a logical approach. Also, having Miller perform this task adds nothing to the efficiency of the organization.

All verifications should be made prior to mailing the invoice, ideally by a different employee.

12

Are extensions and footing recalculated?

See answers for question 11.

13

Are cash discounts recomputed and verified as to actual days?

Cash discounts are verified by the sales division.

System appears adequate. Financial information should be fairly presented.

None.

14

Can a sale possibly be made and goods shipped without an invoice being recorded or mailed?

Using prenumbered sales invoices and bills of lading along with the periodic verification of all numbers is essential in assuring that all sales are recorded. In an earlier case, the use of prenumbered forms is mentioned. Miller suggests that the presence of all forms is tested periodically, but the auditor should specifically ask about that procedure.

If the possibility exists that the company can make sales without recording them, the auditor's ability to gain assurance as to completeness assertion may be severely hampered.

Since the documents are already prenumbered, the auditor needs to make certain that Lakeside has a policy for periodically verifying the presence of all forms.

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(2) Case 5 - Exercise 2 Abernethy and Chapman Internal Control Evaluation Client: The Lakeside Company Prepared by: Date: Exhibit 5-2 is a portion of the audit program that Mitchell designed to test the operating efficiency of controls in the revenue and cash receipts cycle. For each individual test, indicate the anticipated results if the control procedure is working properly. Also, if the control is not functioning properly, list the potential problems that exist. Use the following format for your response: Step 1-A

Anticipated Results The total listed on the sales invoice should agree with the total on the sales invoice slip. In addition, evidence should be present to indicate that a Lakeside employee has already made this same comparison.

1-B

Anticipated Results - The quantity and description of the items sold should be the same as the items shipped. Again, Lakeside employees are supposed to have previously made this comparison and left their initials or other proof of the execution of this test.

1-C

Anticipated Results - Cash received as per the remittance list should be consistent with the invoice and the invoice slip. Customers should be encouraged to include the amount of payment on the invoice slip as a further control procedure. Because of the 71

Potential Problem(s) If the invoices do not agree, the possibility is raised that fictitious or misstated sales are being recorded. Lack of tangible evidence (e.g., initials) that the matching procedure has been carried out would indicate that the employees are not complying with the requirements of the system. Potential Problem - Differences warn the auditor that sales have been both billed and recorded incorrectly, or incorrect amounts or types of inventory have been shipped. Once again, a lack of compliance by Lakeside's employees may be shown if this comparison has not been made. Potential Problem - The cash may have been stolen, or someone in the company may be engaged in lapping.

Step

Anticipated Results Potential Problem(s) discount, the auditor may want to perform this step in connection with the discount computation in Step 1-D.

1-D

Anticipated Results - Calculated cash discounts should be identical with the amounts recorded by the client company. In most cases, this calculated discount figure will be equal to the difference between the sales invoice total and the cash remittance.

Potential Problem - Discounts may be incorrectly recorded to hide cash shortages or as a step in stealing cash funds from the company. Also, the company may be allowing customers to take discounts that have not actually been earned. Allowing these reductions would indicate lack of efficiency in internal control.

1-E

Anticipated Results - All prices on the invoices should agree with the prices being shown on the approved price list.

Potential Problems - Wrong amounts may be paid by customers. Improper pricing, either intentionally or unintentionally, also leads to incorrect sales and receivables figures on the financial statements. If the invoice price is too high, sales and income are overstated; if too low, the figures will be understated, and company employees may be receiving kickbacks from customers.

1-F

Anticipated Results - The extensions and footings on the invoice should be correct.

Potential Problems - Wrong amounts may be paid by customers. Improper footings or extensions, either intentionally or unintentionally, also leads to incorrect sales and receivables figures on the financial statements.

1-G

Anticipated Results - The amount received according to the invoice slip should agree with the listing of individual items

Potential Problems - A discrepancy could indicate the theft of the cash receipts. This test also may alert the auditor to

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Step

Anticipated Results being deposited. In addition, the date of deposit should be the same as the date on which the payment is received.

Potential Problem(s) the possibility of lapping.

1-H

Anticipated Results - All cash remittances should be recorded promptly as credits to the specific subsidiary ledger accounts.

Potential Problems - Since the subsidiary ledger is not well controlled in the Lakeside organization, this procedure may be used to determine the possibility of errors within the ledger. This test also may indicate lapping as well as other manipulations of the accounts so as to conceal cash shortages.

1-I

Anticipated Results - Each invoice should be initialed by either Rogers or Miller to indicate credit approval.

Potential Problems - Because the credit system is not well documented, the auditor will be searching for evidence that sales can be made without credit approval. Such evidence would have an effect on the auditor's judgment as to the amount of evidence needed in examining the allowance account and bad debt expense.

2-A

Anticipated Results - Each debit entry should be corroborated by an appropriate sales invoice agreeing as to amount and customer.

Potential Problems - This test has major significance in that it can alert the auditor to any falsification of sales for the year. Fictitious sales could easily be created by Lakeside since they prepare all sales invoices and other documents internally.

2-B

Anticipated Results - Each credit should agree with the cash remittance list as to amount and possibly date of payment depending upon the method of posting.

Potential Problems - This tracing could denote errors in postings within the system. Errors could indicate lapping by company employees.

2-C

Anticipated Results - Each credit

Potential Problems - Again,

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Step

Anticipated Results to a specific account should agree with the listing of individual items on the bank deposit slips.

Potential Problem(s) lapping or attempts by employees to cover cash shortages may be uncovered through this test.

3

Anticipated Results - For each of the customers, complete and updated credit reports should be on file.

Potential Problems - The use of credit reports is an essential step in establishing an appropriate credit-granting system. The presence of these reports would indicate that the control procedure is operating efficiently. If the reports are missing or incomplete, the auditor may want to seek additional evidence as to the validity and collectibility of the receivables.

4

Anticipated Results - Each list should be arithmetically correct. Each total ought to agree in amount and date with the balance entered in the cash receipts journal.

Potential Problems - Cash shortages and cash thefts are often covered by incorrectly footing a listing of cash transactions.

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION (1) This question is similar to the SOX question in Case 4. The emphasis is on the difference between public and privately held companies. The difference involves the testing of the controls. In the public company setting, controls are always tested because of the separate disclosure by management of their evaluation and testing of their system. In both public and privately held companies the evaluation and possible testing of internal controls by the independent auditors is related to the financial statement audit. The amount of substantive testing and the determination of the detection risk is related to the internal control risk.

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CASE 6 SUGGESTED ANSWERS TO DISCUSSSION QUESTIONS (1) In the brief description presented of Lakeside's inventory procurement system, several specific control activities can be seen: *36

The company maintains a perpetual inventory which provides significantly greater control than does a periodic system;

*37

The case implies that the company uses preprinted forms so that adequate information is captured whenever a document is prepared;

*38

All purchase requisitions are reviewed and authorized before merchandise is ordered;

*39

Incoming inventory is inspected for damage upon receipt;

*40

All invoices are matched with the appropriate purchase requisition and receiving report before payment is approved;

*41

Prices of every invoice are verified; and

*42

The mathematical accuracy of each invoice is checked prior to payment.

(2) Canceled checks are the last document in this system, while receiving reports are one of the first. Whenever auditors select a final document such as a canceled check and search for its documentation, they are seeking to substantiate the validity of the balance being reported. All forms and documents must be present to prove that the amount and the company's reporting were both correct. Such testing also seeks to discover whether false transactions have been entered into the system. For example, if a canceled check is found without a corresponding receiving report or purchase requisition, the possibility exists that money has been stolen from the company; a payment was made for merchandise that was not ordered nor received. Taking a beginning document such as a receiving report and tracing the impact of the transaction through an entire system is intended to provide evidence of completeness and that the system and its controls are working as designed. Obviously, such testing will also provide evidence as to the validity of the account balance, but this particular procedure is more often associated with the 75

completeness assertion and internal control evaluation. (3) How might Lakeside pay for goods that were received? The company could, as an example, receive an invoice and not properly match it with the corresponding receiving report. The receiving report might state that 10 items were actually acquired while the invoice was for 20 or 100. The individual doing the review may not notice the discrepancy and erroneously approve the invoice. As another possibility, this individual might authorize an incorrect invoice in order to receive a kickback from the vendor. How might Lakeside fail to pay for goods that were not received? If either the receiving report or the invoice is lost, the documents will not match and payment cannot be made. Thus, the company may wait indefinitely for the other (lost) form before approving the cash disbursement. (4) Audit documentation, also called a working paper, is designed to demonstrate that the auditor has obtained sufficient, competent evidence on which to base an opinion as to the fair presentation of the client's financial statements. Given that overall objective, the working paper indicates the testing that was performed and the evidence that was accumulated. The working paper should also specify any problems that were encountered and their resolution. The working paper must demonstrate that this portion of the examination was properly planned and that all assistants were adequately supervised. In addition, the audit documents as a whole must indicate that internal control was studied and evaluated. All audit documents are the property of the auditor and are maintained by the auditor in order to support the opinion rendered by the auditor. (5) A CPA firm must establish policies and procedures for the supervision of work at all organizational levels to provide reasonable assurance that the examination conforms to generally accepted auditing standards. Procedures for supervision are necessary to ensure that appropriate judgments and conclusions have been drawn from the work performed. Not every member of an audit team will have the expertise necessary to evaluate the handling of each accounting and auditing problem that arises. Furthermore, some of the audit staff may lack an in-depth knowledge of the client or the client's industry, thus increasing the possibility of incorrect judgments. Supervision by auditors having the necessary experience and expertise provides reasonable assurance that sufficient evidence and proper conclusions were obtained. Auditing literature places emphasis on the existence of appropriate supervisory 76

policies and anticipates that practices will be used by a firm in each audit engagement to verify proper supervision. One such procedure is to have staff members leave their initials to indicate the completion of a test or later review. Thus, the working paper shown in Exhibit 6-1 was originally produced by Art Heyman (AH) and subsequently reviewed by Carole Mitchell (CM), and Wallace Andrews (WA). From the location of the initials, this auditing firm must require acknowledgment at every point of audit judgment to indicate that the supervisors concur with the actions taken. This policy enables the firm to monitor the degree of supervision in each area of the audit as well as to ensure that no critical problem will escape the attention of supervising auditors. (6) Because of the great volume of audit documentation accumulated during an engagement, most firms use an indexing system to organize all materials. Indexing allows the auditor easier access to the various documents and expedites the review process. The "N-2" designation on this document is apparently part of an indexing system, although no indication is given in the case as to the actual derivation of the symbols. Abernethy and Chapman may be using a code in which the letter N refers to the inventory account, and this particular document presents the results of the second testing procedure performed on that account. (7) One of the purposes of audit documentation is to serve as an historical record of all audit testing performed by the CPA firm. This documentation provides a guideline for future audits but, more importantly, serves as evidence should the auditor's work ever come under question. To assure that the audit documents clearly reflect the procedures that were carried out and the evidence gathered, many auditing firms require that the objective, the scope, and the conclusions reached be included in the documentation of each test. Furthermore, by having to furnish this information, the staff auditor is more likely to understand the purpose of the procedures being applied. (8) Audit procedures are the steps that are required to test a particular control, transaction, or account. Some firms write procedures specifically designed for a particular audit client. Also, some firms have standardized audit procedures for use on all audits. For quality control standards, standardized procedures are preferable to ensure that all audits are performed in a like fashion. However, these standardized procedures should be supplemented with procedures 77

designed to meet the particular circumstances of each client. SUGGESTED ANSWERS TO EXERCISES (1) Exhibit 6-1 may well be a student's first view of audit documentation. Therefore, discussion of its clarity and completeness should force the student into a close examination of the structure and function of the document. Students should be encouraged to discuss the strengths of this particular working paper as well as its weaknesses. Case 6 - Exercise 1 The Lakeside Company Inventory Purchases and Cash Disbursements Transactions In-charge Review Comments December 31, 2006 Prepared by: Date: Item on Working Paper The fifth procedure states that the auditor "examined canceled checks for amounts, dates, signatures, endorsements, and payee." The fifth procedure Exception (A)

Exception (A)

Problem Obviously, the auditor is not just physically examining this information but is confirming the data against some other document (the invoice). This reconciliation is not clearly stated. No indication is given as to the purpose of verifying the account code. Poorly written. The staff auditor does not indicate whether the $200 and the $360 amounts are over or under the current list price. The explanation for the discrepancies is vague. Stating that "the difference represents monthly purchases from Cypress at different prices than shown in current price list" indicates nothing about the reason for the change. The major problem, though, with this explanation (and the actual testing procedure) is that Thomas' word is accepted as an adequate explanation 78

Item on Working Paper

Problem for the discrepancy. The auditor provides no information that any further testing has been carried out to verify these amounts. The assumption has apparently been made through the comment "Pass Further Work" that the differences are immaterial and, thus, do not require additional testing. Since all of the supervisors have added their initials, concurrence appears to exist with this evaluation. Students may want to discuss whether these two discrepancies warrant further examination and, if so, what testing could be performed.

Exception (B)

Also vague and poorly written. Once again, Thomas' explanation is apparently accepted without further question or testing. The comment does not indicate the amount of the differences that are involved in this replacement. Therefore, judging the materiality of the items will be quite difficult for the audit supervisors. Seems relatively clear. An auditor would prefer to see this policy in an official Lakeside manual rather than accepting oral evidence, but in a small company such as Lakeside, that may not be possible. The auditor should adjust the flowchart and memorandum for this system to include this discovery

Exception (C)

Note: On the whole, other than comments A and B, this working paper appears to be clear and comprehensive. By reviewing the steps of the audit program listed in this case, students can see that Heyman has performed the audit procedures designed by Mitchell. (2) Attached is one example of an audit document that could be produced by carrying out the prescribed auditing procedures. A great amount of variety exists in format, and students ought to be evaluated on the clarity and understandability of their approach rather than on the development of a particular structure. 79

In reviewing this audit document with students, the instructor should be aware that this question was developed with several educational objectives in mind: *43

To introduce students to the types of testing procedures performed by auditors in verifying the operating efficiency of a company's control policies and procedures.

