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# CHAPTER 11 A RISK-BASED AUDIT APPROACH PART II

I. Review Questions 1. Use the model AR = IR x CR x DR to solve for different values of Audit Risk (AR) when internal control risk (CR) is iven different values. In all cases IR = !."! and DR = !.1!# therefore# AR = !."! x CR x !.1! When CR is !.1! !.%! !.'! !."! 1.!! +. a. AR is !.!!" or !." \$ercent !.!&% or &.% \$ercent !.!() or (.) \$ercent !.!*1 or *.1 \$ercent !.!"! or ".! \$ercent

Risk of Assessing Control Risk Too Low or Overreliance is a matter of ,ud ment a-out the im\$ortance (.ke/0) characteristic of a \$articular client control \$rocedure. An auditor can take more risk of assessin control risk too low on unim\$ortant controls than on im\$ortant (.ke/0) ones. Alternativel/# the risk of assessin control risk too low can -e considered a constant (sa/# !.!%) and the im\$ortance of a control can -e measured in terms of a smaller or lar er tolera-le rate. (1he authors \$refer the latter a\$\$roach.) Risk of Assessing Control Risk Too High or Underreliance is a matter of ,ud ment a-out the efficienc/ of an audit en a ement. 1he risk can -e 2uite hi h when the audit team is willin to do extensive su-stantive work an/wa/. If the work -ud et is ti ht# auditors need to find o-,ective wa/s (e. .# lar er test of controls audit sam\$les) to miti ate the risk. Tolerable Deviation Rate is a ,ud ment a-out how many control deviations can exist in the \$o\$ulation# /et the control can still -e considered effective. Auditors need to -e careful a-out -rushin aside findin s of deviations. !"ected Deviation Rate in the #o"\$lation is an estimate# usuall/ -ased on assum\$tions or sketch/ information# of the im-edded incidence of control deviations. 1he onl/ use of this estimate in classical attri-ute sam\$lin is to fi ure a sam\$le si3e in advance. 1he statistical evaluation (CU4 calculation) does not use it.

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c.

d.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

e. #o"\$lation Definition mi ht -e called a ,ud ment a-out identification of the \$o\$ulation of control \$erformances that corres\$ond to an audit o-,ective. 5or exam\$le# an auditor would want to -e sure he is sam\$lin from a file of recorded documents if his o-,ective is to audit the controls over transaction validity.

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Assessin the control risk too low causes auditors to assi n less control risk (CR) in \$lannin \$rocedures than \$ro\$er evaluation would cause them to assi n. 1he result could -e (1) inadvertentl/ conductin less audit work than \$ro\$erl/ necessar/ and takin more audit risk (AR) than ori inall/ contem\$lated# \$erha\$s to the un\$leasant results of failin to detect material misstatements (dama in the effectiveness of the audit) or (+) discoverin in the course of the audit work that control is not as ood as first -elieved# causin an increase in the audit work# \$erha\$s at a time when doin so is ver/ costl/ (dama in the efficienc/ of the audit). 1he im\$ortant consideration involved in ,ud in an acce\$ta-le risk of assessing control risk too high is the efficiency of the audit. Assessin control risk too hi h causes auditors to think the/ need to \$erform a level of su-stantive work which is reater than a \$ro\$er evaluation of control would su est. Assessing control risk too high leads to overa\$diting. 6ome auditors ma/ -e willin to acce\$t hi h risks of assessin the control risk too hi h -ecause the/ intend to overaudit an/wa/# and the audit -ud et can su\$\$ort the work. 7ther auditors want to minimi3e their work (within acce\$ta-le \$rofessional -ounds of audit risk) and thus want to minimi3e the risk (\$ro-a-ilit/) of overauditin -/ mistake. 1echnicall/# the risk of assessin control risk too hi h in relation to an attri-ute sam\$le is the \$ro-a-ilit/ of findin in the sam\$le (n) one deviation more than the .acce\$ta-le num-er0 for the sam\$lin \$lan. 5or exam\$le# if the \$lan called for a sam\$le of 1!! units and a tolera-le rate of ) \$ercent at a !.1! risk of assessin control risk too low# the .acce\$ta-le num-er0 is 3ero deviations. 1he \$ro-a-ilit/ of findin 1 or more deviations when the \$o\$ulation rate is actuall/ + \$ercent is8 9ro-a-ilit/ (x : ! 8 n = 1!!# r = !.!+) = = = 1 ; (1 ; r) n 1 ; (1 ; !.!+) 1!! !.*(' or *(.' \$ercent

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All the elements of the risk model are \$roducts of auditors< \$rofessional ,ud ments. Auditors must ,ud e8

## A\$dit Working #a"ers

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(nherent risk ; the \$ro-a-ilit/ that material errors or irre ularities have entered the accountin s/stem used to develo\$ financial statements. (nternal control risk ; the \$ro-a-ilit/ that client<s s/stem of internal control \$olicies and \$rocedures will fail to detect material errors and irre ularities# \$rovided an/ enter the data accountin s/stem in the first \$lace. Analytical "roced\$res risk ; the \$ro-a-ilit/ that auditors< anal/tical \$rocedures will fail to \$roduce evidence of material errors and irre ularities# \$rovided an/ have entered the accountin s/stem in the first \$lace and have not -een detected and corrected -/ the client<s internal control \$rocedures. A\$dit risk ; the \$ro-a-ilit/ that auditors will not discover -/ an/ means errors and irre ularities that cause an account -alance to -e materiall/ misstated. 1est of detail risk a\$\$ears at first lance to -e the \$roduct of a formula and not a \$rofessional ,ud ment. =owever# ever/thin in the risk model is a ,ud ment# so the test of detail derived from the model is no less a ,ud ment. (. An incorrect acce"tance decision directl/ im\$airs the effectiveness of an audit. Auditors wra\$ u\$ the work and the material misstatement a\$\$ears in the financial statements. An incorrect re)ection decision im\$airs the efficienc/ of an audit. 5urther investi ation of the cause and amount of misstatement \$rovides a chance to reverse the initial decision error. '. Detection risk is the com\$onent of audit risk that is controlla-le -/ the auditor. It ma/ -e raised or lowered -/ reducin or increasin the amount of su-stantive audit testin . It is determined -/ the auditor<s assessment of inherent risk and control risk. 1he auditor deals with -oth inherent risk and control risk durin the \$lannin \$hase of the audit. In2uir/ of client \$ersonnel# stud/ of the -usiness and industr/# a\$\$lication of anal/tical \$rocedures# and documentation of the auditor<s initial understandin of internal control are all \$erformed durin the \$lannin \$hase of the audit. 5urther stud/ of internal control \$rocedures ma/ occur after the \$lannin \$hase if the auditor wishes to further reduce the assessed level of control risk# and considers it economicall/ feasi-le to do so. An auditor would assess control risk to -e at maximum when (1) effective controls for the assertion have either not -een desi ned or not \$ut in \$lace# or (+) when the auditor -elieves \$erformin su-stantive tests of the assertion is more cost effective. >hen an auditor assesses control risk to -e -elow the maximum# the auditor should -elieve that effective controls are \$resent to \$revent or detect misstatements in the financial statement assertions.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

1!. >hen the auditor assesses control risk at a level lower than maximum# the auditor ma/ enerall/ \$erform fewer su-stantive tests. 11. 1he audit risk model is useful in mana in audit risk for assertions. ?/ determinin \$lanned audit risk for an assertion# assessin inherent and control risks# an auditor can determine the allowable detection risk (the amount of detection risk an auditor can allow) for an assertion. Allowa-le detection risk is used to determine the nature# timin # and extent of audit \$rocedures for the assertion. 1+. Detection risk exists -ecause auditors (1) ma/ use an ina\$\$ro\$riate audit \$rocedure# (+) ma/ misa\$\$l/ an audit \$rocedure# ()) ma/ misinter\$ret the findin s# or (&) do not examine 1!! \$ercent of an account -alance or transaction class. 1). 1he amount of audit evidence an auditor must ather varies inversel/ with allowa-le detection risk. As allowa-le detection risk decreases# the amount of evidence re2uired increases# and vice versa. Cha\$ter 1+ introduces audit \$rocedures and discusses how auditors modif/ audit \$rocedures to o-tain sufficient com\$etent evidential matter -/ chan in (1) the nature# (+) the timin # or ()) the extent of \$rocedures. 1&. 1he audit risk model is Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR) 1%. Risks identified at the financial statement level ma/ have a su-stantial im\$act on the assessment of inherent risk for s\$ecific assertions. 5or exam\$le# concern a-out mana ement inte rit/# identified as a risk at the financial statement level# would cause an auditor to assess a hi her level of inherent risk for existence of sales. II. Multiple Choice Questions 1. +. ). &. %. (. '. *. ". 1!. 11. d d c d a a a a 1+. 1). 1&. 1%. 1(. 1'. 1*. 1". +!. +1. ++. d a d d c a a d a +). +&. +%. +(. +'. +*. +". )!. )1. )+. )). c c d d c d a a a )&. )%. )(. )'. )*. )". &!. &1. &+. c d d d c a c d

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III. Comprehensive Cases Case 1. 5actors that will affect /our evaluation of audit risk include inte rit/ of mana ement ; @imene3<s re\$utation and lawsuit. trend toward domination of o\$eratin and financial decisions -/ @imene3. increased mana ement com\$ensation -ased on \$erformance. a ressive attitude toward financial re\$ortin -/ new \$ersonnel. \$rofita-ilit/ inconsistent with the industr/.

Case 2. 1he factors that will affect @osefina<s audit risk and -usiness risk are (a) this is a s\$ecial audit# (-) the audit will -e used to set the value of certain assets# (c) the auditor is to evaluate an/ dis\$uted amount (althou h this is a common \$rovision in \$urchase a reements# one mi ht 2uestion whether auditors should a ree to such terms)# and (d) the materialit/ level is set at 9%!#!!!# even thou h that is considera-l/ -elow an amount that mi ht -e determined usin a \$ercenta e of assets andAor income. 1hese factors will increase the risk at the financial statement level and \$otentiall/ increase -usiness risk. Case 3. a. 1he audit risk model ives the followin results8 AR = IR x CR x DR (or) DR x AR A (IR x CR) (1) +.%B (+) !.('B ()) 1 (&) ).))B (%) +.%B

In the third situation# the auditor does not have to accumulate an/ evidence -ecause inherent risk and control risk ive the a\$\$ro\$riate level of \$lanned audit risk. -. (1) ) (tied) (+) % ()) 1 (&) + (%) ) (tied)

Case 4. a.

(1) Cedium (&) 4ow (+) 4ow (%) 4ow ()) 4ow (1) 4east (+) + (tied) ()) + (tied) (&) + (tied) (%) + (tied)

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Case 5. 1.

a. -.

1his will have an im\$act on audit risk for valuation of accounts receiva-le. Accumulation of additional evidence re ardin collecta-ilit/ of receiva-les will -e necessar/. 1his situation ma/ or ma/ not affect overall audit risk# de\$endin on the im\$act of the financin needed and whether the com\$an/ will -ecome so heavil/ levera ed that \$rofita-ilit/ -ecomes inade2uate. 1his situation mi ht create increased -usiness risk -ecause of the \$otential chan e in ownershi\$. It would have an im\$act on audit risk for valuation of stockholders< e2uit/. Additional evidence will have to -e accumulated relatin to stockholders< e2uit/# as well as an/ additional de-t incurred. 1he client<s chan in of its accountin s/stem will affect control risk in each c/cle# \$rimaril/ for existence# com\$leteness# and valuation. Additional information will have to -e accumulated a-out the s/stem in each c/cle. 1his will affect risk at the financial statement level# which ma/ also have an im\$act on risk for assertions relatin to earnin s and valuation of assets. 5or exam\$le# the volatilit/ in the industr/ ma/ indicate the \$otential for inade2uate industr/ earnin s or for a client<s earnin s -ein inconsistent with the industr/. Additional evidence will have to -e accumulated a-out the financial via-ilit/ of the client and to \$rovide evidence that mana ement fraud does not exist. 1he increase in inventor/ will affect existence and valuation of inventor/. Additional evidence will have to -e accumulated a-out the existence and valuation assertions. 6ales and collection 9rimaril/ affects existence# com\$leteness# and valuation assertions Increase Ac2uisitions and \$a/ments 9otential im\$act on all assertions Increase 6ales and collections Daluation# cutoff# and existence Eo effect

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a.

-. ). a. -. &. a.

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a. -.

Case 6. 1.

a. -. c. a. -. c. a. -. c.

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## A\$dit Working #a"ers

&. a. -. c. 9roduction and warehousin Daluation Increase

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## CHAPTER 12 AUDIT PROCEDURES

I. Review Questions 1. .9rocedures0 relate to acts to -e \$erformed. .6tandards0 deal with measures of the 2ualit/ of \$erformance of those acts and the o-,ectives to -e attained -/ the use of \$rocedures. 1he standards are less su-,ect to chan e. 1he standards \$rovide the criteria for re,ectin # acce\$tin # or modif/in a \$rocedure in a iven circumstance. An exam\$le of the relative sta-ilit/ of standards and \$rocedures is found in the chan e from nonFGD9 to GD9 s/stems. Eew \$rocedures were re2uired to audit GD9 s/stems# -ut auditin standards remained unchan ed and were the criteria for determinin the ade2uac/ of the new \$rocedures. A .su-stantive audit \$rocedure0 is an/ action (resem-lin a s\$ecific variation of one of the seven eneral audit \$rocedures) undertaken for the \$ur\$ose of \$roducin evidence a-out a \$eso amount of a disclosure that a\$\$ears in the financial statements under audit. 1he nat\$re of a \$rocedure is its descri\$tion ; usuall/ associated with one of the seven eneral audit \$rocedures. 5or exam\$le# the nature of a \$rocedure ma/ -e confirmation# doc\$ment# vo\$ching# etc. 1he timin of a \$rocedure is the \$eriod durin which it is \$erformed ; usuall/ distin uished as interim (-efore the -alance sheet date)# year'end (on or close to the -alance sheet date)# and s\$bse*\$ent (after the -alance sheet date). 1he e!tent of a \$rocedure is the num-er of details audited with it# or another measure of intensit/ or fre2uenc/. 7ftentimes# e!tent is measured -/ the sam\$le si3e. ). Ins\$ection techni2ues include \$h/sical examination of assets# examination of documents and records# \$erformance of mechanical accurac/ tests# and anal/tical \$rocedures. Douchin and tracin are two t/\$es of commonl/ \$erformed documentation. +o\$ching involves the examination of documents that served as a -asis for recordin the transaction. Douchin usuall/ starts with a recorded transaction

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

and works -ack to the documents and addresses existence. Tracing involves determinin whether source documents have -een recorded \$ro\$erl/ in the accountin records. ?/ tracin # an auditor can o-tain evidence that the recordin of the transaction is com\$lete.

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An in*\$iry involves re2uestin information from client \$ersonnel and receivin their res\$onse. 1he re2uest and res\$onse ma/ -e either written or oral. A confirmation is a res\$onse a third \$art/ makes directl/ to the auditor on the re2uest of a client. 1he res\$onse includes information a-out certain transactions# relationshi\$s# andAor -alances that have an im\$act on a s\$ecific financial statement assertion. Confirmations are usuall/ considered more relia-le -ecause the/ are from outside \$arties# while in2uiries are made of client \$ersonnel. >hen e2uivalent \$rocedures are availa-le to satisf/ the need for evidence# an auditor ma/ consider cost in selectin amon the alternatives. Douchin is relevant to testin the existence of salesH tracin is not. 1racin is relevant to testin the com\$leteness of sales# -ut vouchin is not.

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## II. Multiple Choice Questions 1. +. c d ). &. c a %. (. c c '. *. a d ". d

III. Comprehensive Cases Case 1. 1he o-,ectives for the audit of >esson<s securities investments at Decem-er )1 are to o-tain evidence a-out the assertions im\$licit in the financial \$resentation# s\$ecificall/8 1. !istence. 7-tain evidence that the securities are -ona fide and held -/ >esson or -/ a res\$onsi-le custodian. +. Occ\$rrence. 7-tain evidence that the loan transaction and securities \$urchase transactions actuall/ took \$lace durin the /ear under audit. ). Com"leteness. 7-tain evidence that all the securities \$urchase transactions were recorded. &. Rights. 7-tain evidence that the securities are owned -/ >esson. Obligation, 7-tain evidence that 9%!!#!!! is the amount actuall/ owed on the loan. %. +al\$ation. 7-tain evidence of the cost and market value of the securities held at Decem-er )1. Decide whether an/ writedowns to market are re2uired -/ IAA9. (. &eas\$rement.

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#resentation and Disclos\$re. 7-tain evidence of the committed nature of the assets# which should mean the/ should -e in a nonFcurrent classification like the loan. 7-tain evidence that restrictions on the use of the assets is disclosed full/ and a rees with the loan documents.