*44

To assist students in developing the ability to discover and evaluate control problems. In this case, a number of problems exist; some are meaningless, while some are quite significant. If this question is approached, at least partially, as a discussion question, student ideas as to the meaning and importance of each problem can be quite interesting.

*45

To aid students in developing audit document construction techniques. As in a previous case, one or more of the students' efforts can be chosen and presented to the class as a whole or in small groups for a technical critique.

(3) If Art Heyman found inconsistencies in this part of the audit his primary responsibility is to document the items. He should do only enough work at this point to fully understand the nature of the inconsistency, so that his documentation is adequate. In conversations with Mitchell, further work may be developed.

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Case 6 - Exercise 2 Lakeside Company Inventory Purchases and Cash Disbursements Transactions December 31, 2012 Audit Doc. No. Prepared by: AH 12/2/12 Reviewed by: Reviewed by:

Date 8/20/09 8/21/09 8/24/09 8/27/09 8/28/09 9/2/09 9/3/09 9/7/09 9/7/09 9/14/09 9/16/09 9/21/09

Vendor Cypress Cypress Cypress Cypress Cypress Cypress Cypress Cypress Cypress Cypress Cypress Cypress

Purchase Requisition Number 6702 6703 6705 6704 6706 6707 6708 6710 6709 6711 6712 6713

Receiving Report Number 3918 3919 3920 3921 3922 3923 3924 3925 3926 3927 3928 3929

Invoice Number 711 802 991 1261 1313 1406 1510 1616 1691 1812 2072 2149

Check Number 3091 3121 3164 3203 3251 3310 3345 3397 3425 3451 3471 3510

Check Amount $2,413.95 $523.80 $1,810.28 $2,860.03 $6,030.04 $2,577.10 $3,745.60 $354.05 $1,507.77 $11,698.88 $2,941.36 $14,867.97

1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 1,

Audit Procedures 2, 3, 4, 5, 6 2, 3, 4, 5, 6, G 2, 3, 4, 5, 6, C 2, 3, 4, 5, 6, E, F 2, 3, 4, 5, 6, G, D 2, 3, 4, 5, 6, B, G 2, 3, 4, 5, 6, E 2, 3, 4, 5, 6, A, G 2, 3, 4, 5, 6, G, B 2, 3, 4, 5, 6, G, C 2, 3, 4, 5, 6, G, E 2, 3, 4, 5, 6, G, C

Audit Objective: To verify that items received were properly ordered, received, and paid. Scope:  Population: All receiving reports prepared during the period under audit.  Sample: Judgmentally selected 12 receiving reports from inventory department file. Pulled reports sequentially, randomly starting with #3918. Audit Procedures: 1. Review receiving reports. All complete and signed by inspectors, except A. 2. Compared receiving report with purchase invoice for quantity and description. All agreed except B.

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3. Compared receiving report to purchase requisition for quantity and description. All agreed except B and C. All requisitions approved by Rogers or Miller. 4. Invoices reviewed for compliance to see if they were checked, extended, and footed by Lakeside employees. All were except D. 5. Compared invoice prices with Cypress master price list. All agreed except E. 6. Inspected canceled checks and compared them to invoice amounts, recomputing 3% discount. All agreed except E. Comments: A Receiving report not in file. Client should be asked to find it or provide a reason for its absence. Unless it is accounted for, the scope of testing may need to be expanded. AH B On two invoices Cypress billed Lakeside for items different from those received. In both cases the bill was for the items ordered, not those received. R.R. #3923 shows an item that is more expensive than the one billed, while R.R. #3927 has an item that is less expensive than the one billed. The purchase requisition for R.R. #3923 indicates Lakeside's acceptance of a replacement but no indication in connection with R.R. #3927. Lakeside has paid for goods ordered, not goods received. This reflects a serious problem with both the Lakeside and Cypress systems. AH C Some receiving reports indicate receiving a different amount of goods than ordered. Requisitions indicate that goods have been backordered in both cases. Lakeside, however, paid only for goods received. System is functioning properly. AH D No indication on this invoice that pricing, footing, or extensions were verified. Other invoices show initials and tick marks. Failure to comply with the system in this one case. AH E In a number of cases, invoice prices were less than the master price list. There seems to be a discount on special items, but more evidence is needed. AH F One invoice was reduced by a 4% discount, instead of 3%. Further inquiry required to determine reason. AH G In virtually all cases, checks were issued 2 or 3 days after the 20-day deadline for taking discounts, but Lakeside took the discount in every case. Further inquiry is required to determine if Lakeside still has a liability for these amounts. AH

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Audit Conclusion: Further testing necessary because of exceptions noted.

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CASE 7 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) A company profit-sharing arrangement is a matter of auditor concern because it provides an incentive for employees to generate artificially high income figures. These individuals can receive direct financial benefits from the manipulation of reported earnings. This potential problem is even more of a concern in the Lakeside engagement because controls are weak and each store is geographically isolated from the oversight provided by the administrative offices. (2) This case describes the payroll system used by the Lakeside Company. Tests of controls are designed by the auditor to verify that specific control features identified as possible strengths are operating effectively. A sample of such tests would include the following: a. Compare the payroll records produced by Sarah Sweet to time tickets completed by hourly employees noting agreement as to hours worked; b. Verify that time tickets have been appropriately authorized; c.

Recalculate salaried employees' monthly pay and compare to the payroll records;

d. Recalculate salesmen's commissions and compare to payroll records; e. Recalculate payroll deductions based on government payroll tables and the data listed on the W-4 form filed by each employee. Compare these deductions to the company's payroll records; f.

Recompute Lakeside's payroll taxes and compare to total reported balance;

g. Verify mathematical accuracy of net wage figures (salary less deductions); h. Foot the payroll record;

84

i.

Verify that each payroll record has been properly authorized by Mark Hayes;

j.

Compare the payroll transfer made from the general fund each period to the total payment computed on the payroll record;

k.

Review canceled checks for proper signature, amount, payee, date, and endorsement;

l.

Review payments made for withholdings and payroll taxes. Compare these amounts to payroll records kept for each of these items.

(3) Existence or Occurrence - For payroll expense, the auditor would want to determine that all employees do, indeed, work for the company. If 48 employees are paid each period, the auditor needs to ensure that 48 individuals are working for Lakeside. The auditor should be concerned that one or more employees are stealing money by receiving more than one check. A review of the payroll records completed by the employees before they begin work provides some evidence that the individuals do exist. In addition, the auditor can accompany the paymaster (or whoever serves in this capacity) when paychecks are distributed. This procedure allows the auditor to identify the person receiving each check to ensure that the employee is the same as is listed on the check itself. Completeness - Completeness is not usually a major problem in the area of payroll expense, where misstatements most often result from having extra expense recorded (because of theft) rather than from having transactions omitted. However, the auditor still wants to ascertain that the $1.1 million figure to be reported contains all applicable payroll expenses. Thus, for example, verifying that a year-end expense accrual has been made helps to prove that all expenses were recorded. Furthermore, if payroll taxes and other costs are to be reported within the payroll expense figure, the auditors should determine that all such costs (Social Security, unemployment taxes, medical insurance premiums, etc.) have been properly included in the final balance to be presented. Rights and Obligations - For payroll expense, the auditor would want to ascertain that work did occur during the period for which the company does have a legal obligation to pay. The auditor would review the time tickets to make sure that they seem proper and then recompute the amounts to be paid based on the hours worked. These calculations provide evidence that the payments were, indeed, the actual obligations of the client company. Valuation or Allocation - Since an expense rather than an asset is involved, the auditor is more interested in allocation than valuation. Verification should be 85

made that the proper expense is being allocated to the current year. Hence, the auditor should recompute the cutoff made of the payroll calculation at both the beginning and ending of the fiscal year. Determination needs to be made that the figure being reported is for 2009 only. Presentation and Disclosure - The auditor wants to make certain that the financial statements fairly present the payroll expense figure. As shown in Exhibit 3-1, a balance for "Salaries, Commissions, Bonuses" is reported for both the stores and the distributorship. The auditor needs to determine that the separation into these two classifications is properly performed. In addition, the specific accounts included within this single category should be consistent from year to year so that comparability is enhanced. Since the company does not manufacture its inventory, no portion of the payroll expense should be assigned to Cost of Goods Sold. (4) Types of evidence-gathering procedures that are used by an auditor during an examination would include the following. (One method for approaching this question is to ask the students to identify the accounts that could be tested through each procedure.) a) Observation of activities and conditions - usually a test of controls to provide evidence of operating efficiency. b) Physical examination and count - used to prove that an item physically exists and agrees with the ledger balance. c) Confirmation - proves existence of a balance by communication directly with an outside party. d) Inspection of documents - demonstrates that control procedures have been performed or provides support for reported balances. e) Recomputation (including footings, cross-footings, extensions, recalculations, etc.) - demonstrates that control procedures have been performed or provides support for reported balances. f)

Retracing transactions from origination to final reporting - ensures that accounting system is functioning properly so that balances will be correctly reported.

g) Scanning accounting records - an analytical procedure designed to highlight significant or unusual differences.

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h) Inquiry (including discussion, questioning, etc.) - helps auditors to learn design of accounting systems and internal control and to evaluate efficiency of operations. i)

Examination and corroboration of subsidiary records - serves as support for reported balances.

j)

Correlation with related information (including ratio and trend analysis) another analytical procedure to identify possible problem areas.

k)

Review of subsequent events - provides support for year-end balances and identifies happenings that require disclosure.

l)

Reliance on outside experts - used for evidence-gathering purposes that go beyond purely auditing and accounting skills such as inventory valuations and engineering estimates.

m) Examination of legal letters and confirmations - helps to identify, assess, and value significant events and contingencies. n)

Obtaining a representation letter from the client's senior management management acknowledges responsibility for statements and provides evidence in areas where other evidence may not be available.

This question also asks about the competence (significance and reliability) of these procedures. Each test is potentially quite important and produces reliable evidence, but only if used in the appropriate circumstances. For example, confirmation is one of the most important steps in auditing cash bank balances but is rarely used in connection with an account such as land. Physical examination is essential in auditing marketable securities where ownership and value can often be ascertained visually. This same procedure is much less of a factor in examining equipment. An audit procedure must match an account and the type of evidence needed. (5) Maintaining a separate payroll bank account is a common control procedure encountered by auditors. Having a separate payroll account: 

Allows for easier application of control procedures, such as limit tests, item counts, and validity checks;



Operates as a safety measure. By setting aside sufficient cash for payroll, the company guards against spending money required for that purpose;



Allows for additional control over unclaimed checks, uncashed checks, etc.; 87



Facilitates the audit function in that the payroll balances are easier to verify;



Limits the amount of money that would be subject to theft in a payroll system;



Facilitates reconciliation of the bank account. Some organizations even use 12 bank accounts - one for each month - to limit the problems associated with the bank reconciliation process.

(6) Some of the more critical potential problems involving payroll include: A.

Checks are issued to fictitious employees or to former employees who have left Lakeside, with the checks being diverted and fraudulently cashed. Substantive tests that may disclose this problem:  Observe distribution of payroll checks.  Review personnel files for a sample of employees to verify current status is maintained.  Compare names in files to time tickets and verify authorization of time tickets.  Review company's system for removing names of employees who no longer work for the company.  Compare current number of employees to previous years for unusual differences.

B.

Payroll deductions are recorded or computed incorrectly, through error or as part of a defalcation scheme. Substantive tests that may disclose this problem:  Review W-4 forms, voluntary deduction forms, and employee contracts for completeness.  Compare payroll register to W-4 forms recomputing appropriate deductions.

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 Mathematically verify payroll deductions (foot and cross-foot) and compare payroll balance to canceled payroll checks.  Review payroll tax forms for agreement with computed balances and with payroll register. C.

Year-end accrual may be ignored or incorrectly computed. Substantive tests that may disclose this problem:  Review last payroll for the year to verify that recording was made in proper period.  Recalculate accrual and verify against the first payroll of the subsequent period.

SUGGESTED ANSWERS TO EXERCISES (1) This problem extends the students' introduction to working paper construction by placing them in the role of supervisor. A number of errors exist in the example presented in Exhibit 7-1, and the students should be able to identify most of them. 

The working paper is not properly dated so that a reviewing auditor cannot be certain that this testing applies to 2012.



The columns are not labeled. No method exists for identifying the information that has been gathered.



In the first three columns, abbreviations such as "SM," "M-2," and "Salar." are used without explanation, which makes possible the erroneous usage of the information.



In the column that starts with $388, the seventh item and two items in the next column do not have tickmarks, which may indicate that they have not been tested. No indication is given as to the significance of these three omissions.



According to the working paper, none of the items in the column that begins with $39 has undergone any testing. That possibility seems unlikely, since 89

an exception has been found at point A. 

Comment A is vague and does not indicate any reason for the exception nor does it discuss the significance of the problem. In addition, the note makes no mention of potential testing that may be required because of the exception.



Two canceled checks could not be found at point B, but no reason is given nor is any suggestion included for further testing.



One tickmark (a caret) was used for two different tests. The reviewer has no method of distinguishing the actual procedure performed.



Several of the auditing procedures listed at the bottom (on the left) use vague terms such as "company records," "government records," and "calculations" without any specific identification. Thus, determining the procedures actually performed and the specific documents analyzed would be virtually impossible.



The working paper does not contain objectives, scope, or conclusion (see Exhibit 6-1). Therefore, it does not clearly spell out what was done or what was found. No indication is presented as to the method of selecting the employee names that have been used.

(2) a. A completed Exhibit 7 worksheet is shown on the following page. b. See “Conclusion” on the working paper below.

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Exhibit 7 Lakeside Company Account 585, Estimated Bonus Expense, for Nine Months ended September 30, 2011 and 2012 Doc. No. Prepared by Reviewed by 2011 Bonus Plan

Sales

STORE

STORE

STORE

STORE

STORE

STORE

TOTAL

No.1

No.2

No.3

No.4

No.5

No.6

STORES

$547,000

$795,600

$472,200

$484,600

$746,000

$221,600

$3,267,000

-Sales Returns

$15,800

$50,380

$23,900

$28,100

$60,020

$22,600

$200,800

-Cost of Sales

$325,200

$478,600

$276,400

$274,400

$458,000

$136,200

$1,948,800

-Dir. Sal. Exp.

$90,400

$118,400

$78,600

$77,200

$109,600

$64,600

$538,800

-Rent

$19,200

$56,800

$24,000

$26,400

$60,000

$24,000

$210,400

=Bonus Basis

$96,400

$91,420

$69,300

$78,500

$58,380

($25,800)

$368,200

2%

2%

2%

2%

2%

2%

$1,928

$1,828

$1,386

$1,570

$1,168

$0

x Bonus % =Bonus

$7,880

2012 Bonus Plan

Sales -Sales Returns -Cost of Sales -Dir. Sal. Exp. -Rent =Bonus Basis

STORE

STORE

STORE

STORE

STORE

STORE

TOTAL

No.1

No.2

No.3

No.4

No.5

No.6

STORES

$639,800

$797,800

$917,600

$530,800

$729,200

$242,400

$3,857,600

$24,400

$59,800

$99,000

$44,700

$96,500

$22,400

$346,800

$370,600

$456,800

$462,000

$304,800

$436,000

$147,600

$2,177,800

$102,400

$118,600

$80,800

$82,400

$110,200

$64,400

$558,800

$21,000

$66,000

$26,400

$28,000

$64,000

$24,000

$229,400

$121,400

$96,600

$249,400

$70,900

$22,500

($16,000)

$544,800

4%

4%

4%

4%

4%

4%

4%

$4,856

$3,864

$9,976

$2,836

$900

$0

$22,432

x Bonus % =Bonus

Audit Objective: To determine the appropriate balance is the estimated bonus expense account (# 585). Scope: The bonus calculations for all six stores. Audit Procedures: 91

    

Agreed all sales, cost of sales, and salary expense amounts to the September 30, 2011 and 2012 trial balances. Agreed all sales returns and rent amounts to client documentation (cannot be performed by the students). Agreed bonus percentages to bonus agreement approved by the board of directors. Footed and cross-footed each row and column. Recomputed bonus amount.

Comments: Client makes an "imputed rent" charge to Store No. 6 for the purpose of determining this bonus. Sales (A/C 500); Sales Returns (Prepared by Client); Cost of Sales (A/C 550); Direct Salary Expense (A/C 580); Rent (Prepared by Client). Audit Conclusion: The 2011 bonus expense account is overstated (actual balance = $12,000 v. estimated balance = $7,880); however, the amount of overstatement ($4,120) does not seem material. Pass further testing. The 2012 expense appears to be overstated by $16,568 (= $39,000 recorded - $22,432 estimated). This overstatement represents approximately 6% to 7% of net income and, thus, is fairly significant. (It overstates an expense, it understates net income). We suggest that the client make an adjustment as follows: 230-1 Estimated Bonus Liability 585-1 Estimated Bonus Expense

$16,568 $16,568

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS During the audit of the internal control system (Sect 404), the CPAs can conclude that the management report on their evaluation and audit of the system is fairly stated and that the system works as it was designed and the design is effective. That is the best case situation. Problems create other reporting options based on whether the management report identifies the problem, or the CPAs have found a problem that is unreported by the management. It is possible to conclude that the management report is fair and the system is ineffective and the significant deficiencies have been identified both in the management report and the CPA internal control audit. • Management’s report. Management will state its responsibility for maintaining adequate internal control over financial reporting and give its assessment of whether or not internal control over financial reporting is effective. According to 92

the rules, management cannot state that internal control over financial reporting is effective if even one material weakness exists at year-end. • Auditor’s report. The independent auditor will evaluate and report on the fairness of management’s assessment. The auditor also will perform an independent audit of internal control over financial reporting and will issue an opinion on whether internal control is operating effectively as of the assessment date (i.e., the company’s fiscal year-end). If one or more material weaknesses exist at the company’s fiscal year-end, the auditor cannot conclude that internal control over financial reporting is effective. Source: Internal Control over Financial Reporting: An Investor Resource, December 2004 by: Deloitte & Touche LLP; Ernst & Young LLP; KPMG LLP; PricewaterhouseCoopers LLP. Documenting a significant deficiency could appear as in this example: A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. The company has no effective human resource function and personnel files are inadequate to assure approval of salaries and wages. In addition, salaries are not approved by the board of directors. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 200X financial statements, and this report does not affect our report dated [same date as below] on those financial statements. Source: Perspectives on Internal Control Reporting A Resource for Financial Market Participants, December 2004 by: Deloitte & Touche LLP; Ernst & Young LLP; KPMG LLP; PricewaterhouseCoopers LLP. [Note: Payroll example was not in the original quoted material].

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CASE 8 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) A number of reasons could explain a difference between the physical inventory count and a company's perpetual inventory records. When faced with any discrepancy such as this, the auditor should consider all possible causes. 

The perpetual records may be in error. A large volume of transactions are processed during the course of a year, and some amount of human error is to be expected in the recording.



The cost flow assumption (FIFO, in this case) may have been improperly applied in the perpetual records.



The inventory may have been counted incorrectly by the company. Merchandise on hand, for example, could have been overlooked.



Inventory might be out on consignment.



Inventory might have been stolen.



Damaged or obsolete inventory may have been disposed of by the company without recording a reduction in the subsidiary ledger.



Goods in transit could have been incorrectly handled in either the perpetual records or the physical inventory.



The rollback procedure used to arrive at the December 31 year-end figure may have been incorrectly applied.



The specific cost assigned to each inventory item might have been incorrect in certain cases.



The final inventory listing (Exhibit 8-4) may have been extended or footed erroneously.

The question as to whether the $6,000 difference warrants further attention is subject to the auditor's judgment. Since the financial records are adjusted to agree with the physical inventory, the auditor is primarily interested in potential 94

errors contained in the counted figure. If Mitchell has appropriately observed the taking of the physical count, the possibility of errors in the quantity of inventory should be at a minimum. Additional testing, such as verifying the costing, the extensions, and the footings will further reduce the risk of a material error in the figure to be reported. The presence of perpetual records adds another dimension to the inventory verification. By comparing the ending figures from the physical count with the perpetual records, the auditors can determine whether differences are connected with the quantity or the unit cost for the individual inventory items. If the $6,000 is primarily created by quantity differences, the auditors should consider the need for selected recounts. Conversely, if the difference is based on costing variances, the auditors will concentrate on establishing the validity of those particular figures. A question may be raised by the students as to the reasonableness of a $6,000 difference between the physical count and the perpetual inventory records. For a company having $3.5 million in cost of goods sold and a warehouse with over $650,000 in inventory, this difference is not significant in size even with the use of a perpetual system. A more important issue would be the composition of the difference. If a great number of items are not in agreement with the records and simply net to a $6,000 variance, the auditors have reason to be concerned. Conversely, if only a few items display differences, verification is much easier. (2) An overcount of inventory leads to a decrease in cost of goods sold and, thus, an increase in reported net income. In any situation in which the company desires a high reported income (for example, to maintain high stock prices, in anticipation of a loan or a bond issuance, to reach the level anticipated by a financial forecast, etc.), overcounting of inventory must be of concern to the auditors. This possibility is especially relevant to the Lakeside stores because of the profitsharing plan. The inventory is being counted by the manager and assistant manager of each store, the same people who receive a bonus based on that store's net income. Therefore, these employees can increase their bonus for the current year simply by overcounting the inventory. (3) An undercount of ending inventory leads to an increase in cost of goods sold and a decrease in reported net income for the current year. The most obvious reason for a company to undercount ending inventory is to defer payment of income taxes. A manipulation of this kind would be especially tempting to a company experiencing cash flow problems. Other reasons for undercounting inventory 95

may be encountered but are less compelling than the motive to overcount. One possible incentive is to push earnings from a very high performance year into the next to smooth out a growth curve and avoid having to achieve that record again in the following year. In a different vein, if the company must undergo union contract negotiations in the near future, reporting less net income might prove to be advantageous. However, little evidence exists in this case to indicate that Lakeside's management would be tempted to reduce reported earnings except possibly for the accompanying reduction in current taxes. (4) In the engagement letter prepared by Abernethy and Chapman (see Exhibit 3-1), the firm stated that it expected "to obtain reasonable but not absolute assurance that major misstatements do not exist." When a material misstatement goes undetected and is reported in the client's financial statements, the question to be raised concerns the difference between reasonable and absolute assurance. In assessing responsibility in such cases, the public accounting firm is judged against the work of the average prudent auditor. The firm must provide proof that the examination was performed at least as well as would have been done by the average prudent auditor. If a misstatement is missed that would have been detected by the average prudent auditor, the firm is normally considered to be guilty of negligence in the performance of the audit examination. In that case, any losses incurred by the client company resulting from this mistake can be recaptured from the firm. However, because Lakeside is privately owned, the CPA firm will probably be liable to third parties for losses only if gross negligence can be proven. Unfortunately, the distinction between negligence and gross negligence is not clearly delineated by the courts. (5) A decision to observe less than 100% of the ending inventory always exposes the auditor to some degree of risk. This risk is based on the possibility that a material misstatement exists in the inventory not being observed. Three factors would reduce that risk level in the audit of the Lakeside Company. First, according to the September 30, 2012, trial balance, the inventory at the warehouse makes up nearly 80% of the total inventory owned by Lakeside. Thus, the possibility of a material problem in the inventory held at the stores is limited. Second, the perpetual records enable the auditors to isolate variances at all stores which can then be subjected to recounts or further testing if necessary. Third, Lakeside appears to have an efficient system of taking the physical inventory. Unless Mitchell and her staff spot weaknesses in the actual procedures in use, the efficiency of this system offers assurance that the count in each store has been accurate.

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(6) One method of manipulating net income is to record sales in one year with recognition of any subsequent returns being delayed until the following period. Normally, this problem is overcome by a year-end adjustment to establish an estimation of all subsequent returns. As evidence of the validity of this estimation, the auditor will review any sales returns received at the beginning of the new year. The auditor should be aware that companies can alter reported earnings significantly by shipping out large quantities of inventory at the end of a year knowing that most of the items will be returned. If the shipments are recorded immediately as sales, while the returns are estimated based on historical data, the company can overstate current income. (7) As indicated in Question (2), above, overcounting of inventory is a potential concern in any audit but especially so in the Lakeside engagement. Mitchell records the last tag number as a preventive measure against the preparation of falsified tags subsequent to her observation. (8) This question can generate debate among students who often expect the auditors to perform extensive auditing procedures in regard to damaged and obsolete merchandise. In reality, Mitchell's role is that of an observer; damaged or obsolete inventory is the client's responsibility. The Lakeside memorandum clearly indicates that company employees should separate these items prior to the inventory count. Mitchell will want to verify that all damaged or obsolete inventory items have been segregated and correctly valued. If she is convinced that such inventory has been isolated, she needs only to ascertain that the value has been appropriately established by the company. If Mitchell is not satisfied by the method used to value these items, especially if the total is material, she has the option of calling upon an independent appraiser to assist her in substantiating the valuation process. A different problem arises if Mitchell discovers any damaged or obsolete inventory that has not been separated from the rest of the merchandise. Unless the client can provide a reasonable explanation, this discovery casts doubts on the reliability of the counting process. Mitchell may then need to extend her testing procedures to search for further evidence of such inventory.

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(9) Lakeside's procedures for taking its physical inventory seem well designed especially since perpetual records are available for comparison purposes. By following the process outlined in Exhibit 8-1, the company should be able to arrive at an accurate ending inventory figure. SUGGESTED ANSWERS TO EXERCISES (1) An audit program designed to verify the inventory listing and the reconciling items would include steps such as the following: a.

Trace the tags recorded by the auditor (Exhibit 8-3) to the physical inventory listing (Exhibit 8-4), noting agreement as to description and quantity.

b.

Verify that no tags were added to the inventory listing beyond the last tag recorded by the auditor.

c.

For each of the inventory items recorded by the auditor, compare the unit cost indicated on the inventory listing with the cost per the master price list (Exhibit 6-6). Note agreement as to description as well as unit cost. (Note: Students may choose to select a new sample for this and the remaining tests. The advantages to using the same sample throughout are that recording on the working paper may be simplified and efficiency gained.)

d.

For each of the inventory items recorded by the auditor, mathematically verify the extensions on the physical inventory list.

e.

Refoot the inventory listing.

f.

Using the master price list, compute a cost for the January 1-2, 2013, receiving reports. Compare this total to the inventory listing for agreement.

g.

Using the master price list, compute a cost for the January 1-2, 2013, bills of lading. Compare this total to the inventory listing for agreement.

h.

Review the inventory listing to ascertain that all tag numbers are included with no duplications.

i.

By review of Cypress discount announcements, establish validity of monthly discounts included in inventory listing. (With the information included in this 98

case, this step will not be possible for the students to perform.) j.

Recompute the 3% discount taken by Lakeside and compare this amount with the inventory listing noting agreement.

k

Agree the "total adjusted cost of inventory - 12/31/09" to the general ledger at December 31, 2012.