Case 2. 1/\$es of \$rocedures used -/ auditors in eneral# with exam\$les8 1. +. ). Recalculation -/ the auditor J recom\$utin the client<s calculation of de\$reciation ex\$ense 7-servation -/ the auditor J o-servation# testFcountin of client<s \$h/sical inventor/Ftakin Confirmation -/ letter J o-tainin accounts receiva-le confirmations J o-tainin client<s law/er<s letter In2uir/ and written re\$resentations J ask client \$ersonnel a-out accountin events J com\$lete an internal control 2uestionnaire J o-tain written client re\$resentation letter Douchin J find -rokers< invoices and cancelled checks showin a reement with record amounts for securities investments 1racin J select a sam\$le of shi\$\$in documents and trace them to sales invoices# sales ,ournal recordin and \$ostin to eneral led er 6cannin J scan ex\$ense accounts for credit entries J scan \$a/roll check lists for unusuall/ lar e checks Anal/tical \$rocedures ; an/ exam\$le that fits one of these8 J com\$are financial information with \$rior \$eriods J com\$are financial information with -ud ets and forecasts J stud/ \$redicta-le financial information \$atterns (e. .# ratio anal/sis) J com\$are financial information to industr/ statistics J stud/ financial information in relation to nonfinancial information An a\$dit confirmation is a written statement to the C9A from someone outside the enter\$rise on a fact that a \$erson is 2ualified to affirm. 1he two main characteristics a confirmation should \$ossess are8 1. 1he \$art/ su\$\$l/in the information re2uested must -e knowled ea-le and inde\$endent# i.e.# he must have knowled e of information of interest to

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Case 3. a. -.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

the auditor and he must -e outside the sco\$e of influence of the or ani3ation -ein audited# and +. 1he auditor must o-tain the information directl/ from the informed \$art/.

Case 4. 1.

6cannin for de-it -alances in accounts \$a/a-le Recalculation of amounts on su\$\$ortin documents Douchin of account entries to su\$\$ortin documents Douchin of \$olicies from ex\$ense and \$re\$a/ment entries Recalculation of ex\$iration of insurance \$remium Anal/sis of interrelationshi\$s ; com\$are insurance covera e to assets owned and leased 6cannin inventor/ records for .old0 lastFissue dates Der-al in2uir/ ; 2uestion inventor/ control \$ersonnel a-out slowFmovin inventor/ Douchin ; examine ,ournal entries for evidence of actual -ook writeFdown of the s\$ecific inventor/ items 1racin ; trace remittance amounts to a\$\$ro\$riate customer<s account Recalculation ; recalculate amount of discounts and allowances Douchin ; examine authoritative documents su\$\$ortin unusual discounts andAor allowances 7-servation and examination -/ the auditor ; of the inventor/ and the inventor/Ftakin \$rocedures Confirmation -/ letter ; of inventor/ held in outside warehouses Recalculation ; of the accurac/ costFflow calculations A material decline in sales ma/ indicate unrecorded salesH a decrease in cost of oods sold ma/ -e due to unrecorded \$urchasesH and an increase in cost of ood sold ma/ -e the result of omissions from the endin inventor/. An increase or decrease in ross \$rofit will result from an/ one or a com-ination of the a-ove omissions. A decline in the miscellaneous revenue account -alance# or the a-sence of a \$reviousl/ existin source of miscellaneous revenue# could -e attri-uta-le to a failure to record miscellaneous revenue. Unrecorded accounts \$a/a-le at /earFend would cause an increase in calculated accounts \$a/a-le turnover.

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Case 5. a.

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## A\$dit Working #a"ers

d. e.

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An a\$\$arent increase in accounts receiva-le turnover ma/# in fact# -e the result of failure to record credit sales transactions. A hi her than avera e o\$eratin return ma/ -e indicative of unrecorded \$urchases or o\$eratin ex\$ensesH a lower than avera e return could result from unrecorded sales.

Case 6. a.

1his is an ina""ro"riate a\$\$lication of costA-enefit to auditin . 1he second standard of audit field work states that the auditor is to ather sufficient com\$etent evidential matter to su\$\$ort the audit o\$inion. If two or more sets of audit \$rocedures are availa-le for satisfactoril/ achievin a set of s\$ecific audit o-,ectives# the costA-enefit conce\$t su ests selection of the least costl/ set of \$rocedures. In the \$resent instance# the cost savin s from not o-servin the -ranch inventories is achieved onl/ at the sacrifice of o-tainin sufficient evidence to su\$\$ort the audit o-,ective concernin existence of the inventories.

-. 1his is an a""ro"riate a\$\$lication of the costA-enefit conce\$t. Confirmation with the trustee# who is an inde\$endent third \$art/# achieves the audit o-,ectives concernin existence and ownershi\$ ,ust as satisfactoril/ as examination of the securities ; and it is a less costl/ \$rocedure. Case 7. 1. +. ). &. %. (. '. Case 8. 1. +. ). &. %. (. '. *. o-servation ins\$ection (anal/tical \$rocedures) ins\$ection (examination of documents) ins\$ection (examination of documents) in2uir/ ins\$ection (mechanical accurac/ tests) ins\$ection (examination of documents) confirmation f l h e \$ m d *. ". 1!. 11. 1+. 1). 1&. n k c a ,

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## CHAPTER 13 audit evidence

I. Review Questions 1. +. ). &. %. (. '. Refer to \$a e &"&# +nd and &th \$ara ra\$hs of the text-ook. Refer to \$a e &"&# )rd \$ara ra\$h of the text-ook. Refer to \$a e &"(# )rd \$ara ra\$h of the text-ook. Refer to \$a e &"'# 1st \$ara ra\$h of the text-ook. Refer to \$a e &"'# +nd \$ara ra\$h of the text-ook. Refer to \$a e &"*# &th \$ara ra\$h of the text-ook. !ternal doc\$mentary evidence is evidential matter o-tained from the other \$art/ to an arm<sFlen th transaction or from outside inde\$endent a encies. Gxternal evidence reaches the auditor directl/ and does not \$ass throu h the hands of the client. !ternal'internal doc\$mentary evidence is documentar/ material that ori inates outside the -ounds of the client<s data \$rocessin s/stem -ut which has -een received and \$rocessed -/ the client. (nternal doc\$mentary evidence consists of documentar/ material that is \$roduced# circulates# and is finall/ stored within the client<s information s/stem. 6uch evidence is not touched -/ outside \$arties at all or is several ste\$s removed from thirdF\$art/ attention. *. Auditors can hel\$ the effectiveness of confirmation re2uests -/8

## A\$dit Working #a"ers

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=avin the confirmation letters \$rinted on the client<s letterhead and si ned -/ a client officer. ?ein careful to -e assured of relia-le addresses for reci\$ientsH that is# -ein assured that the confirmations are not misdirected (for exam\$le# to a client<s accom\$lices in fraud). c. Askin confirmation of information that reci\$ient can su\$\$l/# like the amount of a -alance or the amounts of s\$ecified invoices or notes (not the -alances of homeowners< mort a es or financial amounts# like certificates of de\$osit with accrued interest# for which \$eo\$le usuall/ do not kee\$ their own accountin records). d. Controllin the mailin and return of confirmations so the client cannot tam\$er with them. e. Receivin the re\$l/ directl/# so the client cannot interce\$t and alter them. -act\$al evidence is direct evidence# in that conclusions ma/ -e drawn from the evidence without further corro-oration. An exam\$le of factual audit evidence is \$h/sical o-servation of inventor/ for existence. (nferential evidence is indirect# in that direct conclusions cannot -e drawn from the evidence. 1he auditor t/\$icall/ examines other evidence to further corro-orate the inferences drawn. An oral statement -/ a \$roduct mana er that one or more \$roducts are full/ salea-le and not o-solete is an exam\$le of inferential evidence. 1he auditor ma/ \$erform inventor/ turnover tests andAor determine the date of last sale of the \$roduct to further corro-orate the \$roduct mana er<s statement.

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1!. 6ufficienc/ of audit evidence is a matter of audit ,ud ment. Caterialit/ and the 2ualit/ of internal control are im\$ortant in redients in determinin sufficienc/. If internal control \$roduces over sales \$rocessin and cash recei\$ts# for exam\$le# are effective# the auditor ma/ elect to confirm fewer customers< accounts receiva-les than under conditions of weak internal control. 11. 9h/sical evidence tests the existence assertion. Gxam\$les of \$h/sical evidence are inventor/ o-servation# examination of securities# ins\$ection of \$lant asset additions# and count of cash on hand. 1+. 1he 2ualit/ of existin internal control is the ma,or factor su\$\$ortin the stren th of documentar/ evidence. A voucher \$roduced under conditions of stron internal control over the \$rocessin of vendors< invoices# for exam\$le# \$ossesses reater validit/ and is therefore stron er evidence than vouchers \$roduced under weak control conditions. 1). Auditin standards define an acco\$nting estimate as .an a\$\$roximation of a financial statement element# item or amount.0 Gstimates are used -ecause (1) an amount is uncertain \$endin s\$ecific future events or (+) relevant data cannot -e accumulated on a timel/# costFeffective -asis. Gxam\$les of accountin estimates include allowance for uncollecti-le accounts# o-solete inventor/# useful lives

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

and residual values of fixed assets# natural resources and intan i-les# accruals for taxes on real and \$ersonal \$ro\$ert/# accruals -ased on actual assum\$tions in \$ension \$lans# contract revenue usin \$ercenta e of com\$letion method# liti ation losses# fair values in nonmonetar/ exchan es# and current values in \$ersonal financial statements.

1&. In evaluatin the reasona-leness of accountin estimates# an auditor should consider the internal controls related to the estimates in order to reduce the likelihood of material misstatements in the estimates# whether the accountin estimates are reasona-le iven the situation# and whether the accountin estimates are \$resented in accordance with a\$\$ro\$riate accountin \$rinci\$les. 1%. Gvidence is \$ersuasive if the auditor considers the evidence to -e sufficient and com\$etent enou h to afford a reasona-le -asis for an o\$inion. II. Multiple Choice Questions 1. +. ). d d c &. %. (. c a d '. *. ". d d 1!. d 11. a 1+. 1). -

III. Comprehensive Cases Case 1. a. Gvidential matter o-tained from inde\$endent sources outside an enter\$rise \$rovides reater assurance of relia-ilit/ (com\$etenc/) than that which is secured solel/ within the enter\$rise.

-. Accountin data and financial statements develo\$ed under satisfactor/ conditions of internal control are more relia-le (com\$etent) than those which are develo\$ed under unsatisfactor/ conditions of internal control. c. Direct \$ersonal knowled e o-tained -/ the inde\$endent auditor throu h \$h/sical examination# o-servation# com\$utation# and ins\$ection is more \$ersuasive than information o-tained indirectl/. 1/\$es of evidence vidential items.so\$rces d. 4etter from creditor a. Conthl/ statements -. Doucher re ister c. Audit com\$utation of discounts +. in reliability rank 1. Gxternal +. GxternalFinternal ). Internal &. Cathematical (-ased on unaudited data)

Case 2. 1.

## A\$dit Working #a"ers

c. a. d. -. Audit com\$utation of ex\$ense amounts 4etter from -ond trustee Cancelled checks Cinutes of directors< meetin s 1. +. ). &. Cathematical (-ased on unaudited data) Gxternal GxternalFinternal Internal

14-15

## CHAPTER 14 audit w !"in# \$a\$e!%

I. Review Questions 1. +. Refer to \$a e %++# )rd \$ara ra\$h of the text-ook. 1he ma,or function of audit work\$a\$ers is to \$rovide evidence of conformance with enerall/ acce\$ted auditin standards. As a -od/# the work\$a\$ers are the \$rinci\$al record of the evidence which the auditor has athered and evaluated in su\$\$ort of the audit o\$inion. ). &. %. Refer to \$a es %+& to %+% of the text-ook. Refer to \$a e %+&# +nd \$ara ra\$h of the text-ook. >ith electronic s\$readsheets# audit ad,ustments need onl/ -e entered once ; in the su\$\$ortin schedule. 1he ad,ustments are then automaticall/ reflected in lead schedules and in the workin trial -alance throu h e2uations entered in a\$\$ro\$riate cells. 1he cell e2uations .link0 the work\$a\$ers such that an ad,ustment need -e entered onl/ once in order for all affected work\$a\$ers to -e automaticall/ u\$dated. (. 9ermanent files contain information that is of a continuin interest to the auditor. A \$ermanent file t/\$icall/ contains (1) co\$ies or a-stracts of si nificant com\$an/ documents and (+) auditorF or clientF\$re\$ared information on accounts. CurrentF/ear files contain workin \$a\$ers \$re\$ared to su\$\$ort the assertions em-odied in the financial statements. Client \$ersonnel ma/ \$re\$are workin \$a\$ers to reduce the time s\$ent -/ the auditor on the en a ement. >hen client \$ersonnel \$re\$are workin \$a\$ers# the auditor should ive the client \$ersonnel detailed instructions. >orkin \$a\$ers \$re\$ared -/ the client should -e identified as 9?C (\$re\$ared -/ client) and

'.

14-16
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

should involve no decision makin . 1he auditor should test com\$leted workin \$a\$ers a ainst underl/in documentation.

*.

".

1he lead schedule# es\$eciall/ on lar er en a ements# is desi ned to -rid e the a\$ -etween the workin trial -alance and the eneral led er -/ listin all eneral led er accounts that are re\$orted as one account in the financial statements. 6u\$\$ortin schedules is a term for workin \$a\$ers that su\$\$ort the amounts \$resented in the financial statements -/ \$rovidin su\$\$ort for a detailed account on a lead schedule. 6u\$\$ortin schedules re\$resent the -ulk of workin \$a\$ers. In eneral# a \$ro\$erl/ \$re\$ared workin \$a\$er should meet firm \$olic/# have a \$ro\$er headin # clearl/ indicate the work \$erformed# clearl/ meet the audit o-,ective for which it was desi ned# and clearl/ state the auditors< conclusion.

1!. 1he \$rior /ear<s audit workin \$a\$ers are a useful uide to staff assistants -ecause the audit \$rocedures \$erformed in the \$rior /ear usuall/ are similar to those of the current /ear. ?/ referrin to last /ear<s workin \$a\$ers# the assistant can see how the \$rocedures were documented and is iven a \$ossi-le format for or ani3in the current /ear<s workin \$a\$er. In addition# exce\$tions noted in last /ear<s workin \$a\$ers ma/ alert the assistant to \$ossi-le \$ro-lems in the current /ear. 5inall/# the \$rior /ear<s workin \$a\$ers contain information su-stantiatin the -e innin -alances for the current /ear. 11. 1he more common t/\$es of audit workin \$a\$ers and their \$rinci\$al \$ur\$oses ma/ -e summari3ed as follows8 (1) A\$dit administrative working "a"ers ; aid the auditors in \$lannin and administration of the audit# and include such items as the audit \$ro rams# 2uestionnaires and flowcharts# decision aids# time -ud ets# and en a ement letters. (+) Working trial balance ; re\$resents the -ack-one of the auditors< workin \$a\$ers# for it contains the -alances of the led er accounts# the ad,ustments and reclassifications deemed necessar/ -/ the auditors# and the ad,usted amounts that a\$\$ear in the financial statements. It also contains references to all su\$\$ortin schedules and anal/ses# thus servin to control the other t/\$es of workin \$a\$ers. ()) Lead sched\$les ; workin \$a\$ers that serve to com-ine similar eneral led er accounts# the total of which a\$\$ears on the workin trial -alance. (&) Ad)\$sting )o\$rnal entries ; material misstatements in the accounts disclosed -/ the auditors< investi ation are corrected -/ means of ad,ustin ,ournal entries. 1hese a\$\$ear on the auditors< workin trial -alance# and in addition# a list of such entries is turned over to the client at the conclusion of the audit with the re2uest that the/ -e a\$\$roved and entered in the accountin records.

## A\$dit Working #a"ers

14-17

(%) Reclassification entries ; entries necessar/ to \$ro\$erl/ reflect financial results -ut not re\$resentin misstatements in the financial records of the client. (() %\$""orting sched\$les ; althou h the term schedule is at times a\$\$lied to various t/\$es of workin \$a\$ers# the \$referred usa e is to desi nate a listin of the details or elements com\$risin the -alance in an account at a s\$ecified date. 9re\$aration of such a listin is often an essential ste\$ in determinin the nature of an account. (') Analyses ; consist of workin \$a\$ers showin the chan es which occurred in an account durin a iven \$eriod. ?/ anal/3in an account# the auditors determine its nature and contents. (*) Reconciliations ; workin \$a\$ers that \$rove the relationshi\$ -etween two amounts o-tained from different sources. (") Com"\$tational working "a"ers ; used to verif/ such data as interest ex\$ense# income taxes# and earnin s \$er share. (1!) Corroborating doc\$ments ; workin \$a\$ers that \$rovide su\$\$ort for s\$ecific re\$resentations made in the financial statements# such as letters of re\$resentations from clients# law/ers< letters# audit confirmations# and co\$ies of the contracts. 1+. Audit workin \$a\$ers are the \$ro\$ert/ of the auditorH however# the/ must not violate the confidential relationshi\$ -etween client and auditors -/ makin the \$a\$ers availa-le to outsiders or even to the client<s em\$lo/ees without s\$ecific \$ermission from the client. 1). Refer to \$a e %)%# 1st and +nd \$ara ra\$hs of the text-ook. 1&. Refer to \$a e %)%# )rd \$ara ra\$h of the text-ook. II. Multiple Choice Questions 1. +. ). &. %. (. '. *. d d c a d c c d ". 1!. 11. 1+. 1). 1&. 1%. 1(. a d d d d 1'. 1*. 1". +!. +1. ++. +). +&. d c c d d a +%. +(. +'. +*. +". )!. )1. )+. d d c d c d d

14-18
%ervices
Case 1. a.