(2) One technique for approaching this case is to assign Question (1) for one class period, with the working paper to be prepared only after review of the students' audit programs. This procedure helps to stress the connection between preparing an audit program, evidence gathering, and developing a working paper. It demonstrates a continuum from: 

establishing the audit procedures to be performed, to



indicating the steps actually taken by the auditor, to



documenting the evidence collected.

In reviewing the audit documents prepared by the students, the instructor should insist that each specific audit procedure be spelled out along with the results of that testing. As always, the working paper should be clear and complete, but it must also indicate the fulfillment of each audit program step. The attached working paper has been created as an example. It was produced to correspond with the audit procedures outlined in Exercise (1). In completing this assignment, procedure (i) has not been performed because the information was not made available in the case. In addition, the working paper has been prepared under the assumption that all goods are sold FOB. shipping point and all purchases are acquired f.o.b. destination. These assumptions have been made to simplify the audit testing, but the students may want to discuss the additional procedures that would be required if other f.o.b. points had been appropriate.

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Lakeside Company Tests of Inventory Listing—Warehouse 12/31/12 Inventory Item Amplifiers Component Systems Beepers Stereo Systems Amplifiers Speakers Stereo Systems CD Players Receivers Stereo Systems VCRs Speakers Head Phones CD Players

WP # F-3 p. 1 Prepared by: PR 1/12/13 Reviewed by:

Tag No.

Serial Number

Quantity

116 124 102 138 130 150 127 142 113 126 104 137 147 132

BC76-W JB45-M CB21-S FU87-R KZ54-T YG28-Y RA69-M RW21-X NB73-X JH88-A CZ55-H BF23-G PO88-Q CD00-N

22 69 80 60 88 71 99 49 112 77 46 84 49 121

Audit Procedures                                          

Audit Objectives:  To verify that the physical count she observed agrees with the inventory listing.  To verify that the inventory listing provides a fairly presented inventory cost balance. Scope: Items that were selected during the inventory observation. See WP F-1 and F-2. Audit Procedures:  Traced items to inventory listing noting agreement as to description and quantity. No exceptions noted.  Traced items from inventory listing to master price list noting agreement as to description and unit cost. No exceptions noted.  Recomputed extensions on inventory listing. No exceptions noted. Other Procedures:  Agreed last tag (#152) on inventory listing to WP F-1.  Footed inventory listing. No exceptions noted.  Accounted for sequence of tag numbers on inventory listing. No exceptions or duplicates noted. Audit Conclusion: The inventory listing is fairly stated.

100

Lakeside Company Tests of Inventory Counts--Warehouse 12/31/12

WP # F-3 p. 2 Prepared by: PR 1/12/13 Reviewed by:

Receiving Reports (January 1-2, 2013) Date and Item

Rec. Rep.

Qty.

Unit Cost

Total Cost

Audit Proc.

Jan. 1, 13 Televisions

JB45-H

3988

22

481.87

10,601.14



Jan. 2, 13 Headphones

KJ32-K

3989

32

9.95

318.40



Jan. 2, 13 Portable Media Players

RX04-L

3989

10

285.99

2,859.90

 @

Total

13,779.44

Bills of Lading (January 1-2, 2013) Amplifier

XY76-R

Bill # 6015

Qty. 20

Unit Cost 219.95

Total Cost 4,399.00

Audit Proc.

Jan. 1, 13 Jan. 1, 13

Televisions

BM09-H

6015

10

812.35

8,123.50



Jan. 2, 13

Stereo Systems

AB15-M

6016

20

256.98

5,139.60



Jan. 2, 13

Stereo Systems

JH88-A

6016

12

324.00

3,888.00



Jan. 2, 13

Receivers

CS33-P

6016

10

698.98

6,989.80



Jan. 2, 13

Televisions

AR65-C

6016

6

1,318.87

7,913.22



Jan. 2, 13

Speakers

BF23-G

6017

8

469.00

3,752.00

 @

Total

42,205.12



Audit Objective: To verify that the reconciling items to the inventory listing are valid and reasonable. Scope: All reconciling items to the inventory listing. Audit Procedures:  Agreed quantity and description to WP F-1. No exceptions noted.  Agreed to master price list noting agreement as to description and unit cost. No exceptions noted. @ Agreed to inventory reconciliation Other Procedures:  Recomputed discounts on inventory reconciliation without exception.  Footed inventory reconciliation without exception.  Inventory adjustment of $6,156.78 is immaterial. Pass further work. Audit Conclusion: Inventory reconciling items are valid and reasonable.

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WP # F-1, p. 3 Prepared by: PR 1/12/13 Reviewed by: Lakeside Company RECONCILIATION OF PHYSICAL INVENTORY - WAREHOUSE December 31, 2012 Item TOTAL COST OF INVENTORY - 1/3/2013 WAREHOUSE Less: Inventory Received on January 1 January 2 (from Receiving Reports) Add: Inventory Shipped Out on January 1 and January 2 (from Bills of Lading) TOTAL COST OF INVENTORY - 12/31/2012 WAREHOUSE Less: Adjustments for Monthly Discounts Given by Cypress Tag 113 - Discount $30.00 x 85 Items Purchased Tag 121 - Discount $ 8.25 x 40 Items Purchased Tag 132 - Discount $12.60 x 60 Items Purchased Tag 146 - Discount $11.50 x 80 Items Purchased Tag 149 - Discount $ 6.50 x 35 Items Purchased SUB-TOTAL Less: Adjustment for 3% Cash Discount TOTAL ADJUSTED COST OF INVENTORY 12/31/20012 – WAREHOUSE INVENTORY IN WAREHOUSE PER PERPETUAL INVENTORY RECORDS INVENTORY ADJUSTMENT (REDUCTION)

Amount $1,434,101.69

Procedures @

(13,779.44)

x-ref. F-3 p. 1

40,205.12

x-ref. F-3 p. 1

1,460,527.37

F

(2,550.00) (330.00) (756.00) (920) (227.50) 1,455,743.87 43,672.32 1,412,071.55

R R R R R

1,425,896.25

A

13,824.66

*

R F

Audit Objective: To verify that the inventory balance is valid and reasonable. Scope: The listing to the inventory balance reconciliation. Procedures: @ Agreed to Inventory Listing F Footed R Recalculated A Agrees to T/B * Immaterial—Pass further testing. (Note: students may agree to adjust this amount). Audit Conclusion: The inventory balance is fairly stated as of December 31, 2012.

102

CASE 9 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) Any company which does not maintain an extensive accounting staff will often rely on the independent auditors for information concerning the application of authoritative pronouncements. Most CPA firms assume some responsibility for keeping client companies aware of important accounting standards and the potential effects on financial reporting. Thus, Rogers' lack of knowledge about Statement 34 is not unusual; a bigger surprise might be that the company's auditors had not previously discussed the requirement with this client. (2) Where possible, expense accounting follows the matching principle which states that expenses should be recognized in the period in which they assist in generating revenues. An asset produces no revenues prior to being placed into service. Therefore, any expense recognition (such as depreciation or interest) would be inappropriate during construction. Only after the asset is in use generating revenues should any related expense be recorded. (3) Theoretically, the management of the client company prepares all financial figures which are then corroborated by the independent auditors. However, Lakeside apparently has no one on its staff with the expertise to make this particular calculation. In such cases, the auditor is frequently forced to generate the data, and provide figures which are presented to the client as proposed adjustments. Lakeside should be warned though that this task is outside the realm of a normal audit and, if extensive, may require an additional fee. (4) This question offers another opportunity for interesting class discussion. Students often view accounting as a discipline in which all questions can be ultimately resolved by an adequate knowledge of accounting standards. In this instance, they face a case of financial statement manipulation that is being carried out by the client within the framework of accounting's own official guidelines. A review of FASB Statement 13 can be assigned to assist the 103

students in analyzing this case. Paragraph 29 of this pronouncement states: "Insofar as the separate financial statements of the related parties are concerned, the classification and accounting shall be the same as for similar leases between unrelated parties except in cases where it is clear that the terms of the transaction have been significantly affected by the fact that the lessee and lessor are related. In such cases the classification and/or accounting shall be modified as necessary to recognize economic substance rather than legal form. The nature and extent of leasing transactions with related parties shall be disclosed." After reading FASB Statement 13, students may argue that the lease is actually for a number of years (probably the life of the building) and that the proposed series of one-year contracts is only a sham to create the appearance of an operating lease. In reality, the lease (or so this argument would go) is for over 75% of the economic life of the property. However, if new lease payments are to be negotiated each period (or if Lakeside intends to stay for only a short time in that location), a legitimate economic reason may exist for this arrangement. Unless Lakeside can show such a rationale for the one-year leases, the auditor will probably use the "actual" life of the lease as justification for requiring capitalization. The auditors also need to verify that the $21,000 payment for the building has not been "significantly affected" by the relationship between Lakeside and Rogers. Abernethy and Chapman will want to learn how this figure was determined and, perhaps, seek information about rental rates for similar property in the vicinity of that store. Rogers states that "the price is quite reasonable for that store at that location," but his opinion does not provide the auditors with much assurance. Regardless of the accounting, as a related party transaction, the auditors must ensure that the nature and extent of the lease has been fully disclosed within the financial statements. Rogers has indicated that such reporting will be made. Even if the lease were deemed to be an operating lease, the information included within these notes could be used by readers to come to an understanding of the nature of this transaction. This case indicates the importance of a complete knowledge of accounting. A decision-maker need not be limited to working with just the numbers presented in financial statements but should become capable of using and understanding all of the information that is provided. [Note: Another interesting issue is whether or not the Rogers Development Company is a variable interest entity (VIE) that should be consolidated, as defined in FASB Interpretation No. 46. See the "Apply Your Research" section for this case].

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(5) The recording of accounting information is normally based on objective evidence gathered by analyzing the impact of transactions that occur between the reporting entity and outside parties. However, related party transactions do not provide evidence with the same degree of objectivity. Sales prices or contracts, for example, might not be negotiated as they would otherwise be with outsiders. Figures may simply be fixed by management. Consequently, to inform the financial statement readers of the impact of these dealings, the relationship must be described along with the details of the transactions. (6) The potential impairment of value of Store Six has been an underlying problem throughout the Lakeside audit. In discussing this issue, students frequently concentrate on the wrong issues: client retention versus safety from litigation. Audit opinions, however, should be based on the actual evidence accumulated and the related reporting employed by the client, not on the avoidance of problems. Such a limited approach fails to recognize the auditor's function: to gather corroborative evidence on which to base an opinion as to the fair presentation of the financial statements. Virtually no corroborative evidence is presented in these cases in connection with Store Six and its potential impairment of value; therefore, students have no basis for any specific course of action. In practice, auditors first gather as much evidence as possible and only then do they make a final determination when faced with this type problem. Students can be asked to list the kinds of evidence Abernethy and Chapman might seek in evaluating the possibility of a material impairment of value in connection with Store Six. This exercise is a good technique for demonstrating the necessity of creativity in the auditor's work. The auditor needs to consider all possible ways to gain assurance about the future of this store. A few of the evidence-gathering procedures that might be carried out would include: 

Discussion with the owners and managers of the shopping center as to their strategies for renting more space and improving customer traffic.



Further inquiry of Rogers as to a justification for his favorable forecast regarding this store. If these projections are based on tangible data or on specific plans, the auditors will have much more assurance than if Rogers is simply acting on intuition.



Talk to owners and managers of the stores located in the shopping center to see whether their projections are similar to those of Rogers.



Search for any studies that have been prepared on the consumer 105

electronics business which might (a) project a break-even point for a store or (b) assess the risks involved in the failure of a single outlet. 

Hire a real estate appraiser to estimate the sales value of the building if it should have to be sold. This valuation will enable the auditor to anticipate the potential loss being faced by Lakeside.

One final point should be made in connection with this potential impairment of value. The implication is made throughout these cases that the primary responsibility for resolving this issue lies with the auditors. That is not correct. The financial statements are representations of the management of the client company. As such, management is responsible for justifying the financial reporting. Unless Rogers makes a significant attempt to prove his present position in this controversy, the auditors will have trouble rendering an unqualified opinion. (7) Little doubt exists that Rogers has issued a subtle threat to the new audit firm. One of the primary reasons for investigating the integrity of management prior to accepting an engagement is to avoid the possibility of this type of blackmail. This warning was issued in such a way by Rogers that Abernethy and Chapman will probably not need to consider the possibility of resigning but, if a similar threat is ever made in an overt manner, immediate resignation by the CPA firm should be considered. SUGGESTED ANSWERS TO EXERCISE (1) This assignment requires the students to analyze the client's Warehouse account. In this case, for the first time, no audit program is available. The students must determine which procedures to perform and then record the actions taken as well as the evidence accumulated. The instructor may want to discuss this requirement by simply asking the class what evidence-gathering techniques should have been carried out by the auditor. An example of a completed working paper for this assignment is attached.

106

LAKESIDE COMPANY Building-Warehouse/Office A/C 111-1 12/31/12

Doc. No. Prepared

I-3 by:

AH Date: 1/14/13 Description Balance per books - Beg. of Year Additions: Grade land and pour foundation October - Warehouse Construction November - Warehouse Construction Roofing repair and warehouse construction Disposals: None Balance per books - End of Year Proposed Adjustments: Reclassify to expense Excluded invoice Partially excluded invoice Capitalize interest Subtotal of additions less disposals Proposed reclassification—E Adjusted Total  

Amount $327,000 $21,800 $16,900 $25,300 $14,600

Audit Procedures 1 Invoice No. 3145 3189 3214 3228 Cash Rec. No. None

2 2 2 2

405,600 ($3,500) $17,100 $1,600 $2,345 $96,145 ($96,145) $327,000

Adj. Entry A B C D E

Audit Objective: To verify the fair presentation of the "Building-Warehouse/Office" account. Scope: All charges and potential charges to the account.

Audit Procedures:  Traced to 12/31/11 audited balance per predecessor auditor's audit documents noting agreement. (Note: Although necessary, this procedure cannot be performed with the information given in this text.) 2. Traced to general ledger noting agreement. Also, traced to purchase invoice noting agreement as to amount, and approval. Other Audit Procedures:  Examined 9/1/09 minutes of Board of Directors' meeting noting approval for expansion.  Examined bank confirmation from Virginia Capital Security Bank indicating lien on warehouse in connection with $100,000 loan. Proposed Adjustments: A 640-1 111-1 B 111-1

$3,500 roof repair incorrectly classified in asset account. AJE 1 Repairs and Maintenance 3500Building-Warehouse/Office

3500-

Invoice #3316 for December work by Heilman Construction received after year-end. AJE 2 Building-Warehouse/Office 17100-

107

210-2

Accounts Payable

17100-

C Invoice #3408 for work done 12/28/09-1/8/10 by Gaines Electrical Company received after yearend. Accrue four days (4/12 x $4,800= $1,600). AJE 3 111-1 Building-Warehouse/Office 1600210-2 Accounts Payable 1600D Capitalize interest on building loans. This figure is roughly estimated based on the expenditures on construction (from "subtotal" on previous page) of $93,800, the interest rate charged on the direct loan, 10%, and the time of construction during 2012 (3 months from October to December, per the invoices in Exhibit 9-6). Thus, $93,800 x 0.10 x 3/12 = $2,345. 111-1 220-1

AJE 4 Building-Warehouse/Office Accrued Interest Payable

E

Warehouse expansion not in service at 12/31/09. Reclassify to new account.

New acct. 111-1

AJE 5 Construction in Progress-Warehouse

23452345-

96145-

Building-Warehouse/Office

96145-

Audit Conclusion: Account is fairly stated, after adjustments, in accordance with GAAP.

108

(2) Lakeside Company Impairment Test – Store 6 December 31, 2012 Prepared by: AH Date: 1/13/13 Instructions: Using the two-step approach, perform an impairment test given the information available. Step One: Recoverability Test Source of Information

Store profitability report/bonus calculation

Future Cash Flows

$160,000 (audit procedure 1)

Book Value

$186,000 (audit procedure 2).

Difference

$(26,000)

Is impairment indicated?

Yes, since the difference is negative.

Step Two: Measurement of Impairment Source of Information

Prior years work papers, appraisal

Market Value of Asset

$150,000 (audit procedure 3)

Book Value of Asset

$186,000 (above)

Impairment Amount

$36,000

Audit Objective: To determine whether or not the value of Store 6 is impaired. Scope: An estimate of future cash flows derived from Store 6 and the market value of Store 6. Audit Procedures: Used a two step approach as required by the FASB. 1. Future cash flows were computed from the bonus calculation for Store 6 (see Case 7) as follows. Note the store rent expense is not a cash outflow, and is excluded from the calculation. 109

Sales -Sales Returns -Cost of Sales -Dir. Sal. Exp. Net cash flows per year x Estimated life Total net cash flows for store 6

$242,400 $22,400 $147,600 $64,400 $8,000 20 years $160,000

2. Cost $256,800 Cost – Accumulated Depreciation $70,800. Agreed to the trial balance as of 9/30/12 (since 12/31/12 balances were not given). 3. The market value of the asset was estimated using the appraisal received in 2011. The market has not changed dramatically in the past year; thus, this is a reasonable estimate of the current market value. Comments: There appears to be an impairment of approximately $36,000 based on the results of the testing above. Recommended Adjustment: New Acct. Loss on Impairment ………………………… $36,000 111-6 Building – Store 6……………………..

$36,000

Audit Conclusion: After the recommend adjustment, the carrying value of Store 6 is fairly stated. Note for discussion: The students may decide that the amount is immaterial. Is $36,000 material given that total assets are $3,638,000 (1%) in 2011, or total income was $244,000 (15%)? The amount of recommended impairment depends on the answers to that question. Students answers will likely vary greatly on this exercise.

110

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(1) Quoting from the Act: Section 301: Public Company Audit Committees. Each member of the audit committee shall be a member of the board of directors of the issuer, and shall otherwise be independent. "Independent" is defined as not receiving, other than for service on the board, any consulting, advisory, or other compensatory fee from the issuer, and as not being an affiliated person of the issuer, or any subsidiary thereof. The SEC may make exemptions for certain individuals on a case-by-case basis. The audit committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer. The audit committee shall establish procedures for the "receipt, retention, and treatment of complaints" received by the issuer regarding accounting, internal controls, and auditing. Each audit committee shall have the authority to engage independent counsel or other advisors, as it determines necessary to carry out its duties. Each issuer shall provide appropriate funding to the audit committee. (2) Quoting from the act: Section 302: Corporate Responsibility For Financial Reports. The CEO and CFO of each issuer shall prepare a statement to accompany the audit report to certify the "appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer." A violation of this section must be knowing and intentional to give rise to liability.

111

CASE 10 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) The sheer quantity of transactions that are processed by most modern corporations prohibits the auditor from attempting to evaluate more than a portion of the total. Many large companies record millions of transactions per year, a number that could not possibly be verified by an audit team at an acceptable cost. Even if complete testing were possible, nonsampling risk would still exist because of potentially unrecorded transactions, fraudulent transactions, and auditor errors and oversights. Just as importantly, independent auditors are employed to provide reasonable rather than absolute assurance as to the fair presentation of a company's financial statements. The desired degree of assurance can be achieved without examining every item. Thus, some amount of risk is tolerated in the testing procedures being applied. Statistical sampling allows certain aspects of that risk to be measured mathematically. Auditors use statistics to determine the number of items that should be examined to reduce sampling risk to a level that is considered justified. (2) Statistical sampling does not create additional work; rather, it guides the auditor in performing the proper amount of work. In addition, although statistical sampling may initially appear to be complex, the various procedures become significantly easier with practice. In any sampling plan (statistical or judgmental), a degree of uncertainty about the final results must be accepted. Statistical sampling allows the auditor to set in advance the amount of risk that is acceptable for a particular test. Mathematical formulas and charts then enable the auditor to compute the size of the sample that is necessary to reduce the risk involved to this tolerable level. Computer programs make these calculations quick and easy. An auditor who appropriately calculates a sample size of 89, for example, knows that the examination of this number of items will provide results within predetermined parameters. Statistical sampling also forces the auditor to consciously consider several important aspects of the specific testing procedure. In this case, Mitchell has to analyze the type of work being performed by the client and then set an acceptable risk of assessing control risk too low (ARACR). She must also evaluate the ability of the client personnel and estimate an expected population exception rate. Finally, she has to arrive at a tolerable exception rate, the highest 112

rate at which reliance can be justified. All of these considerations are important in applying this audit procedure. The statistical sampling plan being used by Abernethy and Chapman requires the auditor to consider each of these limits before testing can begin. (3) Sampling for attributes is utilized whenever an auditor wants to estimate the occurrence rate of a specified characteristic. This procedure is frequently applied in tests of controls where the auditor is seeking to measure the prevalence of errors made by employees in following the control procedures built into a particular accounting system. Thus, the auditor is attempting to determine a rate —the percentage of errors committed. Although sampling for attributes has other uses within an examination, it does enable the auditor to derive this specific information being sought in a test of controls. (4) Mitchell is seeking to verify that a proper cutoff has been performed by the client in recording its year-end accounts payable and accrued expenses. In this process, a number of invoices are to be reviewed to ensure that Luck has appropriately determined the amount owed by Lakeside on December 31, 2009. At the same time, the auditor can also ascertain that a purchase requisition has been prepared for each of these invoices. Mitchell may also elect to examine the invoices to determine if physical evidence exists to indicate that each document has been mathematically proven and properly authorized by company personnel. Thus, several testing procedures can be carried out simultaneously by the audit team. (5) Once again, as in Question (1), the auditor is seeking only reasonable, not absolute, assurance about the fair presentation of the client's financial statements. Thus, the presence of some errors, especially if they are not material, does not necessarily nullify the value of the information. In addition, the auditor rarely relies exclusively on the work of one particular individual in making an assessment. Luck's analysis will provide evidence about this expense accrual, but other testing should be carried out before the audit team is satisfied that the account balances are fairly presented. Luck might commit mistakes for a number of reasons, most of which involve human errors caused by carelessness, fatigue, misunderstanding, etc. She may, for example, misread an invoice or miscalculate the amounts involved. She 113

could also omit an invoice entirely or include one a second time by accident. The possibility also exists that Luck might have purposely misrepresented the yearend accrual as a way of manipulating the income figures to be reported by the company. (6) In most examinations, previous experience with the client and its personnel will assist the auditor in arriving at an estimation of an actual exception rate. However, the firm of Abernethy and Chapman has not audited Lakeside in the past; thus, Mitchell must rely more heavily on other techniques. To begin, she should ascertain the difficulty of the task being performed. She will also have had the opportunity to observe Luck's work throughout the engagement and should hold some opinion as to the reliability of this employee. She may do a pilot test, choosing a relatively small random sample to see what the sample exception rate is. Finally, from experience with other clients, the auditor can usually anticipate an exception rate for a particular task. (7) The 6% figure established by Mitchell in this case is a good example of the importance of an auditor's ability to use judgment developed through experience. The selection of this rate was undoubtedly influenced by a number of factors such as the size of Lakeside's accrual, the adequacy of other testing procedures, Mitchell's evaluation of Luck's ability, the risk involved in accepting an incorrect accrual, experience with other audit clients, etc. However, after assessing these and other possible variables, the ultimate decision as to the line between reliance and non-reliance must always lie with the auditor. (8) According to Exhibit 10-2, a sample size of 40 (left column) with 2 errors (top row) indicates a maximum error rate of 12.8% with a 10% ARACR. Since Mitchell has specified a tolerable exception rate of only 6%, she cannot accept the client's work as a fair representation of the amount of the year-end accrual. The client's total accrual figure may, indeed, still be accurate, but the sample indicates the possibility of too many errors for the accrual to be judged as reliable. The error rate indicates that the risk level is too high for auditor acceptance without additional testing.

114

(9) In most cases, the auditor would now seek to apply other procedures to verify the reported balance. The client might, for example, be requested to reconstruct the accrual with the newly derived balance then being tested, again using sampling for attributes. However, because of the small population size in this case, Mitchell may simply resort to reviewing all 283 invoices to achieve adequate assurance about the accrual. After analyzing the entire population, the auditor can either accept the client's accrual or propose an adjustment. SUGGESTED ANSWERS TO EXERCISES (1-a) ABERNETHY AND CHAPMAN Sampling for Attributes Client: The Lakeside Company Year Ending: December 31, 2012 Audit Area: Accrued Expenses Date of Testing: February 4, 2013 (1) State the objectives of the audit testing: To verify the year-end accrual of expenses developed by the client. (2) Define the attribute or attributes to be estimated: The exception rate made by the client in determining the year-end liability owed in connection with invoices received during December 2012, and January 2013. (3) Define the population: All invoices received by the company during December 2012, and January 2013. (4) Define the sampling unit:

115

Each individual invoice and the accrual established for it as of December 31, 2012. (5) Specify the acceptable risk of assessing control risk too low and discuss any factors affecting this decision: 10% (No information is presented in this case to indicate how this risk level was derived. This is typically either 5% or 10%). (6) Estimate the exception rate of the population, and discuss any factors affecting this estimation: 3% (Discussion Question 6 above examines the factors that should have influenced this estimation.) (7) Specify the tolerable exception rate and discuss any factors affecting this decision: 6% (Discussion Question 7 above examines the factors that should have influenced this parameter.) (8) Indicate the sample size and show the use of the finite correction factor if applicable: 90 Exhibit 10-1 is appropriate for a 10% ARACR. The expected population deviation rate of 3% is found in the left column with the tolerable deviation rate of 6% found across the top. These two figures intersect at a sample size of 132. The finite correction factor presented in the case can be applied as follows: Appropriate Sample Size =

132  90 132 1 283

(9) Indicate the method used to draw a random sample: Random number generator on the CPA firm's computer. (10) Indicate the number of deviations discovered, the rate of deviations in the sample, and the upper deviation rate in the population: 116

Two errors were discovered; the sample exception rate is 2.2% rounded (2/90); and from Exhibit 10-2, two deviations found in a sample of 90 items indicates a maximum rate of 5.8% (CUER) with a 10% ARACR. (11) From a quantitative perspective, is the population reliable? (Include the rationale for your answer): With a 10% ARACR, the sample indicates that Luck's accrual of year-end expenses has a CUER of 5.8%. (12) Describe the types of deviations that were found: The two errors are of relatively small amounts and appear to be caused by mathematical mistakes. (13) Recommendations: Luck's analysis should be considered a fair representation of the yearend accrual derived from these 283 invoices. However, the possibility still exists that other invoices have been omitted either accidentally or to manipulate net income. Thus, a search should be made for liabilities which are unrecorded. (1-b) If three errors were found, then the results for questions (10) through (13) of Exhibit 10-3 would be different. With three errors, the sample exception is 3.3% rounded (3/90); and from Exhibit 10-2, three deviations found in a sample of 90 items indicates a CUER of 7.3% with a 10% ARACR. Since the tolerable rate was 6%, her work should not be considered reliable based on the number of errors it contains.