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

(1) 1he functions of audit workin \$a\$ers are to aid the C9A in the conduct of his work and to \$rovide su\$\$ort for his o\$inion and his com\$liance with auditin standards. (+) >orkin \$a\$ers are the C9A<s records of the \$rocedures \$erformed# and conclusions reached in the audit. 1he factors that affect the C9A<s ,ud ment of the t/\$e and content of the workin \$a\$ers for a \$articular en a ement include8 1. 1he nature of the auditor<s re\$ort. +. 1he nature of the client<s -usiness. ). 1he nature of the financial statements# schedules or other information u\$on which the C9A is re\$ortin and the materialit/ of the items included therein. &. 1he nature and condition of the client<s records and internal controls. %. 1he needs for su\$ervision and review of work \$erformed -/ assistants. Gvidence which should -e included in audit workin \$a\$ers to su\$\$ort a C9A<s com\$liance with enerall/ acce\$ted auditin standard includes8 1. +. ). &. %. d. Gvidence that the financial statements or other information u\$on which the auditor is re\$ortin were in a reement or reconciled with the client<s records. Gvidence that the client<s s/stem of internal control was reviewed and evaluated to determine the nature# timin # and extent of audit \$rocedures. Gvidence of the auditin \$rocedures \$erformed in o-tainin evidential matter for evaluation Gvidence of how exce\$tions and unusual matters disclosed -/ auditin \$rocedures were resolved or treated. Gvidence of the auditor<s conclusions on si nificant as\$ects of the en a ement with a\$\$ro\$riate commentaries.

-.

c.

1he C9A should \$erform an ade2uate examination at minimum cost and effort and the \$recedin /ear<s \$ro rams will aid in doin this. 1he \$recedin /ear<s audit \$ro rams ordinaril/ contain information useful in the current examination (such as descri\$tions of the uni2ue features of a client<s o\$erations or records# a formali3ed se2uence of audit ste\$s in lo ical order# and a\$\$roximate time re2uirements to \$erform various \$hases of the work). 1he auditor should decide whether to use the old \$ro ram or \$re\$are a new one.

Case 2. In eneral# the workin \$a\$er is not set u\$ in a lo ical manner to show what the auditor wants to accom\$lish. 1he \$rimar/ o-,ective of the workin \$a\$er is to verif/ the endin -alance in notes receiva-le and interest receiva-le. A secondar/ o-,ective is to account for all interest income# cash received and cash

## A\$dit Working #a"ers

14-19

dis-ursed for new notes# collateral as securit/# and other information a-out the notes for disclosure \$ur\$oses.

6\$ecific deficiencies of the workin \$a\$er \$resented in the 2uestion are8 a, D -(C( /C0 1ick mark ex\$lanation .tested0 does not indicate s\$ecificall/ what was done. b, (&#RO+ & /T 6hould have se\$arate tick marks meanin 8 A reed to confirmation 5ooted 1raced to cash recei\$ts ,ournal Recom\$uted# etc. Gx\$lain all tick marks on the same \$a e of the workin \$a\$er. Recom\$ute \$ortions of notes which are lon Fterm. Column should sa/ .date \$aid to0 and this should -e confirmed. Include due dates on workin \$a\$er for these notes.

1.

+. ). &. %.

Gx\$lanation of some tick marks is not iven. Classification of lon Fterm \$ortion indicates no verification. 9aidFtoFdate row is confusin . Due dates are missin for C.C. Co.# 9. 9a-lo and 1etra Co. %#R AD%H T %OLUT(O/

c,

1he \$ur\$ose of usin an Gxcel s\$readsheet in this \$ro-lem is to ive the student some ex\$erience in \$re\$arin a sim\$le workin \$a\$er usin an Gxcel s\$readsheet. It should -e ex\$lained to students that this t/\$e of workin \$a\$er ma/ or ma/ not -e \$re\$ared in actual \$ractice# and that often tem\$lates are used to \$re\$are more timeFconsumin workin \$a\$ers. Also# whether or not tick marks are com\$uteri3ed is a matter to -e decided. 1he advanta e is that the com\$leted audit work can then -e stored and reviewed electronicall/# a direction man/ firms are oin . 7n the other hand# it ma/ -e more efficient to indicate audit work manuall/ as it is \$erformed# and a contrast in the color of the tick marks throu h use of a colored \$encil ma/ -e desira-le.

14-20
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

1he formulas used are selfFevident# so no listin is \$rovided. 1wo items deserve comment8 1. +. An advanta e of usin a s\$readsheet \$ro ram for these t/\$es of anal/ses is that footin and crossfootin are done automaticall/. >hen auditor tick marks are done -/ com\$uter# a \$ro-lem arises as to how to \$lace them on the worksheet. 7ne could use narrow columns inserted -etween the scheduled client data# or# as done here# the tick marks are \$laced in -lank rows -eneath the related data.

14-21

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance %ervices

Schedule Prepared by Approved by Account # 110 Note !ece"vable Date \$ade / Due //15/02 / //15/04 11/21/02 / De'and 11/1/02 / 4/1/04 5P200/\$o.6 1/2//0+ / 4/1/05 5P1000/\$o. 6 5/12/02 / De'and 2/+/0+ / 2/1/0/ 5P400/\$o.6 #ntere t !ate / Date Pa"d to 50 / None pd. 50 / 12/+1/0+ 50 / 12/+1/0+ 50 / 2/+0/0+ 50 / 12/+1/0+ /0 / 11/+0/0+ &ace A'ount 5000 +521 1+140 25000 (alue o) Secur"ty None None 24000 50000 *alance 12/+1/02 4000 %& +521 %& 12140 %& 0 *alance 12/+1/0+ +000 0 10+40 20000 !ece"vable 12/+1/02 104 %& 0 %& 24 %& 0 N-1 JD PP #ntere t !ece"vable 12/+1/0+ 212 0 0 2/4 Date 1/21/04 2/15/04

## Add"t"on 0 0 0 25000 ' 0 12000 ' +1000 )

#\$ #\$ #\$ #\$

Pay'ent 1000 ' +521 ' 2400 ' 5000 ' 2100 ' 1/00 ' 15/21 )

## ,arned 115 ( 102 ( 511 ( 4/4 ( 105 ( 1/2 ( 1542 ) -&

!ece"ved 0 102 ' /01 ' 200 ' 105 ' 104 ' 111/ )

#\$ #\$

2100 12000

None 10000

## 0 10400 4+140 )* #) +%,

0 %& 0 124 ) %,

0 54 /01 )* #) +%,

9e:end o) Aud"tor; 8"c% \$ar% ) &ooted #) -ro )ooted %& 8raced to pr"or year <or%"n: paper +%, 8raced total to <or%"n: tr"al balance -& 8raced total to operat"on <or%"n: paper =P/ \$ ,>a'"ned note )or payee3 'ade and due date 3 "ntere t rate3 )ace a'ount3 and value o) ecur"ty. No e>cept"on noted. # !ece"ved con)"r'at"on3 "nclud"n: date "ntere t pa"d to3 "ntere t rate3 "ntere t pa"d dur"n: 200+3 note balance3 and ecur"ty. No e>cept"on noted. ' 8raced to ca h rece"pt ?ournal

14-22

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance %ervices

( !eco'puted )or the year

MANAGEMENT ACCOUNTING (VOLUME II) - Solut o!" M#!u#l CHAPTER 1& BASIC CO'CEPTS A'D E(E)E'TS O* I'TER'A( CO'TRO(
I. Review Questions 1. +. Refer to \$a e %&*# )rd \$ara ra\$h and \$a e %&"# 1st \$ara ra\$h of the text-ook. (nternal control systems are defined as .. . . the \$rocess -/ which an entit/<s -oard of directors# mana ement andAor other \$ersonnel o-tain reasona-le assurance as to the achievement of s\$ecified o-,ectives.0 1he -asic elements of internal control are8 a. -. &. Control environment# and Control \$rocedures.

).

All internal control s/stems# due to the human factor# contain certain inherent limitations. ?ecause of these inherent limitations# internal control \$rovides reasona-le# -ut not a-solute# assurance as to the achievement of control o-,ectives. Cana ement su\$\$ort of internal control is \$rere2uisite to its effectiveness. 1hat is# no matter how sound the other com\$onents# the s/stem will not -e effective if mana ement does not su\$\$ort it and communicate that su\$\$ort throu hout the or ani3ation. An or ani3ational awareness that mana ement takes internal control seriousl/# hel\$s to maximi3e the effectiveness of the control activities. A mana ement o\$eratin st/le that su\$\$orts \$ro\$er ethical -ehavior also enhances the effectiveness of the entit/<s internal control. If em\$lo/ees \$erceive that mana ement conducts itself in accordance with \$ro\$er ethical -ehavior# such conduct will tend to reflect itself throu hout the or ani3ation. 9ro\$er ethical -ehavior# in turn# minimi3es the \$ro-a-ilit/ that financial statements will -e intentionall/ misstated.

%.

(.

A centrali3ed# efficient human resources function# an inte ral \$art of the control environment# enhances com\$etence -/ \$lacin the ri ht \$eo\$le in the ri ht ,o-s and trainin them \$ro\$erl/ to \$erform their assi ned tasks. An effective set of internal controls re2uires a careful anal/sis of decision alternatives# and the assum\$tion of hi h risk onl/ where warranted. A

'.

18-23

## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

*. mana ement attitude eared toward excessive riskFtakin ham\$ers oal attainment and there-/ com\$romises control. Conitorin affects all of the other controls -/ assurin their effectiveness over time. .7n oin 0 monitorin is recurrin and somewhat automatic. An exam\$le is the \$eriodic anal/sis of cost variances and followFu\$ control where the variance is material and controlla-le. .6e\$arate evaluation0 a\$\$lies to those controls not conducive to on oin monitorin . Inte rit/# ethical values# and com\$etence# for exam\$le# cannot -e monitored on a .realFtime0 -asis# -ut re2uire \$eriodic review for effectiveness. 5ixin of res\$onsi-ilit/ enhances control -/ \$rovidin accounta-ilit/ for assets. 1he \$erson res\$onsi-le for \$relistin incomin cash recei\$ts# for exam\$le# will -e initiall/ accounta-le for an/ discre\$anc/ -etween such \$relistin and the recei\$ted de\$osit ticket o-tained from the -ank. Knowled e of such accounta-ilit/# in turn# will encoura e care in \$re\$arin the \$relistin and in transferrin the cash recei\$ts to the \$erson desi nated as res\$onsi-le for \$re\$arin and makin -ank de\$osits.

".

1!. An/ internal control s/stem# re ardless of how sound it is# has certain inherent limitations. 1he s/stem can -e circumvented -/ collusion amon two or more em\$lo/eesH mana ement can override the structureH and the \$rocedures can -reak down tem\$oraril/ causin a la in the ada\$tation of the controls. 5or these reasons# an effective s/stem of internal control \$rovides reasona-le# -ut not a-solute assurance as to the \$revention and detection of material errors or irre ularities. Auditors# therefore# must not rel/ totall/ on a sound control s/stem as su\$\$ort for their audit o\$inion. Rather# the/ must reco ni3e the inherent limitations and# at the ver/ least# \$erform a minimum amount of su-stantive audit testin . 11. 6mall entities# t/\$icall/# cannot afford the de ree of se\$aration of functional res\$onsi-ilities existin in lar er firms. Also# small firms# t/\$icall/# cannot su\$\$ort a se\$arate internal audit staff. 5or these reasons# com\$ensatin controls are necessar/ in smaller or ani3ations. 6uch com\$ensatin controls ordinaril/ re2uire that the ownerAmana er assume an active role in reviewin transactions# examinin documents# reconcilin -ank accounts# and otherwise \$erformin man/ of the tasks normall/ done -/ internal auditors in lar er or ani3ations. 1+. 6e\$aratin recordkee\$in from custod/ of the related assets \$rovides an inde\$endentl/ maintained record which ma/ \$eriodicall/ -e reconciled with assets on hand. 1his inde\$endent record holds the \$ersonnel of a custodial de\$artment accounta-le for assets entrusted to their care. If the accountin records were maintained -/ the custodial de\$artment# o\$\$ortunit/ would exist for that de\$artment to conceal its errors or shorta es -/ mani\$ulatin the records.

18-24

Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
1). Cost controls can -e classified as either \$revention controls or detection controls. A control environment# for exam\$le# that reflects stron mana ement su\$\$ort of effective control activities and \$ro\$er ethical -ehavior# will encoura e or ani3ational \$ersonnel to -e conscientious in \$erformin their assi ned tasks# and there-/ assist in \$reventin errors or irre ularities. 9eriodic inventories and com\$arisons# on the other hand# will assist in detectin errors or irre ularities which have alread/ occurred. ?oth t/\$es of controls are vital to an effective s/stem of internal control. 1&. A com"any control "roced\$re is an action taken for the \$ur\$ose of \$reventin # detectin # or correctin errors and irre ularities in transactions. 1%. Gxam\$les of \$eriodic com\$arisons8 Count of cash on hand. Reconciliation of -ank accounts. Count of securities. Confirmation of accounts receiva-le. Confirmation of accounts \$a/a-le. 9h/sical count of inventor/. 1(. 5our kinds or functional res\$onsi-ilities that should -e se re ated8 1. Authori3ation to execute transactions. +. Recordin of transactions (-ookkee\$in ). ). Custod/ of assets. &. 9eriodic reconciliation (com\$arison) of existin (real) assets to recorded amounts. 1'. Ke/ factors in \$rotectin a ainst losses throu h em-e33lement include an ade2uate internal control structure# fidelit/ -onds# and re ular audits -/ inde\$endent \$u-lic accountants. 1*. Assumin that the eneral cate or/ of transaction has alread/ -een authori3ed -/ to\$ mana ement# at least three em\$lo/ees or de\$artments should usuall/ \$artici\$ate in each transaction to achieve stron internal control. 7ne em\$lo/ee a\$\$roves the transaction after determinin that the details conform to com\$an/ \$olicies# another em\$lo/ee records the transaction in the accountin records# and the third em\$lo/ee executes the transaction -/ releasin andAor takin custod/ of the related assets. (Eote8 the a\$\$roval function ma/ -e omitted in an extremel/ sim\$le transaction such as a cash sale not involvin a check). 1". Refer to \$a e %%' of the text-ook. II. Multiple Choice Questions

18-25

## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

1. d &. +. d %. ). (. III. Comprehensive Cases Case 1. (ELEVANT TO AU)IT* a. Les ASSE(TION A++ECTE) Com\$leteness Daluation Gxistence Daluation EAA Daluation 9resentation ,OA++ECTE)* LearFend ad,ustments for accruals andAor allocations ma/ -e overlooked. Customers ma/ -e -illed for oods not shi\$\$ed. If so# customer accounts ma/ not -e valid. EAA De-its and credits to incorrect accounts are likel/ to cause materialit/ errors. d d '. *. ". a d 1!. a 11. c 1+. c

-.

Les

c. d.

Eo Les

e.

Les

Eo assertions are adversel/ affected# iven the com\$ensatin control of conductin an annual \$h/sical inventor/ Com\$leteness Daluation 6ome cash recei\$ts ma/ not -e de\$osited. Cash in -ank andAor accounts receiva-le ma/ -e overstated# de\$endin on whether or not unde\$osited cash was recorded. 1rade accounts receiva-le should -e ke\$t se\$arate from nontrade receiva-les. Credit -alances in customer accounts should -e re\$orted as current lia-ilities. Invoices ma/ -e su-mitted a second time for \$a/ment and the si ned dis-ursement checks misa\$\$ro\$riated. 1he result ma/ -e de-its to inventor/ or other accounts for nonexistent oods or services. EAA

f.

Les

Les

9resentation

h.

Les

Gxistence Daluation

i.