117

CASE 11 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) Statistical sampling requires the auditor to establish risk parameters prior to the start of a testing procedure. Thus, a desired level of assurance (and, conversely, an acceptable level of risk) is always defined whenever statistical concepts and mathematical formulas are to be utilized. The auditor is aware in advance of the possibility of a mistaken conclusion. Such information is especially important if the audit firm ever has to justify its examination and the opinion rendered. However, application of statistical sampling does demand a specialized degree of knowledge. The auditor must have an adequate understanding of statistical methodology. In addition, developing a statistical sampling plan may require a significant amount of audit time. Judgmental sampling is many times easier and quicker to apply and is, thus, especially appealing in audit areas where exact precision is not required. For the auditor with sufficient experience, this type of sampling can frequently provide satisfactory conclusions about much of the client's data. Unfortunately, since no guidelines exist for key decisions such as acceptable risk levels, required sample size, or the evaluation of final results, the auditor has no way of measuring the potential for an incorrect assessment. In any test, not enough items may have been examined to support a conclusion, or too much testing could occur creating an inefficient audit. Furthermore, if the auditor must ever demonstrate in a peer review or court case the basis for a particular decision, objective evidence to substantiate the judgment is usually not available. There is no correlation between sample size and choice of statistical versus judgmental sampling methods. (2) As the partner-in-charge of the Lakeside examination, Cline must ensure that sufficient, competent evidence has been obtained to satisfy himself that the client's figures are fairly presented. Based on his years of audit experience, if Cline is uncomfortable with the evidence accumulated to date, he is obligated to seek additional assurance. No other individual has the responsibility; no one else can specify the appropriate amount of evidence required in a particular situation. Because the decision is a judgment, some auditors might agree with Mitchell that the testing presented in Exhibit 11-2 is sufficient. However, Cline is 118

in charge of this audit, and he should never accept a client figure until personally satisfied of its fair presentation. (3) Although based on mathematical concepts, statistical sampling relies heavily on the auditor's professional judgment. Such judgments can be seen throughout the sampling plans discussed by the Abernethy and Chapman audit team in Case 11:      

 

The auditors had to decide whether to test the 283 invoices by sampling or by examining the entire population. The auditors had to choose between applying sampling for attributes to evaluate the client's expense accrual or some type of sampling for variables plan. The auditors had to establish an acceptable risk of incorrect acceptance. The auditors had to establish an acceptable risk of incorrect rejection. The auditors had to set a tolerable misstatement, the amount of error the firm was willing to accept in the reported balance. The auditors had to decide which type of sampling for variables plan would be used; both mean-per-unit and difference estimation were discussed in this case. Monetary unit sampling and stratified mean-per-unit sampling are just two of the other techniques used by auditors. The auditors had to select a point estimation of the population error. The auditors had to choose a method for randomly selecting the items to be sampled.

Consequently, even in statistical sampling, a great number of decisions must be made by the auditor. The legitimacy of the results that are eventually achieved is related directly to the auditor's ability to make appropriate decisions in each of these areas. In designing a sample, it is not unusual to obtain assistance from a specialist, normally from within the firm. (4) In the competitive times that now preside over the public accounting profession, the auditor cannot afford to rely on unnecessarily slow and time-consuming techniques. More importantly, though, the auditor can never afford to do an examination in less than a quality manner. Using judgmental sampling simply because it may be faster is a shortsighted approach. Each audit must be performed appropriately regardless of the amount of time involved. Because of the time pressures present in modern auditing, each auditor needs to possess a ready knowledge of statistical sampling techniques so that the efficiency of their use can be increased substantially. Certainly, any procedure is 119

time-consuming if the auditor's understanding is limited. Through education and the utilization of devices such as preprinted forms and computers, statistical sampling plans can be carried out in a minimum of time. However, the auditor should continue to be alert to situations where judgmental sampling can be applied. Not every test warrants the use of statistical sampling, and the auditor needs to be capable of drawing this distinction. (5) If the auditor is seeking to measure a rate of occurrence, sampling for attributes is utilized. Consequently, this type of statistical sampling is often associated with tests of controls where an error rate is being estimated. If, however, the auditor is attempting to determine an amount, sampling for variables is appropriate. This sampling technique is frequently used in substantive testing to evaluate the reasonableness of a reported balance. As is shown by Cases 10 and 11, the distinction between sampling for attributes and sampling for variables is not always as clear-cut as the previous paragraph implies. In Case 10, sampling for attributes was used to verify Luck's expense accrual, whereas sampling for variables was utilized in Case 11 for this same purpose. The auditor must always determine the objective of a specific test and evaluate which type of testing will achieve that goal in the most efficient manner. (6) Given the risk parameters that have been established by the auditor, the actual total of the differences in the client's population is estimated to lie between an understatement of $8,960 ($3,760 + $5,200) and an overstatement of $1,440 ($3,760 -$5,200). Since the auditor wants assurance that the client figure is within $8,000 of the real total, the firm cannot accept the $46,311 as fairly presented. The $8,960 estimation derived from the sample lies outside of the acceptable boundary. The client total may still be appropriate, but this sample indicates that too much risk exists to accept the balance without further testing.

120

SUGGESTED ANSWERS TO EXERCISES (1)-(A) ABERNETHY AND CHAPMAN DETERMINATION OF SAMPLE SIZE SAMPLING FOR VARIABLES Client: The Lakeside Company Form Completed By: Carole Mitchell Audit Area: Accrued Expenses Date of Testing: 2/4/13 Year Ending: 12/31/12 (1) - Estimate the standard deviation of the population. Show the formula being used and identify each element within this formula.

Estimated Standard Deviation =

  e

2

 n e 

2

n 1

e is the value of each unit sampled ē is the average of each unit sampled n is the number of units sampled The initial 30 items selected in Exhibit 11-2 show 26 differences with a zero balance and four with either positive or negative balances.

(e)2 42,025 2,401 12,100 24,336 80,862

e 205 49 (110) 156 300

121

ē = 300/30 or 10

Estimated Standard Deviation =

80,862  3010 30  1

2

 52 rounded 

(2) - Specify the acceptable level of risk for incorrect acceptance. Identify the confidence coefficient (Z value) for this percentage. Include any considerations that were used in arriving at this parameter: The risk of incorrect acceptance was set at 10%, but no information was provided in this case to indicate the rationale for this decision. The Z Value for a 10% risk of incorrect acceptance is 1.28 according to Exhibit 11-1. (3) - Specify the acceptable level of risk for incorrect rejection. Identify the confidence coefficient (Z value) for this percentage. Include any considerations that were used in arriving at this parameter: The risk of incorrect rejection was set at 30%, but no information was provided in this case giving the rationale for this decision. The Z value for a 30% risk of incorrect rejection is 1.04 according to Exhibit 11-1. (4) - Specify a tolerable error for this population. Include any considerations that were used in arriving at this parameter: Tolerable error is $8,000, a figure apparently set judgmentally by Dan Cline. (5) - Specify a point estimate of the population error. Describe the method by which this determination was made: The initial sample of 30 items had an average error of $10 as computed in (l) above. Since 283 items make up the entire population, the point estimate of the population error is $2,830. (6) - Calculate the appropriate sample size. Show the formula being used and identify each element within this formula: Sample size =

 SD   Z a  Z r   N    TM  E  

2

Where: N is the population size Za is the confidence coefficient for the acceptable risk of incorrect 122

acceptance Zr is the confidence coefficient for the acceptable risk incorrect rejection SD is the estimate of the standard deviation of the difference TM is the tolerable misstatement of the population E is the point estimate of the population misstatement Sample size =

 52  1.28  1.04   283    8,000  2,830  

2

 44 rounded 

(1)-(B) ABERNETHY AND CHAPMAN SAMPLING FOR VARIABLES DIFFERENCE ESTIMATION Client: The Lakeside Company Form Completed By: Carole Mitchell Audit Area: Accrued Expenses Date of Testing: 2/4/13 Year Ending: 12/31/12 (1) - State the objectives of the audit testing: To determine the reasonableness of the client's year-end cutoff to arrive at accrued expenses. (2) - Define the population: All differences between the year-end accrual (as determined by the client) and the audited balance. Accruals were computed using all invoices received by the client in December 2012 and January 2013. (3) - Define the sampling unit: The difference between each year-end accrual determined by the client and the proper balance as calculated by the independent auditors. (4) - Specify the acceptable level of risk for incorrect acceptance and identify the confidence coefficient (Z value) for this percentage: Risk of incorrect acceptance is 10% with a confidence coefficient of 1.28.

123

(5) - Specify the acceptable level of risk for incorrect rejection and identify the confidence coefficient (Z value) for this percentage: Risk of incorrect acceptance is 30% with a confidence coefficient of 1.04. (6) - Specify a tolerable error for this population: $8,000 (7) - Specify a point estimate of the population error: $2,830 (8) - Calculate appropriate sample size (all computations should be attached): 50 (given in the problem) (9) - Indicate the method used to draw a random sample: Random number generator using computer (10) - Recompute the standard deviation using the entire sample selected: Estimated Standard Deviation =

  e

2

 n e 

2

n 1

Where: e is the value of each unit sampled ē is the average of each unit sampled n is the number of units sampled All 50 items sampled in Exhibit 11-2 and 11-3 show 43 differences with a zero balance and seven with either positive or negative balances. (e)2 42,025 2,401 12,100 24,336 9,409 22,500 2,209 114,980

e 205 49 (110) 156 (97) (150) 47 100 124

ē = 100/50 or 2

114,980  2 50  50  1

Estimated Standard Deviation =

2

 48 rounded 

(11) - Calculate the average difference within the sample and extend this figure to the entire population: Average Difference of Sample = $100/50 = $2 difference per unit (audited numbers are higher than client's balances) Estimated Total Difference = 283 items x $2 = $566 (client figure is understated) (12) - Determine the precision interval. Show the formula being used and identify each element within this formula (all computations should be attached): Precision Interval =

N  Za 

SD n



N n N

N is the population size n is the total sample size SD is the recomputed estimation of the standard deduction Za is the confidence coefficient for the acceptable risk of incorrect acceptance Precision Interval =

283  1.28 

48 50



283  50  $2,238 283

(13) - Identify the upper and lower confidence limits of the population based on the precision interval and the average difference of the sample: Actual population of difference is estimated to be between an understatement of $2,804 ($566 + $2,238) and an overstatement of $1,672 ($566 - $2,238).

125

(14) - Conclusions/Recommendations: No portion of the computed range of total errors falls outside of the $8,000 tolerable error limit. The client's accrual should be accepted as a fair representation of the year-end liability.

126

CASE 12 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) The examination of a bank cutoff statement is a common audit procedure that serves to generate several types of corroborative evidence. In reviewing this document, the auditor is seeking to verify the client's reported balance for cash and related accounts. In addition, the auditor must always be aware of the possibility of theft in connection with cash held by the client. Thus, the auditor is especially attentive to any information from the cutoff statement (such as a check that did not clear the bank in a reasonable time) suggesting the existence of a defalcation problem. Audit procedures that could be performed using the information obtained in a bank cutoff statement would include: *

Review of the checks clearing the bank during the first few days of the new year. Clearance of these checks serves as evidence of the validity of the "outstanding checks" total included in the client's year-end bank reconciliation. Any check which is not returned by this time may have been falsified to cover a cash shortage.

*

Review of the specific date on which each returned check cleared the bank. This procedure serves as a means of ascertaining the appropriateness of the year-end cutoff made of cash disbursements.

*

Verification of any unusually large check or any check of an odd nature (such as to a related party) that cleared the bank during this subsequent period. Such checks might have been issued at year-end to manipulate cash or other account balances.

*

Identification of all inter-bank transfers made near the end of the year so that they can be scheduled in assessing the possibility of check kiting.

*

Review of all deposits clearing the bank during this cutoff period as proof of the "deposits-in-transit" figure on the year-end reconciliation.

*

Identification of deposited (customer) checks returned by the bank because of insufficient funds as well as any other bank charges reducing the cash balance. This listing enables the auditor to determine the necessity of a year-end adjustment. 127

*

Verification of the bank balance included in the year-end cash reconciliation.

(2) Many thefts and other illegal acts are perpetrated through the use of bank accounts that supposedly have been closed. For example, a dishonest employee can utilize such an account to cash checks made out in the name of the company. The check is first deposited in this account followed by a subsequent withdrawal by the employee. In a different vein, the company itself could use a "closed" account to hide illegal payments or other transactions from the auditors. To gain evidence of the possibility of such actions, a confirmation should be used to obtain final information about any bank account that has been closed by the client during the current year. (3) a.

Warehouse - The construction-in-progress on the warehouse addition must be reported apart from the other land, buildings, and equipment on the balance sheet since it is not yet used in the company's operations. Because of the material nature of the expansion as well as the potential effects on the company, Lakeside also needs to include an explanatory note about the construction. This information would disclose the degree of completion, the anticipated completion date, and an estimation of the final expenditure total.

b.

Fire Damage - Although the fire occurred subsequent to the fiscal year, Statement on Auditing Standards 1 specifies that some events happening after the end of the period "may be of such a nature that disclosure of them is required to keep the financial statements from being misleading." SAS 1 goes on to list a number of examples, including inventory destroyed by fire. Thus, Lakeside's 2010 fire loss will probably require disclosure in the 2009 financial statements. Students may raise a question as to the materiality of the estimated loss especially since it did not occur during 2012 and only disclosure is at issue. Certainly, if the loss is not judged to be material, disclosure will not be required. Frequently, though, unless the amount is extremely small, the auditors will propose reporting a loss simply to avoid any later recrimination, an example of data being included for protection rather than for information. However, if Lakeside objects to the inclusion, the auditor once again faces the materiality issue that has been discussed at several points within these cases. Now that the students are familiar with the information involved in this audit, the question may be asked of them as to whether the nondisclosure of this 2013 loss would require a qualification by the auditors in 128

2012. c.

Declaration of Cash Dividend - Unless the auditor views the declaration of this cash dividend as an abnormal occurrence or an unusually large amount, disclosure would not seem warranted. Little evidence exists to indicate that this distribution will cause the 2012 financial statements to be misleading if not disclosed.