Eo

EAA

18-26

Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18

Case 2. IN,E(ENT O( CONT(OL -EA.NESS a. Inherent T/0E O+ IN,E(ENT O( CONT(OL (EME)/ 1em\$orar/ -reakdown8 environmental chan es not accom\$anied -/ revised controls. Chart of accounts and accountin manualsH trainin of \$ersonnel who determine de-its to various ex\$enditure accountsH review of account distri-ution -/ second \$ersonH internal auditor review of transactions on a test -asis. Cana ement override. ?ills of ladin evidencin shi\$ment of oods should -e \$renum-ered and si ned -/ the carrier. A co\$/ should -e forwarded to accounts receiva-le and should tri er the mailin of an invoice to the customer. 1he numeric se2uence of used -ills of ladin should -e accounted for \$eriodicall/ and -ills of ladin should -e matched with customer invoices on a test -asis. ?illin clerks should not handle cash recei\$ts. Incomin cash recei\$ts should -e \$relisted and com\$ared with dail/ de\$osits. Credits to customer accounts should -e made from remittance advices. Checks should -e forwarded directl/ to the treasurer (cashier) for de\$osit. >riteoffs of customer accounts should re2uire a\$\$roval -/ the credit mana er or some other res\$onsi-le officer. Collusion

-.

Control

c. d.

Inherent Control

e.

Control

f. Case 31 a.

Inherent

1he "lanned assessed level of control risk is the level the auditors intend to use in \$erformin the audit for a \$articular financial statement assertion. 5or exam\$le# after o-tainin the understandin of internal control necessar/

18-27

## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

to \$lan the audit# the auditors will \$ro,ect a \$lanned assessed level of control risk -ased on their understandin of the internal control structure. 1he assessed level of control risk is the level of risk -ased on the tests of controls \$erformed to evaluate control risk for an assertion. Control risk is the actual# -ut unknown# level of risk \$ertainin to an assertion. >hile o-tainin an understandin of the internal control structure# the auditors ma/ determine a "lanned assessed level of control risk for the existence of accounts receiva-le which re2uires them to test a sam\$le of sales transactions. ?ased on the results of the tests of controls for sales# the auditors ma/ arrive at an assessed level of control risk that is either hi her or lower than the level \$lanned. 1he act\$al level of control risk for existence of receiva-les is# as alwa/s# at an unknown level. After o-tainin an understandin of the internal control structure# the auditors assess control risk. At this \$oint the/ ma/ or ma/ not have \$erformed some tests of controls. >hen the/ -elieve that a lower level of assessed control risk ma/ -e \$ossi-le# and that the related reduction of su-stantive tests ma/ -e cost ,ustified# the auditors will \$erform additional tests of controls. 5inall/# when the additional tests of controls have -een \$erformed# the auditors will reassess control risk and desi n su-stantive tests. 7-tain an understandin 9re\$are flowchart 9re\$are checklists 9re\$are 2uestionnaires 9erform walkFthrou h of transactions 9erform some tests of controls Anal/3e results o-tained 9erform in2uir/ \$rocedures Ins\$ect documents for \$erformance 7-serve a\$\$lication of \$rocedures Re\$erform a\$\$lication of \$rocedures Anal/3e results o-tained

-.

Case 41 a.

-.

Determine the \$lanned assessed level of control risk 9erform additional tests of controls

## Reassess control risk and desi n su-stantive tests

Case 51 6ince Das2ue3<s consideration of the internal control structure shows that controls are ver/ weak# he ma/ omit \$erformin tests of controls. =e must# however# have an ade2uate understandin of internal control to \$lan the remainder of the audit. At a minimum# Das2ue3 should o-tain a -asic understandin of the control environment# accountin s/stem# and im\$ortant

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

1hrou h tests of controls the C9As o-tain reasona-le assurance that the internal control \$olicies and \$rocedures are in use and are o\$eratin as \$lanned# and the/ ma/ detect material errors of t/\$es not susce\$ti-le to effective internal control. In addition# such testin ena-les the C9As to com\$l/ with the third standard of field work which calls for o-tainin sufficient com\$etent evidential matter to \$rovide a reasona-le -asis for an o\$inion. Eote to instructor ; Auditors ma/ fore o tests of controls if the/ conclude that internal controls are so weak as to \$rovide no basis for assessing control risk at a level lower than the ma!im\$m. Case 71 0U(0LE CO(01 (#2 M#t&' #l" (&3o'4 !5 #!4 T'#!"6&'' !5 S7"t&8 +lo23\$#'t )&3&89&' 31: 2003
Start STORES Goods from Supplier

## ACCOUNTIN. IN ENTORY C"ER/

Stock-in Report

MANUFACTURIN.
Clerk Prepares Requisition

Requisitio n 1

Stock-in Report

Filed by date

## Supervisor Approves Requisition

Filed by date

Approved Requisitio n

Approved Requisitio 1 n 2

## Filed by !ob "rder

18-30
Posts ransfer to Perpetual Inventory Records Inventory Records at Standard Cost

Filed by date

Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18

Case 81 a.

1he 2uantit/ of seriall/ num-ered tickets issued durin the shift of each cashier is multi\$lied -/ the \$rice \$er ticket to determine the amount of cash which the cashier should have on hand at the end of the shift. 1wo em\$lo/ees \$artici\$ate in each transaction. 1he withholdin cash recei\$ts would re2uire collusion -etween the cashier and the door attendant -ecause the door attendant does not have access to cash and the cashier cannot cause a \$atron to -e admitted without issuin to him a seriall/ num-ered ticket.

-.

1he followin ste\$s should -e taken -/ the mana er to make these controls work effectivel/8 (1) Caintain careful control over unused rolls of tickets. (+) Cake a record of the serial num-er of the first and last ticket issued on each cashier<s shift. ()) Count the cash in \$ossession of cashier at -e innin and end of shift.

In addition to these re ular routines# the mana er should take the followin ste\$s at unannounced intervals8 (&) 7-serve that the cashier never has loose tickets in his or her \$ossession and does not sell tickets in an/ manner other than e,ectin them from the ticket machine. (%) Derif/ -/ ins\$ection of tickets -ein \$resented -/ \$atrons to the door attendant that onl/ recentl/ issued tickets (current serial num-ers) are -ein used. c. Collusion -/ the cashier and door attendant to a-stract cash recei\$ts often consists of the door attendant \$ocketin whole tickets \$resented -/ \$atrons rather than tearin the ticket in half. =e or she ma/ then ive these unused tickets to the cashierH the cashier ma/ then resell the tickets to customers at the -ox office rather than \$unchin out new tickets on the machines. 1he cashier withholds the cash received from sales of these .used tickets0 and divides it with the door attendant.

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

d. 7-servation on a sur\$rise -asis -/ the mana er of the serial num-ers of tickets -ein \$resented at the door -/ customers ma/ reveal that these tickets are not freshl/ issued ones. 7-servation of the cashier<s work ma/ reveal that this em\$lo/ee is handlin loose tickets.

## CHAPTER 1+ CO'SIDERATIO' O* I'TER'A( CO'TRO( I' A *I'A'CIA( STATE)E'TS AUDIT

I. Review Questions 1. An auditor o-tains an understandin of a client<s internal control structure as a \$art of the control risk assessment \$rocess in order (1) to \$lan the nature# timin # and extent of su-se2uent su-stantive audit \$rocedures# and (+) to o-tain information a-out re\$orta-le conditions (control deficiencies) to re\$ort to the client. 1he \$rimar/ reason for conductin an evaluation of a client<s existin internal control s/stem is to ive the auditors a -asis for finali3in the details of the account -alance audit \$ro ram ; to determine the nature# timin and extent of su-se2uent su-stantive audit \$rocedures. A secondar/ \$ur\$ose for conductin an evaluation of internal control is to -e a-le to make constructive su estions for im\$rovements. 7fficiall/# the \$rofession considers these su estions a \$art of the audit function and does not define the work as a CA6 consultation. Another \$ur\$ose of the evaluation is to re\$ort to mana ement and the -oard of directors or its audit committee an/ discover/ of .an/ re\$orta-le conditions0 of internal control deficiencies. ). &. Refer to \$a e %"!# 1st \$ara ra\$h of the text-ook. 1. Advanta es of control 2uestionnaire8 Gas/ to com\$lete. Checklist of 2uestions. 4ess chance of overlookin somethin im\$ortant. Disadvanta es8 Ca/ contain numerous irrelevant 2uestions.

+.

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
1endenc/ to treat it like another form to fill out. +. Advanta es of memorandum documentation8 Can ex\$lain the \$recise controls a\$\$lica-le to the \$articular client. (\$recise tailorin ) Re2uires \$enetratin anal/sis. Cinimi3es tendenc/ toward \$erfunctor/ review. Disadvanta es8 =ard to write. 7ften len th/. =ard to revise in su-se2uent /ears. ). Advanta es of flowchart8 Ira\$hic \$resentation of s/stems. 6hows the ste\$s re2uired and the flow of forms and documents. Gas/ to read and anal/3e. Gas/ to u\$date in su-se2uent /ears. Disadvanta es8 1akes some time to draw neatl/.

%.

.7-servation#0 in a test of control \$rocedure# refers to auditors lookin to see whether client \$ersonnel stam\$ed# initialed# or left other si ns that their assi ned control \$rocedures had -een \$erformed. .Re\$erformance#0 in a test of control \$rocedure# refers to auditors doin a ain the control that was su\$\$osed to have -een \$erformed -/ the client \$ersonnel (recalculatin # lookin u\$ the ri ht \$rice# com\$arin 2uantities# and so forth).

(.

>ritten re\$orts on internal accountin control (IAC) for external use. Ty"e of ngagement 6\$ecial IAC stud/ 6ervice auditor en a ed to re\$ort for -enefit of user auditor and their mutual client. Character of Re"ort Re\$ort on IAC with o\$inion on IAC s/stem taken as a whole. A s\$ecialF\$ur\$ose re\$ort on IAC can take s\$ecial forms# the main feature of which includes an o\$inion relatin to the controls a\$\$lied -/ the service or ani3ation to the client or ani3ation<s transactions.

'.

1he auditor must o-tain a sufficient understandin of the client<s s/stem of internal financial controls to identif/ the t/\$es of \$otential material misstatements of financial statement com\$onents# and the risks associated with

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

each. 6uch understandin is o-tained -/ atherin evidence relatin to the -asic elements of the client<s internal financial controls. *. 1he auditor o-tains an initial understandin of the client<s financial controls -/ stud/in the or ani3ational structure# in2uirin of mana ement# and stud/in last /ear<s workin \$a\$ers if a recurrin audit. 1he documentation of the auditor<s understandin must \$rovide clear evidence of su\$\$ort for the auditor<s conclusions re ardin the assessed level of control risk. 1his is es\$eciall/ necessar/ if control risk is assessed -elow the maximum level. 1he documentation at this \$oint t/\$icall/ consists of some com-ination of narrative memoranda# 2uestionnaires or checklists# and internal control flowcharts# as well as documentation of the auditor<s conclusions# and the reason(s) for assessin control risk -elow maximum# if a\$\$lica-le.

".

1!. 1estin of internal financial controls ma/ \$ermit the auditor to further reduce the assessed level of control risk. 1his# in turn# should lead to a decrease in the nature# timin # andAor extent of su-stantive audit testin in the circumstances. 11. 1he followin factors ma/ cause the auditor to decide not to test the client<s internal financial controls -e/ond o-tainin an initial understandin 8 a. -. Controls ma/ alread/ have -een evaluated as ineffectiveH 5urther testin is not cost effective (i.e.# the cost of further testin is reater than the cost savin s resultin from reduced su-stantive testin )

1+. 6ome com-ination of the followin means is t/\$icall/ utili3ed -/ the auditor in testin a client<s internal financial controls8 a. -. c. Re\$rocessin transactions throu h the client<s s/stemH 7-servation of controlsH and Document examination and testin .

1). &isre"resentation is a form of financial statement misstatement caused -/ intentional efforts -/ mana ement to distort re\$orted financial \$osition andAor results of o\$erations. &isa""ro"riation is a form of fraud where-/ one or more em\$lo/ees effect a transfer of assets from em\$lo/er to em\$lo/ee# accom\$anied -/ concealment in the form of account or su-stance alteration. 1&. 1he followin are some exam\$les of internal control weaknesses and su ex\$anded su-stantive testin # iven the weaknesses8 a. ested

9er\$etual inventor/ records not maintained8 Gx\$and test counts durin inventor/ o-servation -. ?ank accounts not reconciled8 Gx\$and /earFend audit of cash accounts

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
c. Customer exce\$tions to monthl/ statements not investi ated and cleared8 Gx\$and accounts receiva-le confirmation at /earFend.

1%. Re\$orta-le conditions are matters comin to the auditor<s attention# as a result of hisAher stud/ and evaluation of the client<s internal financial controls# relatin to si nificant deficiencies in the desi n or o\$eration or of the internal controls that could adversel/ affect the or ani3ation<s a-ilit/ to record# \$rocess# summari3e# and re\$ort financial data consistent with the assertions of mana ement in the financial statements. 1he \$ur\$ose of the re\$orta-le conditions letter is to inform the audit committee# or similar -od/ within the or ani3ation# of weaknesses for which the/ ma/ not -e aware. 6uch communication increases the likelihood that the weaknesses will -e corrected on a timel/ -asis. 1(. Use of an/ one of the a\$\$roaches to stud/in and documentin a client<s internal financial controls# -/ itself# is inade2uate. Gach a\$\$roach adds a needed dimension to the anal/sis. 1he memorandum re2uires de\$th of anal/sis not found in the flowchart. 1he flowchart# on the other hand# \$romotes ease of understandin and read/ identification of stren ths and weaknesses in controls. 1he 2uestionnaires and checklists add the dimension of com\$leteness of covera e. ?/ usin the three tools in com-ination# the auditor is a-le to ain a dee\$er and clearer understandin of each of the su-sets of the transaction c/cles# includin ma,or control stren ths and weaknesses# there-/ \$ermittin more accurate control risk assessments and more useful su-stantive audit \$ro rams -ased on such assessments. II. Multiple Choice Questions 1. +. ). &. %. (. '. a d *. ". 1!. 11. 1+. 1). 1&. a c a 1%. 1(. 1'. 1* 1". +!. +1. d c a d a ++. +). +&. +%. +(. +'. +*. a a d d d

III. Comprehensive Cases Case 1. a. Iiven identified financial control weaknesses# the auditor ma/ elect to ex\$and the extent of su-stantive testin # or search for and test com\$ensatin controls. In the \$resent case# the followin errors and irre ularities ma/ occur# iven the control weaknesses in the \$a/roll su-set of the ex\$enditure c/cle8 1. =ours ma/ -e in error# inasmuch as the time cards are \$re\$ared -/ em\$lo/ees and not reviewed. 1his could lead to overstatement or understatement of wa es ex\$ense in the income statement. 1his

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

could also affect the carr/in value of finished oods inventories if Muick/ is a manufacturin com\$an/. +. 1he \$a/roll could -e .\$added0 inasmuch as si ned checks are returned to the de\$artment su\$ervisors for distri-ution. 1his could result in overstatements of salaries and wa es ex\$ense on the income statement. It could also cause a finished oods inventor/ overstatement.

-.

If# -ased on the initial understandin # controls are thou ht to -e ade2uate# the auditor should consider the followin alternatives8 1. Document the understandin # assess control risk -elow maximum# as considered a\$\$ro\$riate# and document the -asis for conclusionsH or Document the understandin and test controls as a means for further reduction in the assessed level of control risk. 1his alternative would -e chosen if the followin conditions exist8 a. -. Controls are thou ht to -e effectiveH and Cost reductions throu h reduced su-stantive testin exceed cost of further testin of controls.

+.

c.

1.

Auditors must stud/ and evaluate internal control each /ear -ecause the environment within which the client o\$erates is su-,ect to constant chan eH and controls must ada\$t to these chan es if the s/stem is to remain effective. 1he auditor must identif/ the environmental chan es and determine that the relevant control \$oints remain covered after the chan es. A minimum audit is necessar/# even under conditions of excellent internal control# -ecause of the followin inherent limitations in all internal control s/stems8 Internal control assumes the nonexistence of collusionH Cana ement can override the financial controlsH 1em\$orar/ -reakdowns in the control s/stem ma/ occur and \$roduce material errorsH Iiven that these inherent limitations could \$roduce material financial statement misstatements# and iven that the audit re\$ort \$rovides reasona-le assurance that the financial statements do not contain material misstatements# the auditor must \$erform a minimum audit# even under conditions of excellent internal control if such assurance is to -e \$rovided.

+.

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18

Case 2. ISLAN)E( )(UG STO(E: INC1 0'o3&"" !5 C#"\$ Coll&3t o!" I!t&'!#l Co!t'ol ;u&"t o!!# '& 012es%3-4 Are cu to'er <ho pay by chec% "dent")"ed v"a tore #.D. card or other 'ean @ Doe co'pany pol"cy proh"b"t accept"n: chec% )or anyth"n: e>cept 'erchand" e ale plu a no'"nal ca h a'ount@ # a rece"pt produced by the ca h re:" ter :"ven to each cu to'er@ # the read"n: o) each ca h re:" ter ta%en per"od"cally by an e'ployee <ho " "ndependent o) the handl"n: o) ca h rece"pt @ Are ca h count 'ade on a urpr" e ba " by an "nd"v"dual <ho " "ndependent o) the handl"n: o) ca h rece"pt @ # the read"n: o) each ca h re:" ter co'pared re:ularly to the ca h rece"ved@ # a u''ary l" t"n: o) ca h re:" ter read"n: prepared by an e'ployee <ho " "ndependent o) phy "cally handl"n: ca h rece"pt @ Are rece"pt )or<arded to an "ndependent e'ployee <ho 'a%e the ban% depo "t @ Are each day; rece"pt depo "ted "ntact da"ly@ # the u''ary l" t"n: o) ca h re:" ter rece"pt reconc"led to the dupl"cate depo "t l"p authent"cated by the ban%@ Are entr"e to the ca h rece"pt ?ournal prepared )ro' dupl"cate depo "t l"p or the u''ary l" t"n: o) ca h re:" ter Yes N-

18-37

## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

read"n: @ Are the entr"e to the ca h rece"pt ?ournal co'pared to the depo "t per ban% tate'ent@ Are area "nvolv"n: the phy "cal handl"n: o) ca h rea onably a)e:uarded@ Are e'ployee <ho handle rece"pt bonded@ Are char:ed bac% "te' 5NS& chec% 3 etc.6 d"rected to an e'ployee <ho doe not phy "cally handle rece"pt or have acce to the boo% @

## CHAPTER 1, BASIC AUDIT SA)P(I'- CO'CEPTS

I. Review Questions 1. +. ). &. Refer to \$a e ()*# )rd \$ara ra\$h of the text-ook. Refer to \$a e ()*# &th \$ara ra\$h of the text-ook. Refer to \$a e (&! of the text-ook. Audit conclusions can -e made onl/ a-out the \$o\$ulation from which the sam\$le was drawn# and a conclusion can onl/ -e valid if the sam\$le on which it is -ased actuall/ shows the characteristics of the \$o\$ulation. Auditors can attem\$t to achieve re\$resentativeness# -ut the/ cannot uarantee it. 6am\$lin risk ; the \$ro-a-ilit/ that the sam\$le does not ade2uatel/ reflect the \$o\$ulation ; alwa/s exists. Refer to \$a e (&(# +nd \$ara ra\$hH \$a e (&'# 1st \$ara ra\$h of the text-ook. Refer to \$a e (&'# (th \$ara ra\$h of the text-ook. Refer to \$a e (%+# \$ara ra\$hs 1 to & of the text-ook. Refer to \$a e (%+# \$ara ra\$hs ) and & of the text-ook. Refer to \$a e (%)# &th \$ara ra\$h N \$a e (%&# 1st to )rd \$ara ra\$h of the text-ook.

%. (. '. *. ".

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
1!. %am"ling risk is the \$ro-a-ilit/ that the auditor<s conclusions concernin the \$o\$ulation will -e in error. In terms of conclusions re ardin internal control# sam\$lin risk consists of two su-sets8 Al"ha risk# the risk that the auditor will assess control risk too hi h and \$erform more su-stantive testin than is necessar/ under the circumstancesH and 1eta risk# the risk that the auditor will assess control risk too low and \$erform less su-stantive testin than is necessar/. 5or control testin \$ur\$oses# the auditor is more concerned with -eta risk than al\$ha risk# -ecause -eta risk \$oses the threat of underauditin and is therefore the -asis for the audit o\$inion. 1he auditor controls this risk -/ settin -eta risk sufficientl/ low as to maintain overall audit risk at a level less than or e2ual to 1!B. 11. Refer to \$a es ((1 to (() of the text-ook. 1+. Refer to \$a es (%% to ((! of the text-ook. II. Multiple Choice Questions 1. +. c ). &. d c %. (. d '. *. a d ". a 1!. c

III. Comprehensive Cases Case 1. a. Areas re2uirin the auditors to make ,ud ment decisions when statistical sam\$lin techni2ues are em\$lo/ed (onl/ four re2uired)8 (1) Definin \$o\$ulation# characteristics to -e tested# and deviations. Unless a relationshi\$ is defined -etween the occurrence rate of deviations in the \$o\$ulation and either the validit/ of the client<s financial statement or the stren th of internal control# little useful information is ained -/ estimatin the occurrence rate. (+) Determinin the a\$\$ro\$riate statistical selection techni2ues for drawin a random sam\$le. 1he auditors must reco ni3e the advanta es and disadvanta es of stratified selection# unstratified selection# and s/stematic selection# and determine which techni2ue is a\$\$ro\$riate for selectin an economical random sam\$le. ()) Gsta-lishin the re2uired maximum tolera-le deviation rate and the risk of assessin control risk too low for the \$rocedure. 1his re2uires ,ud ment decisions re ardin materialit/# time# cost# and the \$lanned assessed level of control risk.

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

(&) Inter\$retin sam\$le results. 1his re2uires a decision as to whether the results su\$\$ort the auditors< \$lanned assessed level of control risk# or whether additional sam\$lin is necessar/ to reach a conclusion. (%) 5ollowin u\$ on the discover/ of critical errors or unacce\$ta-le deviation rates. (() Determinin the circumstances under which statistical sam\$lin is a\$\$ro\$riate# and those in which other techni2ues should -e used in lieu# of or to su\$\$lement# the statistical sam\$lin techni2ues. 1his is an o\$enFended 2uestion. 1he student ma/ identif/ numerous other areas in which the auditors must make ,ud ment decisions. -. If the C9As< sam\$le shows an unacce\$ta-le deviation rate# the/ ma/ take the followin actions8 (1) 1he/ ma/ enlar e their sam\$le to increase the \$recision of their estimate. (+) 1he/ ma/ isolate the t/\$e of deviation and ex\$and examination as it relates to the transactions that ive rise to that t/\$e of misstatement. ()) 1he auditors< usual res\$onse to an unacce\$ta-l/ hi h deviation rate is to increase their assessed level of control risk. Accordin l/# the auditors would increase the intensit/ of their su-stantive tests. c. 1echni2ues for selectin an unstratified random sam\$le of accounts \$a/a-le vouchers include the followin 8 Random %am"le. A random sam\$le is a sam\$le of a iven si3e drawn from a \$o\$ulation in a manner such that ever/ \$ossi-le sam\$le of that si3e is e2uall/ likel/ to -e drawn. Items ma/ -e selected randoml/ -/8 (1) 1a-le of Random Eum-ers. Use one of a num-er of \$u-lished ta-les. Usin four columns in the ta-le# select the first *! num-ers which fall within the ran e of 1 to )#+!!. 1he startin \$oint in the ta-le should -e selected randoml/ and the \$ath to -e followed throu h the ta-le should -e set in advance and followed consistentl/. (+) Random Eum-er Ienerator8 Usin enerali3ed audit software# enerate a list of *! random num-ers. %ystematic %am"le. A s/stematic sam\$le is drawn -/ selectin ever/ n th item -e innin with a random start. (1) Gver/ nth item. 6elect ever/ &! th voucher after selectin the initial voucher (from 1 to &!) randoml/. (+) 6everal random startin \$oints. 5or exam\$le# use two random startin \$oints and select &! of the *! vouchers from each of the two se2uences.

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
6elect ever/ *!th voucher ()#+!!A&!) after each of the two random startin \$oints -etween 1 and *! for each of the two se2uences. Case 2. a. (1) 6ince the results of tests of controls t/\$icall/ \$la/ a si nificant role in determinin the nature# timin # and extent of other audit \$rocedures# the auditors usuall/ s\$ecif/ a low level of risk of assessin control risk too low. It is usuall/ set at % or 1! \$ercent. (+) In determinin the tolera-le deviation rate# an auditor should consider the \$lanned assessed level of control risk and the extent of assurance desired from the evidential matter included in the sam\$le. ()) In determinin the ex\$ected \$o\$ulation deviation rate# an auditor should consider the results of \$rior /ears< tests# the overall control environment# or utili3e a \$reliminar/ sam\$le.

-.

(1) 1here is a decrease in sam\$le si3e if the acce\$ta-le level of the risk of assessin control risk too low is increased. (+) 1here is a decrease in sam\$le si3e if the tolera-le deviation is increased. ()) 1here is an increase in sam\$le si3e if the \$o\$ulation deviation rate is increased.

c.

Usin a statistical sam\$lin a\$\$roach# + 5u'& 1814 reveals that ' deviations in a sam\$le of si3e 1!! results in an achieved u\$\$er deviation rate of 1+.*B# well in excess of the tolera-le deviation rate (*B). 1he sam\$le results should thus -e inter\$reted as not su\$\$ortin the \$lanned assessed level of control risk. Usin a nonstatistical sam\$lin a\$\$roach# the 'B estimated \$o\$ulation deviation rate identified in the sam\$le (' deviations A 1!! sam\$le items) a\$\$roaches the tolera-le deviation rate of *B. 1herefore# usin a nonstatistical a\$\$roach# the sam\$le result would also -e inter\$reted as not su\$\$ortin the \$lanned assessed level of control risk.

d.

6tatistical sam\$lin allows the auditors to 2uantif/ sam\$lin risk. As descri-ed in \$art (c)# onl/ when statistical sam\$lin is used do the auditors know that the achieved u\$\$er deviation rate is 1+.*B.

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

CHAPTER 1. APP(ICATIO' O* /UA'TITATI0E TECH'I/UES I' P(A''I'-1 CO'TRO( A'D DECISIO' )AKI'- II
I. Questions 1. 9GR1 is su\$erior to Iantt Charts in com\$lex \$ro,ects -ecause8 a. 9GR1 charts are flexi-le and can reflect sli\$\$a e or chan es in \$lans# -ut Iantt charts sim\$l/ \$lot a -ar chart a ainst a calendar scale. -. 9GR1 charts reflect interde\$endencies amon activitiesH Iantt charts do not. c. 9GR1 charts reflect uncertainties or tolerances in the time estimates for various activitiesH Iantt charts do not. +. 1he use of 9GR1 \$rovides a structured foundation for \$lannin com\$lex \$ro,ects in sufficient detail to facilitate effective control. A worka-le se2uence of events that com\$rise the \$ro,ect are first identified. Gach ke/ event should re\$resent a taskH then the interde\$endent relationshi\$s -etween the events are structured. After the network of events is constructed# cost and time \$arameters are esta-lished for each \$acka e. 6taffin \$lans are reviewed and anal/3ed. 1he .critical \$ath0 com\$utation identifies se2uence of ke/ events with total time e2ual to the time allotted for the \$ro,ect<s com\$letion. @o-s which are not on the critical \$ath can -e slowed down and the slack resources availa-le on these activities reallocated to activities on the critical \$ath. Use of 9GR1 \$ermits sufficient schedulin of effort -/ functional areas and -/ eo ra\$hic location. It also allows for restructurin schedulin efforts and rede\$lo/ment of workers as necessar/ to com\$ensate for

18-42

Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
dela/s or -ottlenecks. 1he \$ro-a-ilit/ of com\$letin this com\$lex \$ro,ect on time and within the allotted -ud et is increased. ). 1ime sli\$\$a e in noncritical activities ma/ not warrant extensive mana erial anal/sis -ecause of availa-le slack# -ut activit/ cost usuall/ increases with time and should -e monitored. &. 1he critical \$ath is the network \$ath with the lon est cumulative ex\$ected activit/ time. It is critical -ecause a slowdown alon this \$ath dela/s the entire \$ro,ect. %. Crashin the network means findin the minimum cost for com\$letin the \$ro,ect in minimum time in order to achieve an o\$timum tradeoff -etween cost and time. 1he differential crash cost of an activit/ is the additional cost of that activit/ for each \$eriod of time saved. (. 6lack is the amount of time an event can -e dela/ed without affectin the \$ro,ect<s com\$letion date. 6lack can -e utili3ed -/ mana ement as a -uffer a ainst -ottlenecks that ma/ occur on the critical \$ath. '. Unit ross mar in are t/\$icall/ com\$uted with an allocation of fixed costs. 1otal fixed costs enerall/ will not chan e with a chan e in volume within the relevant ran e. Uniti3in the fixed costs results in treatin them as thou h the/ are varia-le costs when# in fact# the/ are not. Coreover# when multi\$le \$roducts are manufactured# the relative contri-ution -ecomes the criterion for selectin the o\$timal \$roduct mix. 5ixed costs allocations can distort the relative contri-utions and result in a su-o\$timal decision. *. 1his a\$\$roach will maximi3e \$rofits onl/ if there are no constraints on \$roduction or sales# or if -oth \$roducts use all scarce resources at an e2ual rate. 7therwise mana ement would want to maximi3e the contri-ution \$er unit of scarce resource. ". 1he o\$\$ortunit/ cost of a constraint is the cost of not havin additional availa-ilit/ of the constrained resources. 1his is also called a shadow \$rice. 1!. 1he feasi-le \$roduction re ion is the area which contains all \$ossi-le com-inations of \$roduction out\$uts. It is -ounded -/ the constraints im\$osed on \$roduction \$ossi-ilities. 1he \$roduction schedule which mana ement chooses must come from the feasi-le \$roduction re ion. 11. 1he accountant usuall/ su\$\$lies the contri-ution mar in data that is used in formulatin a \$rofitFmaximi3in o-,ective function. In addition# the

18-43

## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

accountant \$artici\$ates in the anal/sis of linear \$ro rammin out\$uts -/ assessin the costs of additional ca\$acit/ or of chan es in \$roduct mix. 1+. a. -. c. d. e. f. . h. i. ,. =ourl/ fee for inventor/ audit (C) 6alar/ of \$urchasin su\$ervisor (E) Costs to audit \$urchase orders and invoices (9) 1axes on inventor/ (C) 6tockout costs (9) 6tora e costs char ed \$er unit in inventor/ (C) 5ire insurance on inventor/ (C) 5ire insurance on warehouse (E) 7-solescence costs on inventor/ (C) 6hi\$\$in costs \$er shi\$ment (9)

1). Althou h the inventor/ models are develo\$ed -/ o\$erations researchers# statisticians and com\$uter s\$ecialists# their areas of ex\$ertise do not extend to the evaluation of the differential costs for the inventor/ models. Ienerall/# discussions of inventor/ models take the costs as iven. It is the role of the accountant to determine which costs are a\$\$ro\$riate for inclusion in an inventor/ model. 1&. Cost of ca\$ital re\$resents the interest ex\$ense on funds if the/ were -orrowed or o\$\$ortunit/ cost if funds were \$rovided internall/ or -/ owners. It is included as carr/in cost of inventor/ -ecause funds are tied u\$ in inventor/. 1%. Costs that var/ with the avera e num-er of units in inventor/8 Inventor/ insurance Inventor/ tax 1otal 9urchase \$rice Insurance on shi\$ment 1otal 9 +.*! +.!% (91!+.+% x +B) 9 &.*% 91!+.+% 1.%! 91!).'%

## Costs that var/ with the num-er of units \$urchased8

1otal carr/in cost = (+%B x 91!).'%) cost of ca\$ital O 9&.*% = 9+%."& O 9&.*% = 9)!.'" 7rder costs8 6hi\$\$in \$ermit Costs to arran e for the shi\$ment Unloadin 9+!1.(% +1.&% *!.+!

18-44

Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
6tockout costs 1otal 1++.!! 9&+%.)!

II. Pro#lems 0'o9l&8 1 (6olution is found on the next \$a e.) 0'o9l&8 2 Re*\$irement 2a3 1he critical \$ath throu h each of the three alternative \$aths calculated as the lon est is ! F 1 F (F 'F *. !F1F+F%F* !F1F)F&F'F* !F1F(F'F* PPPPPPPP + O * O 1! O 1& +O*O'O%O) + O +( O " O ) = = = )& +% &!J

J critical
Re*\$irement 2b3 &! F ) F % = )+ Re*\$irement 2c3 If \$ath & F ' has an unfavora-le time variance of 1!# this means it takes a total time of 1% to finish this activit/ rather than %. 1his ives the \$ath ! F 1 F ) F & F ' F * a total time of )%# -ut since this is less than the critical \$ath of &!# it has no effect. Re*\$irement 2d3 1he earliest time for reachin event % via ! F 1 F + F % is +!# the sum of the ex\$ected times. 0'o9l&8 3

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## C\$#%t&' 18 Application of Quantitative Techniques in Planning, Control and Decision Making !!

Eo# the/ didn<t make a ri ht decision# since the/ included fixed costs which do not differ in the short run. If the/ had used contri-ution mar in instead of ross mar in# the/ would have had 9% for I1 and 9(.%! for I+# therefore the/ would have decided to \$roduce I+ exclusivel/.