(4) For many companies, a number of transactions occur within two or three days of the end of the fiscal year. In seeking evidence of the fair presentation of the financial information, the auditor needs to ensure that the impact of these transactions is recorded in the proper time period. Cutoff testing is designed to accomplish this goal. Reporting problems are especially likely if the client's accounting system is not able to adequately classify the sheer volume of transactions that can occur at year's end. In addition, the auditor must be aware that company management can manipulate reported net income by having the cutoff made either a few days before or a few days after the end of the period. Cutoff testing is especially important in connection with inventory and sales. First, the daily quantity of transactions involving these accounts is usually quite large. Second, if shipment of merchandise is required (either for goods being bought or sold), the auditor must ascertain the point at which the title legally transfers as well as the physical location of inventory at the end of the year. (5) Determining the fair presentation of the liability accounts is a concern to the auditor because of the possibility that obligations may have gone unrecorded by the client company. At least two reasons exist for this potential problem: *

Failure to record liabilities improves a company's debt/equity ratio and, where expenses are involved, would also produce an increased net income for the current period. Therefore, a more favorable financial reporting is possible simply by leaving some liabilities unrecorded until the beginning of the following year.

*

Often the incurrence of a liability will not generate a client-produced document. For example, an obligation for utilities expenses might be acknowledged by the client only at the receipt of an invoice. Thus, the discovery of such liabilities is frequently dependent on the arrival of an invoice which may not be for some weeks after the end of the year. For the auditor, establishing complete assurance that all invoices have been received and liabilities recorded in the proper time period can be difficult to achieve. 129

(6) Contingent losses such as those arising from law suits or the possible closing of a store are frequently quite material in size. Thus, the auditor is usually faced with a potential outcome that can have an enormous impact on reported financial figures. Furthermore, the ability of the auditor (or anyone else) to foresee the future resolution of such contingencies is largely speculation. In the audit of Lakeside, for example, the loss from Store Six may never occur or it may amount to as much as $186,000. The auditor is being forced to evaluate the reporting of possible future outcomes, data that is not easily subjected to attestation. Finally, contingent losses are not always easy to uncover. Unasserted claims, for example, may generate little or no documentation by the client until a formal claim is made. Therefore, the auditor must perform a thorough investigation in hopes of revealing any contingencies that might otherwise go unreported. In seeking evidence of these losses, the auditor will talk with the client management, read the minutes of stockholders' meetings as well as the meetings of the board of directors, check contracts and disputed transactions, read correspondence with lawyers, and review all bank confirmations. (7) As with any confirmation, the letter of inquiry to the legal counsel must be prepared and signed by the client but mailed by the audit firm. The confirmation should direct the recipient to send all responses to the auditor who is attempting to gain assurance about the existence, evaluation, and reporting of both asserted and unasserted claims against the client company. The inquiry letter lists all pending or threatened litigation identified by the client along with management's evaluation of the current status of these actions. The list should be limited to claims for which the law firm has devoted substantial attention so that a proper evaluation can be made. The counsel is requested to furnish information as to the nature of each matter, progress to date, likelihood of an unfavorable outcome, and the range of potential losses. The legal firm is also asked to identify any other asserted claims against the client that are known to exist. This letter also includes a list and evaluation prepared by management of unasserted claims against the company that are considered probable of assertion with a reasonable possibility of unfavorable outcome. The law firm is asked to indicate any disagreements with this client data. The inquiry letter also seeks a confirmation that the client (not the auditor) will be advised of any other unasserted claims that should be disclosed. Finally, the letter requests the law firm to identify the nature and reason for any limitations in the response to these inquiries.

130

(8) The discovery and assessment of pending and threatened litigation has long been an area of contention between the auditing and legal professions. Traditionally, the independent auditor has looked to the client's attorney for information to help evaluate these contingent losses. The legal profession has often protested such inquiries for a number of reasons. One objection is that any communication between the attorney and the auditor may be construed as a breach of the confidentiality that exists between the attorney and the client. Having broken the confidential nature of the relationship, attorneys risk not being able to avail themselves of this privilege in the future. In addition, the question has been raised as to whether the attorney could incur any liability if the assessments provided to the auditor proved to be incorrect. Finally, attorneys are cognizant of the effect upon client retention if they should reveal information to the auditor which the client did not want disclosed. Auditors search for all possible contingent losses which would then be evaluated by the client. The client would describe these contingencies in a letter to the company's legal counsel. The losses would be split between "pending or threatened litigation" and "unasserted claims and assessments." In response to the first category, the attorney was to inform the auditor of any omissions or any disagreements with the client's evaluations. For unasserted claims and assessments, the attorney was asked to inform the auditor only of disagreements with the evaluations. If unasserted claims were omitted, the attorney would advise the client of the necessity of making appropriate disclosure. If the client then refused to report this information, the attorney was instructed to consider withdrawal by resignation. (9) Related party transactions will always concern independent auditors because of the difficulty in distinguishing the economic substance of the transaction from its legal form. To obtain evidence that all related party transactions have been disclosed, auditors send out inquiry letters to all related parties. The letter questions the existence and extent of the dealings with the reporting entity, the nature of the transactions, and the relationship between the parties. Once the identity and terms of these transactions have been established, the auditor has to use other means to verify their validity. Statement on Auditing Standards 45 suggests that the auditor may want to follow such steps as examining contracts, verifying approval by the board of directors, evaluating any collateral, and confirming information with intermediaries such as banks, attorneys, or agents to determine the true economic substance of each transaction. (A complete listing of "related parties" can be found in the glossary to FASB Statement No. 57, Related Party Disclosures.)

131

(10) and (11) In order to arrive at an estimation of the product warranty expense for 2009, the auditors must certainly look at the past history of the company as mentioned in this case. A schedule can be determined from the information given of the expense incurred during the previous months. However, the auditors cannot be satisfied with that evidence alone. Abernethy and Chapman should look for factors that would cause the future repairs of the company to differ from the past. For example, in scheduling the past repairs, the auditors need to watch for any trends that are evident. Repair costs (such as labor or parts) might have begun to climb recently or the incidence of product failure could be falling. Such trends affect the calculation of the client's present liability. The auditors should also look for other changes that are occurring that might have an impact on this estimation. Some products, as an example, might be more likely to break. If so, the auditors should determine if sales of those items were growing or decreasing. A call to Cypress Products could provide valuable data as to the repair rate for various items. This company, most likely, will monitor closely the need for repairs. In addition, publications such as Consumer Reports often provide statistics on the likelihood that products will fail. For example, radios may break more often than stereo systems and, thus, require a different percentage for estimation purposes. Changes at Cypress Products can also impact the product warranty. If Cypress has recently begun to stress quality in its production, repairs may be reduced; whereas, if quality control is not emphasized, Lakeside's repairs can potentially skyrocket. Abernethy and Chapman may want to talk with the management of the local shops that do Lakeside's repairs to see if they have noted changes in the quality of the items produced by Cypress. These individuals can also provide the auditors with information on any changes in repair costs that have occurred recently. Finally, the auditors will want to review the repair costs incurred during the approximately seven weeks following the end of the fiscal year. If repair costs jump during the subsequent period, Abernethy and Chapman may need to raise their estimation. However, if costs are being held at a minimum, the accrual should be decreased.

132

SUGGESTED ANSWERS TO EXERCISES (1) A good introduction to this question is to ask the students to give their estimations of the accrued repair expenses as of December 31, 2012. A number of different responses will probably be volunteered. The instructor can then ask a few individuals to explain the logic used to derive their figures. This exercise serves as a lesson as to the nebulous nature of some accounting problems. The students, who often believe that one absolutely correct answer can be derived for every situation, should be quite interested in the number of legitimate answers that are generated. Obviously, as long as the logic is sound, different estimated amounts can be reasonable. An additional factor in this case concerns the structuring of the data. Quite often, the client will have accumulated information in a manner that is not relevant to the needs of the auditor. Lakeside has classified its repair expense by the month in which the item is returned while the auditors want to match the expense with the month in which the item is sold. Therefore, a necessary step in establishing the appropriate accrual is the restructuring of the data as is demonstrated in the attached working paper. This worksheet presents one method of computing the estimated repair accrual as of the end of 2012. The computation indicates that Lakeside's accrued expenses are actually $24,675 too high; the adjustment will, therefore, increase the company's net income by this amount. A final point which may deserve some class discussion is the necessity of verifying the client's data. To avoid making the case overly complex, the client's figures have been used for this estimation without any testing. By now, the students should realize that such immediate acceptance is inappropriate. The auditor will have to ascertain the validity of this information before relying on it for this computation.

133

LAKESIDE COMPANY Estimated Accrued Product Warranty Expense

W.P. No. M-4 2 Accountant: AH Date: 2/2/13

12/31/12 A: Sales not under warranty Historical Data 1/11 Sales for month 1064000 Repairs: Month of Sales 386 1 month after 1,066 2 months after 1,674 3 months after 1,750 4 months after 686 5 months after 1,142 6 months after 914 Total repair expense 7,618 Repair expense as a percentage of sales 0.72%

Historical Data Cont. Sales for month Repairs: Month of Sales 1 month after 2 months after 3 months after 4 months after 5 months after 6 months after Total repair expense Repair expense as a percentage of sales

2/11 632000

3/11 718000

4/11 958000

5/11 972000

6/11 828000

7/11 742000

8/11 920000

9/11 884000

10/11 1066000

11/11 1172000

12/11 1600000

274 776 638 1,324 640 410 502 4,564

354 658 962 1,316 912 456 404 5,062

444 738 960 1,182 1,404 1,624 1,034 7,386

294 1,028 1,250 882 2,058 1,396 440 7,348

122 552 858 1,594 1,470 980 544 6,120

512 626 1,138 1,082 1,024 912 398 5,692

568 994 924 1,278 1,208 1,350 782 7,104

420 1,118 1,258 1,328 1,188 1,398 280 6,990

584 1,166 1,332 1,834 1,250 1,000 1,166 8,332

938 1,126 1,314 1,690 1,596 1,314 1,408 9,386

1,010 1,896 1,770 2,148 2,402 2,020 1,390 12,636

0.72%

0.71%

0.77%

0.76%

0.74%

0.77%

0.77%

0.79%

0.78%

0.80%

0.79%

1/12 1221000

2/12 762000

3/12 692000

4/12 1114000

5/12 1180000

6/12 818000

B: Sales still under warranty 7/12 8/12 9/12 10/12 844000 1100000 1022000 1205000

11/12 1284000

12/12 1748000

646 1,938 1,722 1,830 2,046 1,616 970 10,768

672 732 794 1,160 1,098 1,038 610 6,104

468 702 820 1,054 584 936 1,288 5,852

670 1,340 1,532 2,108 1,436 1,150 1,340 9,576

842 1,472 1,368 1,894 1,788 1,998 1,158 10,520

736 884 1,032 1,328 1,254 1,106 1,032 7,372

0.88%

0.80%

0.85%

0.86%

0.89%

0.90%

1,198 674 750 1,498 1,648 1,048

502 1,504 2,406 1,704 1,204

554 1,476 1,660 1,752

440 1,538 1,868

846 1,570

1,008

6,816

7,320

5,442

3,846

2,416

1,008

26,848 returns to date for products still with warranty.

134

Audit Objectives: To estimate the accrued product warranty expense as of Dec. 31, 2012. Scope: All sales and returns for warranty claims for 2011 and 2012. Audit Procedures: Agreed Sales per Month to the general ledger. No exceptions noted. Agreed Repairs per Month to the general ledger. No exceptions noted. Comments: A Historical data for the months from January 2011 to June 2012 (18 months) are being used to develop an estimate of monthly repairs expense. This estimate will be applied to the last six months sales of 2012 to determine the year-end accrual. During the 18-month test period, repair expenses showed a gradual increase from 0.72% to 0.90% of sales. Because of this upward trend, it is recommended that Lakeside use 0.95% of sales for estimating repair expenses for the last six months of 2012. B Sales during the last six months of 2012 are still under warranty. These sales total $7,203,000 for an estimated repair expense of $68,428 based on 0.95% (see A above). During the last six months of 2012, $26,848 in repairs were made in connection with these sales. As of December 31, 2012, an estimated liability of $41,580 (= $68,428 - $26,848) remains. Lakeside's accrual of $90,930 should be adjusted ($90,930 recorded balance - 41,580 desired balance = $49,350 overstatement). Proposed Adjustment 220-1 680-

Accrued Expenses Payable Other Misc. Expenses

49,350 49,350

Conclusion Accrued product warranty expense is fairly stated, after adjustment, in accordance with GAAP.