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Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
0'o9l&8 1 Re*\$irement 2a3
TAS.S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Hobbing

7rder 1

7rder & Q Q Q

## Re*\$irement 2b3 +* da/s are re2uired for the four orders.

18-47

Application of Quantitative Techniques in Planning, Control and Decision Making " !! C\$#%t&' 18
0'o9l&8 4 7rder costs 9 Carr/in costs 6 a. Carr/in costs8 M6 + = +%! x 91!".&! + = 91)#('%.!! = = = = Insurance 9*(! O O O O 7ther order costs 91* Cost of ca\$ital on inventor/ +!B x 9+++ = 911".&! = 9*'*

## 1#%!! x 9*'* +%!

9 %#+(*.!! 91*#"&).!!

= +&#!''

1%% units

## 1#%!! x 9*'* 1%%

9 *#&"(.'' 91(#"'%.+'

18-48

## A Risk'based A\$dit A""roach 4 #art (( 0'o9l&8 5

11-49

It is necessar/ to evaluate the annual carr/in costs and ex\$ected stockout costs at each safet/Fstock level. 1he carr/in cost will -e 9+&.&! for each unit in safet/ stock. >ith the iven order si3e# there are 1% orders \$laced a /ear (i.e.# )"#!!!A+#(!! = 1%). ?ased on these com\$utations# we \$re\$are the followin schedule8
%afety %tock ! 1%! 1'% +%! Carrying Costs of %afety %tock ! 1%! x 9+&.&! = 9)#((! 1'% x 9+&.&! = 9&#+'! +%! x 9+&.&! = 9(#1!!!"ected %tocko\$t Costs !.%! x 1%a x 91#(%! = 91+#)'% !.+! x 1%a x 91#(%! = 9 &#"%! !.!% x 1%a x 91#(%! = 9 1#+').% !.!1 x 1%a x 91#(%! = 9 +&'.% Total Costs 91+#)'% *#(1! %#%!'.% (o\$tional) (#)&'.%

a -

1% is the num-er of orders \$er /ear. It should -e evident that at this level the carr/in costs alone exceed the total costs at a safet/ stock of 1'% units. 1herefore# it is not \$ossi-le for this or an/ safet/Fstock level lar er than +%! to -e less costl/ than 1'% units. Indeed# iven a total cost at 1'% units of 9%#%!'.%# stockout costs would have to occur with \$ro-a-ilit/ 3ero for an/ safet/ stock reater than ++%.'+ units (i.e.# 9%#%!'.% A 9+&.&! = 9++%.'+).

III. Multiple Choice Questions 1. +. ). &. %. (. '. *. ". 1!. C ? D ? D C A A A C 11. 1+. 1). 1&. 1%. 1(. 1'. 1*. 1". +!. +1. D C A A A C C D C D +1. ++. +). +&. +%. +(. +'. +*. +". )!. )1. D C C D D ? D G ? A )1. )+. )). )&. )%. )(. )'. )*. C D A C D C D D

18-49

11-50
%ervices

## CHAPTER 12 AUDIT SA)P(I'- *OR SUBSTA'TI0E TESTS

I. Review Questions 1. An incorrect acce"tance decision directl/ im\$airs the effectiveness of an audit. Auditors wra\$ u\$ the work and the material misstatement a\$\$ears in the financial statements. An incorrect re)ection decision im\$airs the efficienc/ of an audit. 5urther investi ation of the cause and amount of misstatement \$rovides a chance to reverse the initial decision error. +. 1he two methods of \$ro,ectin the known misstatement to the \$o\$ulation are the average difference method and the ratio method. Refer to Cha\$ter 1" for formula ex\$ressions of each. 1he im\$ortant thin is to audit all the sam\$le units. Lou cannot sim\$l/ discard one that is hard to audit in favor of addin to the sam\$le a customer whose -alance is eas/ to audit. 1his action mi ht -ias the sam\$le. If considerin the entire -alance to -e misstated will not alter /our evaluation conclusion# then /ou do not need to work on it an/ more. Lour evaluation conclusion mi ht -e to acce"t the book val\$e# as lon as the account counted in error is not -i enou h to chan e the conclusion. Lour evaluation conclusion mi ht alread/ -e to re)ect the book val\$e# and considerin another account to -e misstated ,ust reinforces the decision. If considerin the entire -alance to -e misstated would chan e an acce"tance evaluation to a re)ection evaluation# /ou need to do somethin a-out it. 6ince the exam\$le seems to descri-e a dead end# /ou ma/ need to select more accounts (ex\$and the sam\$le) and \$erform the \$rocedures on them (excludin confirmation) and reevaluate the results. &. a. 1wo main reasons for stratif/in a \$o\$ulation when sam\$lin for varia-les (\$eso) measurement8 6ome units ma/ -e individuall/ si nificant (e. .# lar e) and takin sam\$lin risk with res\$ect to them is not a ood idea. -. Auditors ma/ want to achieve audit covera e of a lar e \$ro\$ortion of \$esos in the -alance -/ choosin the lar est units (a \$rotective sam\$lin o-,ective# which is closel/ related to avoidin sam\$lin risk).

).

18-50

## A Risk'based A\$dit A""roach 4 #art ((

%.

11-51

1he tolera-le misstatement (,ud ed for the audit of a \$articular account -alance) must -e less than the monetar/ misstatement considered material to the overall financial statements. Also# the aggregation of multi\$le tolera-le misstatement amounts for several different -alances under audit must -e e2ual to or less than the amount of monetar/ misstatement considered material to the overall statements. 1he a\$\$ro\$riate eneral set of o-,ectives is the o-,ective(s) of o-tainin evidence a-out each of the client<s assertions in the financial -alance. In eneral# the assertions are a-out8 Gxistence (and cutoff) 7ccurrence (and cutoff) Com\$leteness (and cutoff) Ri hts and o-li ations (ownershi\$# owershi\$) Daluation Ceasurement 9resentation and disclosure

(.

'.

Influence on sam\$le si3e8 6am\$le 6i3e Relationshi\$s8 Audit of Account ?alances #redetermined %am"le %i6e Will 1e5 High Rate or Low Rate or Large Amo\$nt %mall Amo\$nt 6maller 4ar er 6maller 6maller 4ar er 4ar er 4ar er 4ar er 4ar er 6maller 6maller 6maller

%am"le %i6e (nfl\$ence 1. Risk of incorrect acce\$tance +. Risk of incorrect re,ection ). 1olera-le misstatement &. Gx\$ected misstatement %. 9o\$ulation varia-ilit/ (. 9o\$ulation si3e *. 1.

## %am"le %i6e Relation Inverse Inverse Inverse Direct Direct Direct

1he three -asic ste\$s in 2uantitative evaluation are these8 5i ure the total amount of actual misstatement found in the sam\$le. 1his amount is called the known misstatement. +. #ro)ect the known misstatement to the \$o\$ulation. 1he \$ro,ected amount is called the likely misstatement. Com\$are the likel/ misstatement (also called the "ro)ected misstatement) to the tolera-le misstatement for the account# and consider the

).

18-51

11-52
%ervices
a.

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Risk of incorrect acce"tance that likel/ misstatement could -e less than tolera-le misstatement even thou h the actual misstatement in the \$o\$ulation is reater# or the -. Risk of incorrect acce"tance that likel/ misstatement could -e reater than tolera-le misstatement even thou h the actual misstatement in the \$o\$ulation is smaller.

".

Eonstatistical measurements descri-ed in Cha\$ter 1" (\$a e '1*) leave onl/ one avenue for .accountin for further misstatement08 A\$\$l/ ex\$erience and \$rofessional ,ud ment to decide if further misstatement could -e lar e enou h to \$revent an acce\$tance decision. If the \$ro,ected likel/ misstatement is a reat deal less than the amount considered material# an auditor could ,ud e that further misstatement# if known# would not affect acce\$tance. If \$ro,ected likel/ misstatement is close to the amount considered material# ma/-e acce\$tance is not warranted.

1!. Account -alances also can -e audited# at least in \$art# at an interim date. >hen account -alance audit work is done -efore the com\$an/<s /earFend date# auditors must e!tend the interimFdate audit conclusion to the -alanceFsheet date. 1he \$rocess of e!tending the a\$dit concl\$sion amounts to nothin more (and nothin less) than \$erformin su-stantiveF\$ur\$ose audit \$rocedures on the transactions in the remainin \$eriod and on the /earFend -alance to \$roduce sufficient com\$etent evidence for a decision a-out the /earFend -alance. Additional considerations include8 a. If the com\$an/<s internal control over transactions that \$roduce the -alance under audit are not \$articularl/ stron # /ou should time the su-stantive detail work at /earFend instead of at interim. -. If control risk is hi h# then the su-stantive work on the remainin \$eriod will need to -e extensive. c. If ra\$idl/ chan in -usiness conditions mi ht \$redis\$ose mana ers to misstate the accounts (tr/ to sli\$ one -/ the auditors)# the work should -e timed at /earFend. In most cases# careful scanning of transactions and analytical review com"arisons should -e \$erformed on transactions that occur after the interim date. As an exam\$le# accounts receiva-le confirmation can -e done at an interim date. 6u-se2uentl/# efforts must -e made to ascertain whether controls continue to -e stron . Lou must scan the transactions of the remainin \$eriod# audit an/ new lar e -alances# and u\$date work on collecti-ilit/# es\$eciall/ with anal/sis of cash received after the /earFend. 11. Classical variables sam"ling estimates the value of a \$o\$ulation -/ calculatin the mean and standard deviation of a sam\$le and im\$utin the results to the

18-52

## A Risk'based A\$dit A""roach 4 #art ((

11-53

\$o\$ulation. #robability "ro"ortional to si6e sam"ling uses the results of sam\$lin to calculate an estimated u\$\$er error limit and com\$ares this with a \$reset tolera-le error limit. Althou h used for su-stantive testin \$ur\$oses# 996 sam\$lin is actuall/ a variation for attri-ute sam\$lin . 1+. Detection (or -eta) risk affects sam\$le si3e inversel/ for su-stantive testin \$ur\$oses. 1hat is# the hi her the acce\$ta-le detection risk# the smaller the sam\$le si3eH and the lower the acce\$ta-le detection risk# the lar er the sam\$le si3e. 1). #recision is the ran e O ; within which the true answer most likel/ falls. It is set -/ the auditor as a function of materialit/ and those levels of -eta and al\$ha risk deemed acce\$ta-le. Reliability is the likelihood that the sam\$le ran e contains the true value. Also referred to as the confidence level# relia-ilit/ is set -/ the auditor on the -asis of overall audit risk. 1&. 996 sam\$lin is restricted to \$o\$ulations for which the auditor sus\$ects a few errors of overstatement onl/. 1%. 6everal statistical software \$acka es are availa-le to facilitate audit sam\$lin a\$\$lications. In addition to calculatin sam\$le si3e and evaluatin sam\$le results# these \$acka es can also assist in the followin sam\$lin areas8 a. -. c. 6tratif/ \$o\$ulations for sam\$lin \$ur\$osesH Ienerate random num-ers to facilitate sam\$le selectionH Draw the sam\$le# iven com\$uteri3ed data -ases.

II. Multiple Choice Questions 1. +. ). &. a cNd %. (. '. *. c d ". 1!. 11. 1+. d a a c 1). 1&. 1%. 1(. a a c d 1'. 1*. 1". +!. d c d

%\$""orting Com"\$tations5 Audited Dalue &'#%+! ). c. ?ook Dalue &*#!!! d. 9&*! 1+! = 9& = 9&#*!! = ).%B

'.

18-53

11-54
%ervices

91%'#%!!

## 9&%!#!!! x ).%B = III. Comprehensive Cases Case 1. a.

Al"ha risk is the risk of re,ectin a \$o\$ulation that is essentiall/ correct. 1eta risk is the risk of acce\$tin a \$o\$ulation that is materiall/ incorrect. Al\$ha risk affects audit efficienc/ -ecause overauditin results from incorrectl/ re,ectin a \$o\$ulation. ?eta risk im\$acts audit effectiveness -ecause underauditn results from incorrectl/ acce\$tin a \$o\$ulation. Collectivel/# al\$ha and -eta risk com\$rise sam"ling risk# defined as the \$ro-a-ilit/ that the auditor will draw erroneous conclusions a-out a \$o\$ulation. Attention to# and 2uantification of# al\$ha and -eta risk assist the auditor in a\$\$l/in an audit risk a\$\$roach to su-stantive testin . Durin the audit \$lannin sta e# the auditor identifies areas of hi h audit risk and sets detection (-eta) risk low for these areas. 1he result is that more su-stantive testin is devoted to the hi h risk areas relative to the lower risk areas. 1his a\$\$roach enhances -oth audit efficienc/ and audit effectiveness. ?ecause it is closel/ related to the -asis for the auditor<s o\$inion# al\$ha risk is usuall/ set e2ual to overall audit risk. ?eta risk is set on the -asis of the auditor<s evaluation of inherent risk and control risk. 1he reater these risk factors# as determined -/ the auditor durin the audit \$lannin sta es# the lower the -eta risk set -/ the auditor. 1he lower the acce\$ta-le -eta risk# the lar er the sam\$le si3es for su-stantive testin \$ur\$oses. Al\$ha and -eta risk# therefore# \$rovide the necessar/ link -etween audit risk anal/sis and su-stantive audit testin . (1) CeanF\$erFunit estimates the total value of a \$o\$ulation -/ (1) usin the sam\$le mean as an estimate of the true \$o\$ulation mean# and (+) extendin this estimated \$o\$ulation mean -/ the num-er of items in the \$o\$ulation. 1he com\$utations are as follows8 (1) Gstimated \$o\$ulation mean = 9%*+#!!! A +!! lots = 9+#"1! \$er lot (+) Gstimated total value = 9+#"1! \$er lot x +#!!! lots = 9%#*+!#!!! (+) Ratio estimation estimates total \$o\$ulation value -/ (1) usin the ratio of the sam\$le audited values to -ook values as an estimate of the ratio of \$o\$ulation audited value to -ook value# and (+) a\$\$l/in the

-.

c.

Case 2. a.

18-54

## A Risk'based A\$dit A""roach 4 #art ((

11-55

estimated ratio to the \$o\$ulation -ook value. 1he com\$utations are as follows8 (1) Gstimated ratio of audited to -ook value = 9%*+#!!! A 9(!!#!!! = "'B (+) Gstimated total value = "'B x 9%#"!!#!!! = 9%#'+)#!!! ()) Difference estimation estimates total \$o\$ulation values -/ (1) usin the avera e difference -etween the audited and -ook values of sam\$le items as an estimate of the avera e difference for all \$o\$ulation items# (+) extendin the estimated avera e difference -/ the num-er of items in the \$o\$ulation# and ()) usin the resultin estimate of the total difference -etween audited and -ook value to com\$ute the estimated total value. 1he com\$utations are as follows8 (1) Gstimated avera e difference in audit and -ook values8 (9%*+#!!! F 9(!!#!!!) A +!! lots = F 9"! \$er lot (+) Gstimated total difference = F 9"! \$er lot x +#!!! lots = F 91*!#!!! ()) Gstimated total value = 9%#"!!#!!! F 91*!#!!! = 9%#'+!#!!! -. 1he sam\$le contains an element of sam\$lin error with res\$ect to the avera e \$eso value of \$roduction lots. 1he mean -ook value of the \$o\$ulation is 9+#"%! (9%#"!!#!!! A +#!!! lots)# while the mean -ook value in the sam\$le is 9)#!!! (9(!!#!!! A +!! lots). CeanF\$erFunit estimation uses the mean value of the sam\$le as the -asis for estimatin total value. 1hus# if the sam\$le contains a dis\$ro\$ortionate num-er of hi her (or lower) \$riced items# this sam\$lin error will affect the estimate of the total \$o\$ulation value. 1he estimate of total value develo\$ed in ratio estimation is -ased u\$on the ratio of audited values to -ook values# rather than u\$on mean \$eso value. If this ratio has no tendenc/ to var/ with the \$eso value of the lot# the estimate of total value is not affected -/ the mean value of items in the sam\$le. =owever# sam\$lin error ma/ still -e \$resent if the sam\$le lots are not

18-55

11-56
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

re\$resentative of the \$o\$ulation with res\$ect to the ratio of audited values to -ook values.

Case 3. 1he auditors would \$ro,ect the misstatement found in the sam\$le to the \$o\$ulation usin either the ratio or difference a\$\$roach. 1he ratio a""roach would result in a \$ro,ected misstatement of 9(%#%!!. 1his ma/ -e com\$uted -/ first calculatin the ratio of the audited to -ook value as 1.!1)1 R9+)#1!! A 9++#*!! (since there is a net understatement of 9)!!# the audited value is 9+)#1!!)S and estimatin the audited value of the \$o\$ulation as8 1.!1)1 x 9%#!!!#!!! = 9%#!(%#%!! (rounded) 1he \$ro,ected misstatement is thus 9(%#%!! under the ratio method. 1he difference a""roach results in an avera e difference of 91.%! (9)!! net difference divided -/ +!! items). Culti\$l/in -/ the 1!!#!!! invoices indicates a \$ro,ected misstatement of 9(+#&!! (91.%! x &1#(!!). Case 4. 1he audit risk (ultimate risk) of material misstatement in the financial statements (AR) is the \$roduct of8 (1) (nherent risk 2(R3# the risk of material misstatement in an assertion# assumin there were no related internal controls. (+) Control risks 2CR3# the risk of material misstatement occurrin in an assertion# and not -ein \$revented or detected on a timel/ -asis -/ the internal control structure. ()) Detection risk 2DR3# the risk that the auditors< \$rocedures will lead them to conclude an assertion is not materiall/ misstated# when in fact such misstatement does exist. In e2uation form# this relationshi\$ is ex\$ressed as follows8 AR = IR x CR x DR 1his e2uation ma/ -e restated to solve for the allowa-le detection risk as follows8 DR = AR A (CR x IR) Usin the risk levels set forth in the \$ro-lem# the allowa-le risk of reliance u\$on su-stantive tests is com\$uted as illustrated -elow8 DR = .!+ A (.+ x .%) = .+!

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## A Risk'based A\$dit A""roach 4 #art ((

11-57

1hus the risk of incorrect acce\$tance should -e limited to +! \$ercent if the auditors are to achieve their o-,ective of holdin audit risk to + \$ercent.

Case 5. a.

(1) Re2uired sam\$le si3e is calculated as follows8 Recorded amount of \$o\$ulation x Relia-ilit/ factor 1olera-le misstatement ; (Gx\$ected misstatement x Gx\$ansion factor) 9%!!#!!! x ) 9+%#!!! ; (9+#!!! x 1.()

6am\$le si3e =

6am\$le si3e =

("

Eote8 1he relia-ilit/ factor is from the 3ero misstatements row of the 996 sam\$lin ta-le iven in the case. (+) 1he sam\$lin interval is calculated sim\$l/ -/ dividin the -ook value of receiva-les -/ the sam\$le si3e# as follows8 6am\$lin interval = Recorded receiva-les A 6am\$le si3e = 9%!!#!!! A (" = 9'#+&( -. 1he results ma/ -e evaluated as follows8 (1) #ro)ected misstatement = 1ook +al\$ e 9 %! *!! *#%!! A\$dite d +al\$e 9 &' '(! *#1!! = = ()) (ncremental allowance = Reliability #ro)ected (ncremental &isstatemen t 9 ) &! &!! Taintin g7 (B %B EA %am"lin g (nterval 9'#+&( '#+&( EA #ro)ected &isstatemen t 9 &)% )(+ &!! 91#1"'

18-57

11-58
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

-actor ).!! &.'% (.)! (ncremen 2(ncrement 4 83 &isstatement 1.'% 1.%% .'% .%% 9&)% )(+ Allowance 9)+( 1"" 9%+%

## = 91#1"' O 9+1#')* O 9%+% = 9+)#&(!

E71G68 #ro)ected misstatement (a) 1aintin \$ercenta es are calculated as the difference -etween -ook and audited value divided -/ -ook value (e. .# (9%! ; 9&') A 9%! = (B). (-) Eo taintin \$ercenta e is calculated for items in excess of the sam\$le interval and the actual misstatement is extended to \$ro,ected misstatement (as for the third error). 1asic "recision is alwa/s the relia-ilit/ factor for 3ero misstatements multi\$lied times the sam\$lin interval. (ncremental allowance (a) Relia-ilit/ factors are read from the 996 sam\$lin ta-le iven in the case# startin at 3ero misstatements. (-) .Increment ; 10 is the difference in the two ad,acent relia-ilit/ factors minus 1 (e. .# &.'% ; ).!! ; 1.!! = .'%). (c) Cisstatements in excess of the sam\$lin interval are not considered in the incremental allowance. 1his is -ecause the nature of the \$rocess re2uires that all items in excess of the sam\$lin interval -e included in the sam\$le ; therefore no allowance for items not in the sam\$le is necessar/. c. 1he results o-tained in \$art b would indicate that the auditors ma/ acce\$t the \$o\$ulation as not containin a tolera-le misstatement at the % \$ercent level of risk of incorrect acce\$tance. 1he auditors would also consider the results o-tained in con,unction with other audit tests. 1he advantages of \$ro-a-ilit/F\$ro\$ortionalFtoFsi3e (996) sam\$lin classical varia-les sam\$lin are as follows8 over

Case 6. a.

18-58

## A Risk'based A\$dit A""roach 4 #art ((

-.

11-59

996 sam\$lin is enerall/ easier to use than classical varia-les sam\$lin . 1he si3e of a 996 sam\$le is not -ased on the estimated variation of audited amounts. 996 sam\$lin automaticall/ results in a stratified sam\$le. Individuall/ si nificant items are automaticall/ identified. If no misstatements are ex\$ected# 996 sam\$lin will usuall/ result in a smaller sam\$le si3e than classical varia-les sam\$lin . A 996 sam\$le can -e easil/ desi ned and sam\$le selection can -e in -efore the com\$lete \$o\$ulation is availa-le.

## %am"ling interval = Recorded receiva-les A 6am\$le si3e = 9)!!#!!! A (! = 9%#!!!

c.

#ro)ected misstatement = 1ook +al\$ e 9 &!! %!! )#!!! A\$dite d +al\$e 9 )+! ! +#%!! &isstatemen t 9 *! %!! EA Taintin g7 +!B 1!!B EA %am"lin g (nterval 91#!!! 1#!!! EA #ro)ected &isstatemen t 9 +!! 1#!!! %!! 91#'!!

## CHAPTER 23 THE CO)PUTER E'0IRO')E'T

I. Review Questions 1. In a batch "rocessing system# documents evidencin transactions and events are athered and \$rocessed -/ rou\$s. 1he da/<s sales invoices# for exam\$le# ma/ -e converted to machineFreada-le form and \$rocessed the next mornin . In a real time system# transactions are in\$ut into the s/stem and \$rocessed as the/ occur. A -ranch sale# for exam\$le# ma/ -e in\$ut into the s/stem via a terminal at a remote location. 1he com\$uter checks for \$roduct availa-ilit/# customer authenticit/# customer credit a\$\$roval# and shi\$\$in termsH and if all conditions are met# the sale is \$rocessed immediatel/ and the sales invoice and shi\$\$in order are \$roduced.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

+. In a realFtime s/stem# much of the data are stored internall/ and documentation is often not as extensive as in a -atch s/stem. Retrieval and audit of transaction data# therefore# are often more difficult in a realF time s/stem. Also# controls are more likel/ to -e \$ro rammed in realF time s/stems# and for this reason# are more difficult to test.
). Inasmuch as com\$uter \$rocessin re2uires increased de\$endence on the com\$uter s/stems and software for the accurac/ and com\$leteness of \$rocessin # documentation assumes ma,or si nificance relative to effective control. Documentation facilitates reviewin and u\$datin s/stems and \$ro rams as the environment chan esH and it also minimi3es the \$ro-a-ilit/ of unauthori3ed s/stem and \$ro ram chan es which could result in loss of control and decreased relia-ilit/ of financial data. In a -atch s/stem# files are stored offFline for the most \$art# and access control assumes the form of safe uardin the \$ro rams# transaction files# and master files -/ assi nin res\$onsi-ilit/ for the files to a li-rarian and institutin a formal checkout s/stem. 7nl/ those \$ersons authori3ed to \$rocess transactions (com\$uter o\$erators) are \$ermitted access to transaction and master filesH and \$ro rammers are \$ermitted access to \$ro rams onl/ for testin and .de-u in 0 \$ur\$oses. In an onFline# realF time s/stem# transactions and master files are stored internall/# often in a s/stem of inte rated data -ases. Access control in this t/\$e of data environment assumes the form of controllin access to data -ases and fixin of res\$onsi-ilit/ for the data -ase com\$onents. Assi nin a \$assword to an individual who is res\$onsi-le for the data -ase com\$onent accessi-le -/ that \$assword# cancelin \$asswords of former em\$lo/ees# and fre2uent chan in of existin em\$lo/ees< \$asswords are exam\$les of access controls in a realF time s/stem. Recordin forms and transaction lo s assure consistenc/ and com\$leteness of data in\$uts. 1he form or lo should include codes descri-in such transaction com\$onents as em\$lo/ee num-er# customer num-er# vendor num-er# de\$artment num-er# stock num-er# \$urchased \$art num-er# or ,o- num-er. 1he form should also \$rovide for 2uantities# \$rices# dates# and usuall/ a short narrative descri\$tion of \$roducts# \$arts# materials# or services for \$urchase and sales transactions. A transaction file is the -atch of entered data that has -een converted into machineFreada-le form. A transaction file ma/ contain \$a/roll information for a s\$ecific \$eriod of time. It is similar to a ,ournal in a manuall/ \$re\$ared s/stem. A master file contains u\$dated information throu h a \$articular time \$eriod. It is similar to a led er in a manual s/stem.

&.

%.

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## A Risk'based A\$dit A""roach 4 #art ((

'.

11-61

6mall -usinesses have found that microcom\$uters or \$ersonal com\$uter s/stems are cost effective for \$rocessin accountin data. In small -usinesses# one would ex\$ect to find microcom\$uters (or \$ersonal com\$uters) usin commerciall/ availa-le software. In the com\$uteri3ed s/stem# documents to su\$\$ort a transaction ma/ not -e maintained in reada-le form# re2uirin associated \$erformance of controls. =owever# the com\$uteri3ed s/stem will ena-le \$rocessin of transactions to -e done more consistentl/# duties to -e consolidated# and re\$orts to -e enerated more easil/.

*.

II. Multiple Choice Questions 1. +. ). &. d c a a %. (. '. *. c c c ". 1!. 11. 1+. c c d c 1). 1&. 1%. 1(. c d a a 1'. 1*. 1". +!. c a a

III. Comprehensive Cases An auditor should have the followin concerns a-out the ?ox s/stem8 Does the s/stem have an/ flaws or incom\$ati-ilitiesT (Eo one a\$\$ears to have tested the software or found out a-out others< satisfaction with it.) 1he com\$uter sits out in the o\$en. (An/one could have access to and dama e the hardware.) An/one could come u\$ with the \$assword -/ uessin . 1he -acku\$ disks are not stored in a safe \$lace. >as the conversion a\$\$ro\$riatel/ executed# with no data lost or addedT

## CHAPTER 21 I'TER'A( CO'TRO( I' THE CO)PUTER I'*OR)ATIO' S4STE)

I. 1. Review Questions 1he \$ro\$er installation of I1 can lead to internal control enhancements -/ re\$lacin manuall/F\$erformed controls with com\$uterF\$erformed controls. I1F

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

-ased accountin s/stems have the a-ilit/ to handle tremendous volumes of com\$lex -usiness transactions cost effectivel/. Com\$uterF\$erformed controls can reduce the \$otential for human error -/ re\$lacin manual controls with \$ro rammed controls that a\$\$l/ checks and -alances to each transaction \$rocessed. 1he s/stematic nature of I1 offers reater \$otential to reduce the risk of material misstatements resultin from random# human errors in \$rocessin . 1he use of I1 -ased accountin s/stems also offers the \$otential for im\$roved mana ement decisions -/ \$rovidin more and hi her 2ualit/ information on a more timel/ -asis than traditional manual s/stems. I1F-ased s/stems are usuall/ administered effectivel/ -ecause the com\$lexit/ re2uires effective or ani3ation# \$rocedures# and documentation. 1hat in turn enhances internal control.

+.

>hen entities rel/ heavil/ on I1 s/stems to \$rocess financial information# there are new risks s\$ecific to I1 environments that must -e considered. Ke/ risks include the followin 8 Reliance on the f\$nctioning ca"abilities of hardware and software . 1he risk of s/stem crashes due to hardware or software failures must -e evaluated when entities rel/ on I1 to \$roduce financial statement information. +isibility of a\$dit trail. 1he use of I1 often converts the traditional \$a\$er trail to an electronic audit trail# eliminatin source documents and \$a\$erF -ased ,ournal and records. Red\$ced h\$man involvement. 1he re\$lacement of traditional manual \$rocesses with com\$uterF\$erformed \$rocesses reduces o\$\$ortunities for em\$lo/ees to reco ni3e misstatements resultin from transactions that mi ht have a\$\$eared unusual to ex\$erienced em\$lo/ees. %ystematic vers\$s random errors. Due to the uniformit/ of \$rocessin \$erformed -/ I1 -ased s/stems# errors in com\$uter software can result in incorrect \$rocessin for all transactions \$rocessed. 1his increases the risk of man/ si nificant misstatements. Una\$thori6ed access. 1he centrali3ed stora e of ke/ records and files in electronic form increases the \$otential for unauthori3ed onFline access from remote locations. Loss of data. 1he centrali3ed stora e of data in electronic form increases the risk of data loss in the event the data file is altered or destro/ed. Red\$ced segregation of d\$ties. 1he installation of I1F-ased accountin s/stems centrali3es man/ of the traditionall/ se re ated manual tasks into one I1 function. Lack of traditional a\$thori6ation. I1F-ased s/stems can -e \$ro rammed to initiate certain t/\$es of transactions automaticall/ without o-tainin traditional manual a\$\$rovals.

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## A Risk'based A\$dit A""roach 4 #art ((

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/eed for (T e!"erience. As com\$anies rel/ to a reater extent on I1F-ased s/stems# the need for \$ersonnel trained in I1 s/stems increases in order to install# maintain# and use s/stems.

).

9eneral controls relate to all as\$ects of the I1 function. 1he/ have a lo-al im\$act on all software a\$\$lications. Gxam\$les of eneral controls include controls related to the administration of the I1 functionH software ac2uisition and maintenanceH \$h/sical and onFline securit/ over access to hardware# software# and related -acku\$H -ackFu\$ \$lannin in the event of unex\$ected emer enciesH and hardware controls. A""lication controls a\$\$l/ to the \$rocessin of individual transactions. An exam\$le of an a\$\$lication control is a \$ro rammed control that verifies that all time cards su-mitted are for valid em\$lo/ee ID num-ers included in the em\$lo/ee master file. 1he most si nificant se\$aration of duties uni2ue to com\$uter s/stems are those \$erformed -/ the s/stems anal/st# \$ro rammer# com\$uter o\$erator# and data -ase administrator. 1he idea is that an/one who desi ns a \$rocessin s/stem should not also do the technical work# and an/one who \$erforms either of these tasks should not also -e the com\$uter o\$erator when real data is \$rocessed. 1/\$ical duties of \$ersonnel8 %ystems analysis8 9ersonnel will desi n and direct the develo\$ment of new a\$\$lications. #rogramming8 7ther \$ersonnel will actuall/ do the \$ro rammin dictated -/ the s/stem desi n. O"erating8 7ther \$eo\$le will o\$erate the com\$uter durin \$rocessin runs# so that \$ro rammers and anal/sts cannot interfere with the \$ro rams desi ned and executed# even if the/ \$roduce errors. Converting data8 6ince this is the \$lace where misstatements and errors can -e made ; the interface -etween the hardco\$/ data and the machineFreada-le transformation# \$eo\$le unconnected with the com\$uter s/stem itself do the data conversion. Library'kee"ing8 9ersons need to control others< access to s/stem and \$ro ram software so it will -e used -/ authori3ed \$ersonnel for authori3ed \$ur\$oses. Controlling8 Grrors alwa/s occur# and \$eo\$le not otherwise connected with the com\$uter s/stem should -e the ones to com\$are in\$ut control information with out\$ut information# \$rovide for correction of errors not involvin s/stem failures# and distri-ute out\$ut to the \$eo\$le authori3ed to receive it. Documentation differs si nificantl/ as to inclusion of \$ro ram flowcharts# \$ro ram listin s# and technical o\$eratin instructions. 5ile securit/ and retention differs -ecause of the relativel/ delicate form of the ma netic media re2uirin fire\$roof vault stora e# insulation from other ma netic fields# safe uards from accidental writin on data files# and so forth.

&.

%. a. -. c. d.

e. f.

(.

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%ervices
'.

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Auditors review documentation to ain an understandin of the s/stem and to determine whether the documentation itself is ade2uate for hel\$in mana e and control the com\$uter \$rocessin . Res\$onsi-ilities of the data-ase administrator (D?A) function are8 Desi n the content and or ani3ation of the data-ase# includin lo ical data relationshi\$s# \$h/sical stora e strate / and access strate /. 9rotect the data-ase and its software# includin control over access to and use of the data and D?C6 and \$rovisions for -acku\$ and recover/ in the case of errors or destruction of the data-ase. Conitor the \$erformance of the D?C6 and im\$rove efficienc/. Communicate with the data-ase users# ar-itrate dis\$utes over data ownershi\$ and usa e# educate users a-out the D?C6 and consult users when \$ro-lems arise. 9rovide standards for data definition and usa e and documentation of the data-ase and its software.