(2) This question has been included to emphasize the audit report as the end product of the auditor's work. As this text has been an exploration of the attest function rather than a full-scale audit, determination of an appropriate opinion for 2012 is not feasible. Presented below are two possible conclusions for this case. The first is based on an unqualified opinion on the 2012 statements because Abernethy and Chapman either believes the potential impairment of value on Store 6 is not material, or that its likelihood is only remote. The second possible conclusion is that disclosure is needed in connection with the problems encountered with Store Six, and that Rogers is unwilling to make this disclosure. In both cases, the assumption is made that King and Company, the predecessor auditor, continues to believe that a qualified opinion is still appropriate for the 2011 statements. Since comparative statements are being published, Abernethy and Chapman also have to provide information about this previous opinion. 135

UNQUALIFIED OPINION INDEPENDENT AUDITOR'S REPORT We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2012, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Lakeside Company as of December 31, 2011 were audited by other auditors whose report dated March 15, 2012, on those statements included a qualified opinion due to inadequate disclosure of a potential impairment of value for one of Lakeside's stores. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 2012 financial statements referred to above present fairly, in all material respects, the financial position of the Lakeside Company as of December 31, 2012, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Abernethy and Chapman Certified Public Accountants Richmond, Virginia February 15, 2013

136

QUALIFIED OPINION INDEPENDENT AUDITOR'S REPORT We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2012, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Lakeside Company as of December 31, 2011, were audited by other auditors whose report dated March 15, 2012, on those statements included a qualified opinion due to inadequate disclosure of a potential impairment of value for one of Lakeside's stores. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. During 2010, the company made a $186,000 investment in a retail store located in the eastern sector of Richmond, Virginia. This store has failed to reach a break-even sales point to date, and total recovery of the Company's investment is highly uncertain. In our opinion, the chances are reasonably possible that the asset's value has been permanently impaired and should be reduced to the net realizable value in conformity with generally accepted accounting principles. In our opinion, except for the effects of not recording or disclosing the impairment of value of the asset, as discussed in the preceding paragraph, the aforementioned financial statements present fairly, in all material respects, the financial position of the Lakeside Company at December 31, 2012, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Abernethy and Chapman Certified Public Accountants Richmond, Virginia February 15, 2013

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CASE 13 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) The authoritative auditing literature describes a material internal control weakness as a condition where a company's systems fail to reduce to a relatively low level the risk that a material error or irregularity will both occur and avoid being detected within a timely period by employees in the normal course of performing their assigned duties. If any such weakness does exist, the company is exposed to the danger that an error or irregularity will occur, go undetected, and then directly affect reported financial figures. The auditor's role is to accumulate sufficient, competent evidence on which to form an opinion as to the fair presentation of the client's financial statements. However, during this investigation, one or more material control weaknesses may be discovered. A description of these problems should be immediately communicated to the client. In this way, management has the opportunity to reduce the possibility that subsequent errors and irregularities will go undetected. This report can also protect the auditor from legal responsibility if losses are incurred by the client at a future point in time because of the weakness. Consequently, if Abernethy and Chapman discovers a material weakness in Lakeside's internal control, this information must be conveyed to the client as soon as possible so that corrective actions can be taken. The description is to be communicated either orally or in writing and should go to the senior management of the company as well as the board of directors (or its audit committee). (2) Management prefers to understand how the information is accumulated, manipulated and reported. The old manual/paper systems provided an easy to understand process. The computer takes the same information but does not let the manager see the data manipulation. From the fraud perspective, the computer makes it harder to alter records for most managers who do not have the computer ability to do it within the system. On the other hand, a manager who does have computer skills can conceivably alter the data from within. (3) Many individuals in business are skilled in one particular industry: audio equipment, car sales, fashion design, etc. Others are trained in one general aspect of business such as marketing, personnel, shipping, etc. Although these people may be extremely efficient and productive, they are not necessarily 138

knowledgeable about computers and computer applications. In the past, they may have focused their attention on a particular function and limited their thinking to the methods that have historically proven successful. Any time that a new approach is put forth, especially one with the complexity of modern technology, human nature seems to resist the change. Rogers has built a large company without a large computer component; he may be skeptical about making significant alterations in a successful operation, especially changes that he admittedly cannot visualize or fully comprehend. Abernethy and Chapman has employed an appropriate system for educating the client. Klontz is developing and will present a series of potential, clearly-defined, functions that could be computerized. Thus, Rogers will be able to analyze the possibilities that are offered by an automated system and judge for himself as to which are worth the costs that are involved. (4) Public accounting firms come into contact with numerous business organizations, their operations, and their accounting systems. Since the client's systems and controls must be understood as a part of the attest function, the auditor has always been in a position to note and propose improvements. Hence, the opportunity and the expertise are both naturally in place to provide advisory work. In recent years, such advice has become more formalized as firms have begun to offer a wide range of services to clients as well as to other organizations. During the last two decades, CPAs have come to recognize such work as a lucrative offshoot of the public accounting profession. (5) A fully computerized accounting system has two major impacts on the work of the independent auditor. First, the traditional audit trail is changed significantly. The series of paper documents that could be followed from the inception of a transaction to its final recording is often unnecessary in an automated system. The information is entered into the computer so that no tangible record of changes and events necessarily exists. Second, computer processing does not utilize the same control procedures commonly found in a manual system. For example, in manual systems, one individual is frequently assigned to review and authorize the work of another employee, a verification task not necessarily required by a computer. Consequently, when an automated system is in use, the internal control must take on new, sometimes creative, forms. Because of the lack of an audit trail and the presence of different control 139

procedures, the audit firm must adapt its examination to new circumstances. Increased emphasis is placed on developing tests of the computer controls to ensure that all of the data being processed is reliable. The auditor would expect the computer installation, for example, to have restricted access to limit the possibility of unauthorized changes. Where direct input into the computer is allowed, pass codes should be used for this same purpose. A control group also needs to be created to monitor all computer processing and its output. In addition, the client should require the use of control totals (batch totals, item counts, or hash totals) to provide evidence of the accuracy of information produced by the computer system. Periodically, the programs in use should be rechecked for unauthorized alterations. Control of a computerized system can also be enhanced by requiring a limited amount of documentation for transactions. A physical receiving report, for example, might be produced to back up the information that has been entered directly into the computer. This document could be used for daily reconciliation of transactions while also allowing for a periodic verification of the computer records. (5) and (6) Public accounting firms have long held that a distinction is maintained between consulting and audit services, a separation that protects them from any possibility of a conflict of interest. In many organizations, the two services are offered through relatively autonomous divisions. Furthermore, the client is free to discuss possible improvements with any other business enterprise providing these services. Many large companies, for example, use one firm for auditing and a different organization for advisory services to avoid becoming too dependent on any one group. Although public accounting firms continue to assert that no problems are created by their movement into consulting, many observers have expressed concern. In the May 18, 1987, issue of Forbes magazine, this controversy was analyzed in an article entitled "Blood on the Ledger." The following two quotations help to explain the possible crisis that is created when CPA firms become involved in consulting work: "One of the issues attracting all this attention is the accounting profession's steady move into consulting: designing computer systems, engaging in strategic planning and providing financial counseling. What's wrong with a bit of diversification? Simply this: An auditor is supposed to be absolutely independent, and the lure of consulting dollars could conflict with that. Even more significantly, an auditor who is, in effect, overseeing the work of his partner, the consultant, might be tempted to be less zealous in searching the client's books." (p. 202)

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"Happily, accounting remains for now at least one of the nation's most admired professions, as shown by a recent Louis Harris poll of shareholders and business leaders who believed accounting to have the highest moral practices of any major profession - better than college professors, lawyers, congressmen, journalists. Yet if something happens to that credibility, there is more at risk than simply the fortunes of the men and women in the green eyeshades. In theory, it is fine if accounting firms want to pursue opportunities in related business fields like strategic or financial consulting. There's even a strong contingent of thought that such endeavors will help the firms better understand their clients - and as a result do better audits for them. But the stakes involved are huge. In the practical work of the marketplace, certified public accountants are the only guarantors of financial integrity the capitalist system has. The further the industry strays from its roots, the bigger the chance of doing damage to its credibility with the public, and that is something from which ultimately no one can profit." (p. 206) The Enron Bankruptcy will have ramifications on auditor independence issues for many years to come. For example, the Government Accounting Office (GAO) issued new independence rules dealing with non-audit services performed by the auditor in governmental audits. Also, the Sarbannes-Oxley Act required that many of the consulting activities be eliminated for a firm's publicly-traded audit clients. SUGGESTED ANSWERS TO EXERCISES (1) The cases in this book have described several of the accounting systems in use by the Lakeside Company. Because of the lack of complete computerization, these various functions are mechanical in design, relying on the skills of the company's employees. Therefore, Abernethy and Chapman can recommend to Rogers a number of specific functions to be modernized through the installation of a new accounting information system. Listed below are a few examples of the types of suggestions that students may provide: -

Payroll The names and pay rates for all employees are programmed into the computer. At the end of each pay period, the number of hours worked by every hourly employee is also entered along with sales figures for individuals being paid on commission. The computer automatically calculates the gross pay for each employee. The amount to be paid to salaried workers is based on individual contract rates while the salary for each hourly and commission 141

worker is determined from the information entered for the period. Federal and state income tax withholding figures are also computed as well as Social Security payments and any other payroll deductions. A net wage for each individual is then derived with the computer printing out the actual paychecks. -

Credit File Information is accumulated about all of the customers to whom credit sales are made. A review board is established by Lakeside to approve or reject the continuation of credit to these customers as well as the extension of credit to new customers. An approved customer list is then entered into the computer and updated as needed. Whenever a sales order is received by the company and processed, the computer scans this file to ensure that credit should be given. The computer also reviews the amount and age of any balances already owed by this same customer. If an excessive amount is presently outstanding or if a balance is past due, credit approval can be rescinded even if the customer is listed in this file.

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Perpetual Inventory All inventory balances are monitored by a computer program. At the time merchandise is transferred to a customer, the identity of the specific items is entered into the computer along with the quantity, perhaps using point-of-sale technology. The computer is programmed to reduce the appropriate account balances and automatically warns of any merchandise that is at an unacceptably low level. Whenever goods are delivered to Lakeside, a description of the newly acquired inventory is similarly entered. Again, the computer updates the information stored in the perpetual records for each of these particular items, thus providing ongoing data about the inventory on hand.

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Accounts Receivable Subsidiary Ledger A listing of all customers is maintained within the database as well as the current amounts owed by each and the age of the receivable. At the time that a new sales order is approved and the merchandise shipped, the dollar amount is entered into the computer so that the specific customer's balance will be updated. When a collection is subsequently received, the payment is also recorded by the computer as a reduction in the appropriate account receivable balance. A daily list of overdue accounts is printed so that new invoices can be mailed or other follow-up procedures instigated.

(2)

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In studying and evaluating the controls surrounding computerized systems, the independent auditor anticipates finding certain procedures in use. Computer controls are divided into "general" and "applications" controls. General controls relate to all EDP activities and include:  A plan of organization and operation of the EDP function.  Procedures for documenting, reviewing, testing, and approving systems or programs and changes in them.  Hardware and programmed controls built into the operating systems.  Access controls.  Other data and procedural controls (e.g., record reconstruction, backup facilities, emergency procedures, etc.). Applications controls relate to specific tasks performed by the EDP department, such as preparing payroll. These controls are intended to provide assurance that the recording, processing, and reporting of data are properly performed. Applications controls can be further divided into "input," "processing," and "output" controls. Input controls ensure that input data is authorized, converted into machinesensible form, verified, and not lost, duplicated, or altered. Processing controls provide assurance that transactions are processed, as authorized, and that none were added or omitted. Output controls ensure that output data are accurate and received only by authorized personnel. In Lakeside's situation, specific controls would include the following: -

All programs should be purchased from reputable software firms or written by employees with an appropriate background in software development. The company's entire accounting system often depends on the reliability of these programs; thus, control must begin with their very creation. Programmers should be segregated from computer operators and not permitted unrestricted access to the hardware so that the programmers cannot manipulate any of the programs.

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Proper documentation should be furnished with all programs to indicate the controls that have been established within the various functions. This documentation allows the client to verify that each program was developed in an appropriate manner and has not been improperly modified since it was put into operation. All program alterations and updates are to be documented and reviewed by appropriate supervisory personnel prior to any changes being made.

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Testing of all programs should be performed before the client relies on them. For a time, as an example, the company may want to run parallel processing where all functions are carried out both manually as well as through the new 143

information system to ensure that the output is accurate. In addition, Lakeside should process test (or erroneous) data using the various computer systems to further verify the reliability of the output. -

All programs should be tested periodically to verify that no unauthorized changes have been made by company employees or any other parties.

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The computer system should be physically protected to prevent unauthorized access as well as any physical damage that might occur because of fire, smoke, heat, water damage, or other problems. In addition, backup files need to be maintained in case current files are destroyed. For example, the company should assure that its perpetual inventory records and its accounts receivable subsidiary ledger can be reconstructed if damaged.

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Because an online, real-time system is being designed by Klontz in Exhibit 13-1, many of the employees of Lakeside will have direct access into the memory of the computer. Access (or pass) codes should be used to limit any one employee's ability to enter and change files that are not directly related to an assigned function. These codes should be changed periodically.

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The computer may be programmed so as to prevent access into files except during assigned times. Entry into a system after working hours, for example, might be prohibited. Thus, employees would be prevented from returning to work during the night to manipulate data.

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Where possible, validity checks could be installed within the various systems so that data must be verified independently before being processed. A customer name, as an example, has to be on an approved customer list before a sale is authorized and merchandise shipped. Likewise, an individual's identification number must be listed on a master employee file, or a paycheck will not be produced.

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Limit tests can be initiated so that transactions above or below specified parameters will not be processed by the computer unless additional authorization is entered. An order for merchandise of over $5,000 might, for example, require further approval before the goods are shipped. Inventory acquisitions for more than $20,000 might also necessitate a similar authorization.

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Employees entering data might be required to complete documents for verification purposes. Obviously, a computerized system can virtually reduce to zero the need for any type of written information. However, control may be enhanced by having employees record a limited amount of data at the point of a transaction solely for reconciliation purposes. As an illustration, a bill of lading may be produced (manually or by the computer) and sent to the customer as a verification of a shipment. A copy of this document can 144

subsequently be used by the company to check the data entered into the computer. SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION (1) Sarbanes-Oxley established a list of proscribed services for a registered auditing firms performing audits under the statute. The definition of these proscribed activities was designed to increase or protect a firm’s independence. This issue resulted from the scandals of the early 2000s, where we observed auditors performing consulting and valuation activities, among others, and consequently were unable to make professional decisions. The list of proscribed activities: Bookkeeping and other accounting services Financial information systems design and implementation Appraisal or valuation services Actuarial services Internal audit outsourcing Management or human resource functions Broker or dealer or investment adviser or investment banking Legal and expert services unrelated to audit Any other service the PCAOB decides to add to the list.

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