*.

".

5ive thin s a \$erson must have access to in order to facilitate com\$uter fraud are8 a. -. c. d. e. 1he com\$uter itself. Data files. Com\$uter \$ro rams. 6/stem information (documentation). 1ime and o\$\$ortunit/ to convert assets to \$ersonal use.

1!. ?ecause man/ com\$anies that o\$erate in a network environment decentrali3e their network servers across the or ani3ation# there is an increased risk for a lack of securit/ and lack of overall mana ement of the network o\$erations. 1he decentrali3ation ma/ lead to a lack of standardi3ed e2ui\$ment and \$rocedures. In man/ instances res\$onsi-ilit/ for \$urchasin e2ui\$ment and software# maintenance# administration# and \$h/sical securit/# often resides with ke/ user rou\$s rather than with features# includin se re ation of duties# t/\$icall/ availa-le in traditionall/ centrali3ed environments -ecause of the read/ access to software and data -/ multi\$le users. II. Multiple Choice Questions 1. +. ). &. %. (. c a d d d '. *. ". 1!. 11. 1+. c a a 1). 1&. 1%. 1(. 1'. 1*. c c c a a 1". +!. +1. ++ +). +&. c c a c c +%. +(. +'. +*. +". )!. c c d d

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## A Risk'based A\$dit A""roach 4 #art ((

III. Comprehensive Cases

11-65

Case 1. Does access to on'line files re*\$ire s"ecific "asswords to be entered to identify and validate the terminal \$ser: 9766I?4G GRR7R6 7R IRRGIU4ARI1IG6 ; unauthori3ed access ma/ -e o-tained to \$rocessin \$ro rams or accountin data resultin in the loss of assets or other com\$an/ resources. Are control totals established by the \$ser "rior to s\$bmitting data for "rocessing: 9766I?4G GRR7R6 7R IRRGIU4ARI1IG6 ; sales transactions ma/ -e lost in data conversion or \$rocessin # or errors made in data conversion or \$rocessin . Are in"\$t totals reconciled to o\$t"\$t control totals: 9766I?4G GRR7R6 AED IRRGIU4ARI1IG6 ; (same as a-ove). Control totals are useless unless reconciled to e2uivalent controls created durin \$rocessin . Case 2. a. 1. (n"\$t control ob)ectives 1ransactions have -een recorded \$ro\$erl/ (neither dou-leFcounted nor omitted ; that is# control over validit/ and com\$leteness) 1ransactions are transmitted from recordin \$oint to \$rocessin \$oint 1ransactions are in acce\$ta-le form +. #rocessing control ob)ectives 4oss or non\$rocessin of data is detected Arithmetic functions are \$erformed accuratel/ 1ransactions are \$osted \$ro\$erl/ Grrors detected in the \$rocessin of data are controlled until corrected and \$rocessed O\$t"\$t control ob)ectives 9rocessed data are re\$orted correctl/ and without unauthori3ed alteration 7ut\$ut is re2uired -/ the user 7ut\$ut is distri-uted onl/ to \$ersons authori3ed to receive it Control "roced\$res 4 in"\$t so\$rce data Re istration at \$oint of entr/ 6e2uential num-erin Irou\$in (-atchin ) with control totals Ke/ verification 9ro rammed edits Gdits for com\$leteness and reasona-leness

).

-.

1.

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%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Checklists to ensure in\$ut arrived and on time +. Control "roced\$res 4 "rocessing controls 9revention of loss or non\$rocessin of data (e. .# control totals) 9erformance of arithmetic functions Assurance of \$ro\$er \$ostin (sam\$le test of \$ostin s) Correction of errors Gxclusion of unauthori3ed \$ersons from o\$eratin areas (e. .# \$ro rammers) Control "roced\$res 4 o\$t"\$t controls Review \$erformed -/ ori inatin area of the re\$orts and other out\$ut data 6am\$lin and testin of individual transactions Use of control totals o-tained inde\$endentl/ from \$rior \$rocessin or ori inal source data Distri-ution lists used to route out\$ut onl/ to authori3ed \$ersons Cakin in2uiries as to whether the out\$ut is desired -/ the reci\$ient

).

Case 3. a.

1he \$rimar/ internal control o-,ectives in se\$aratin the \$ro rammin and o\$eratin functions are achieved -/ \$reventin o\$erator access to the com\$uter or to in\$ut or to out\$ut documents# and -/ \$reventin o\$erator access to o\$eratin \$ro rams and o\$eratin \$ro ram documentation# or -/ \$reventin o\$erators from writin or chan in \$ro rams. 9ro rammers should not -e allowed in the com\$uter room durin \$roduction \$rocessin . 1he/ should su-mit their tests to -e scheduled and run -/ the o\$erators as an/ other ,o-. 7\$erators should not -e allowed to interfere with the runnin of an/ \$ro ram. If an a\$\$lication fails# the o\$erators should not -e allowed to attem\$t to fix the \$ro rams. 1he failed a\$\$lication should -e returned to the \$ro rammers for correction. Com"ensating controls usuall/ refer to controls in user de\$artments (de\$artments other than com\$uter data \$rocessin ). In a small com\$uter installation where there are few em\$lo/ees# se re ation of the \$ro rammin and o\$eratin functions ma/ not -e \$ossi-le (as in a microcom\$uter or minicom\$uter environment). An auditor ma/ find com\$ensatin controls in the user de\$artment such as8 (1) manual control totals com\$ared to com\$uter out\$ut totals and (+) careful ins\$ection of all out\$ut. 6uch com\$ensatin controls in a sim\$le \$rocessin s/stem could \$rovide reasona-le assurance that all transactions were \$rocessed# \$rocessin was \$ro\$er and no unauthori3ed transactions were \$rocessed.

-.

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## A Risk'based A\$dit A""roach 4 #art ((

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An auditor ma/ find the followin com\$ensatin controls that are \$articularl/ im\$ortant when the \$ro rammin and o\$eratin functions are not se\$arate8 1. +. ). &. %. (. '. Case 4. a. @oint o\$eration -/ two or more o\$erators. Rotation of com\$uter duties. Com\$arison of com\$uter times to an avera e or norm. Investi ation of all excess com\$uter time (errors). Ade2uate su\$ervision of all com\$uter o\$erations. 9eriodic com\$arison of a \$ro ram code value to a control value. Re2uired vacations for all em\$lo/ees.

(n"\$t editing is the \$rocess of includin # in GD9 s/stems# \$ro rammed routines for com\$uter checkin as to validit/ and accurac/ of in\$ut. 1/\$es of in\$ut editin controls are8 tests for valid codesH tests for reasona-lenessH com\$leteness testsH check di itsH and tests for consistenc/ of data entered in numeric and al\$ha-etic fields. Gxam\$les of \$a/roll in\$ut editin controls are8 1est for validit/ of em\$lo/ee num-erH 1est for \$ro\$er \$a/ rateH 1est for reasona-leness of hours worked. Gxam\$les of sales in\$ut editin controls are8 1est for validit/ of customer num-erH 1est for credit a\$\$rovalH Credit limit testH 6ales \$rice list.

-.

c.

As GD9 s/stem com\$lexit/ increases# documentation# as well as manual checkin decreases. 1o \$rovide reasona-le assurance as to com\$leteness# existence# and accurac/ of \$rocessed transactions under these circumstances# in\$ut editin -ecomes increasin l/ necessar/. Cost commonl/ associated with su\$ervisor/ \$ro rams contained in onFline realFtime s/stems# design "hase a\$diting involves the auditor in s/stem desi n. 1he oal is to ensure inclusion of controls that will detect exce\$tions or unusual conditions and record and lo information a-out the initiatin transactions. 7nce the necessar/ controls have -een desi ned and incor\$orated into the s/stem# fre2uent visits -/ the auditor to the client<s \$remises are necessar/ to determine that the controls are functionin \$ro\$erl/. 6ome individuals and rou\$s have su ested that inde\$endence ma/ -e im\$aired# iven auditor monitorin and reviewin a s/stem which heAshe has hel\$ed to desi n. 1he AIC9A has taken the \$osition that makin

Case 5. a.

-.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

control recommendations durin s/stem desi n is no different from auditor recommendations for control im\$rovements after the fact and documented in the mana ement letter. c. In some com\$lex GD9 s/stems# a com\$uter audit s\$ecialist ma/ -e needed to assist in desi nin the necessar/ controls# as well as monitorin and reviewin the control functions. A com"\$ter a\$dit s"ecialist is an em\$lo/ee of the C9A firm who# t/\$icall/# will have served on the audit staff for a \$eriod of time# followed -/ s\$eciali3ed trainin in com\$uter s/stem desi n and control# and GD9 auditin . 1he auditor ma/ rel/ on the com\$uter audit s\$ecialist to whatever de ree considered necessar/ to assure \$ro\$er control installation and im\$lementation. 1he inFchar e field auditor must kee\$ in mind# however# that use of a com\$uter audit s\$ecialist does not com\$ensate for the field auditor<s lack of understandin of the internal control# includin the GD9 a\$\$lications.

d.

## CHAPTER 22 AAD#8#NB #N A -=\$PA8,! #N&=!\$A8#=N SCS8,\$S 5-#S6 ,N(#!=N\$,N8

I. Review Questions 1. Additional \$lannin items that should -e considered when com\$uter \$rocessin is involved are8 +. 1he extent to which the com\$uter is used in each si nificant accountin a\$\$lication. 1he com\$lexit/ of the com\$uter o\$erations used -/ the entit/# includin the use of an outside service center. 1he or ani3ational structure of the com\$uter \$rocessin activities. 1he availa-ilit/ of data. 1he com\$uterFassisted audit techni2ues to increase the efficienc/ of audit \$rocedures. 1he need for s\$eciali3ed skills.

Understandin the control environment is a \$art of the \$reliminar/ \$hase of control risk assessment. Com\$uter use in data \$rocessin affects this understandin in each of the \$arts of the control environment as follows8

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The organi6ational str\$ct\$re ; should include an understandin of the or ani3ation of the com\$uter function. Auditors should o-tain and evaluate8 (a) a descri\$tion of the com\$uter resources and (-) a descri\$tion of the or ani3ational structure of com\$uter o\$erations. &ethods \$sed to comm\$nicate res"onsibility and a\$thority ; should include the methods related to com\$uter \$rocessin . Auditors should o-tain information a-out the existence of8 (a) accountin and other \$olic/ manuals includin com\$uter o\$erations and user manual and (-) formal ,o- descri\$tions for com\$uter de\$artment \$ersonnel. 5urther# auditors should ain an understandin of8 (a) how the client<s com\$uter resources are mana ed# (-) how \$riorities for resources are determined and (c) if user de\$artments have a clear understandin of how the/ are to com\$l/ with com\$uter related standards and \$rocedures. &ethods \$sed by management to s\$"ervise the system ; should include \$rocedures mana ement uses to su\$ervise the com\$uter o\$erations. Items that are of interest to the auditors include8 (a) the existence of s/stems desi n and documentation standards and the extent to which the/ are used# (-) the existence and 2ualit/ of \$rocedures for s/stems and \$ro ram modification# s/stems acce\$tance a\$\$roval and out\$ut modification# (c) the \$rocedures limitin access to authori3ed information# (d) the availa-ilit/ of financial and other re\$orts and (e) the existence of an internal audit function. ). 1he .audit trail0 is the source documents# ,ournal \$ostin s and led er account \$ostin s maintained -/ a client in order to kee\$ -ooks. 1hese are a .trail0 of the -ookkee\$in (transaction data \$rocessin ) that the auditor can follow forward with a tracin \$rocedure or -ack ward with a vouchin \$rocedure. In a manual s/stem this .trail0 is usuall/ visi-le to the e/e with \$ostin references in the ,ournal and led er and hardFco\$/ documents in files. ?ut in a com\$uter s/stem# the \$ostin references ma/ not exist# and the .records must -e read usin the com\$uter rather than the naked e/e.0 Cost s/stems still have hardFco\$/ \$a\$ers for -asic documentation# -ut in some advanced s/stems even these mi ht -e a-sent. &. 1he audit trail (sometimes called .mana ement trail0 as it is used more in dail/ o\$erations than -/ auditors) is com\$osed of all manual and com\$uter records that allow one to follow the se2uence of \$rocessin on (or -ecause of) a transaction. 1he audit trail in advanced s/stems ma/ not -e in a humanFreada-le form and ma/ exist for onl/ a fraction of a second. 1he first control im\$lication is that concern for an audit trail needs to -e reco ni3ed at the time a s/stem is desi ned. 1echni2ues such as i ntegrated test

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

facility# a\$dit files and e!tended records must -e s\$ecified to the s/stems desi ner. 1he second control im\$lication is that if the audit trail exists onl/ momentaril/ in the form of transaction lo s or master records -efore destructive u\$date# the external auditor must review and evaluate the transaction flow at various times throu hout the \$rocessin \$eriod. Alternativel/# the external auditor can rel/ more extensivel/ on the internal auditor to monitor the audit trail.

%. 1. +. ).

Ca,or characteristics8 %taff and location of the com"\$ter ; o\$erated -/ small staff located within the user de\$artment and without \$h/sical securit/. #rograms ; su\$\$lied -/ com\$uter manufacturers or software houses. #rocessing mode ; interactive data entr/ -/ users with most of the master file accessi-le for in2uir/ and direct u\$date.

Control 9ro-lems8 1. +. ). &. %. (. '. (. 4ack of se re ation of duties. 4ack of controls on the o\$eratin s/stem and a\$\$lication \$ro rams. Unlimited access to data files and \$ro rams. Eo record of usa e. Eo -acku\$ of essential files. Eo audit trail of \$rocessin . Eo authori3ation or record of \$ro ram chan es. Auditin thro\$gh the com\$uter refers to makin use of the com\$uter itself to test the o\$erative effectiveness of a\$\$lication controls in the \$ro ram actuall/ used to \$rocess accountin data. 1hus the term refers onl/ to the \$ro\$er stud/ and evaluation of internal control. Auditin with the com\$uter refers both to the stud/ of internal control (the same as .auditin throu h0) and to the use of the com\$uter to \$erform audit tasks. ?oth are audit \$rocedures that use the com\$uter to test controls that are included in a com\$uter \$ro ram. 1he -asic difference is that the test data \$rocedure utili3es the client<s \$ro ram with auditorFcreated transactions# while "arallel sim\$lation utili3es an auditorFcreated \$ro ram with actual client transactions. In the test data \$rocedure the results from the client \$ro ram are com\$ared to the auditor<s \$redetermined results to determine whether the controls work as descri-ed. In the "arallel sim\$lation \$rocedures the results from the auditor \$ro ram are com\$ared to the results from the client \$ro ram to determine whether the controls work as descri-ed. 1he test data techni2ue utili3es simulated transactions created -/ the auditor# \$rocessed -/ actual \$ro rams -ut at a time com\$letel/ se\$arate from the \$rocessin of actual# live transactions. 1he integrated test facility techni2ue is

'.

*.

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an extension of the test data techni2ue# -ut the simulated transactions are intermin led with the real transactions and run on the actual \$ro rams \$rocessin actual data. ". User identification num-ers and \$asswords \$revent unauthori3ed access to accountin records and a\$\$lication \$ro rams. 1he transaction lo does not "revent unauthori3ed access -ut ma/ -e reviewed to detect unauthori3ed access. Gven then# res\$onsi-ilit/ could not -e traced to a \$articular individual without user identification num-ers and \$asswords. 1he transaction lo is more im\$ortant to esta-lish the audit trail than to detect unauthori3ed access.

1!. 9enerali6ed a\$dit software is a set of \$re\$ro rammed editin # o\$eratin # and out\$ut routines that can -e called into use with a sim\$le# limited set of \$ro rammin instructions -/ an auditor who has one or two weeks intensive trainin .

11. 1. +. ). &. %. (. '. #hases Define the audit o-,ectivel/ 5easi-ilit/ 9lannin A\$\$lication desi n Codin 1estin 9rocessin /oncom"\$ter a\$ditor involvement 9rimar/ res\$onsi-ilit/ Gvaluate alternatives Review with com\$uter auditor none none Review final test results# com\$are to \$lan Actual com\$uter \$rocessin ; none Use of results ; de\$ends on a\$\$lication *. 5ull res\$onsi-ilit/ 1. +. ). &. %. (. '.

*. Gvaluation

1+. A\$tomated microcom"\$ter work "a"er software enerall/ consists of trial -alance and ad,ustment worksheets# workin \$a\$er (lead schedule) forms# eas/ facilities for ad,ustin ,ournal entries# and electronic s\$readsheets for various anal/ses. 1). A microcom\$uteri3ed electronic s\$readsheet can -e used instead of \$a\$er and \$encil to create the form of a -ank reconciliation# with s\$ace \$rovided for text lists of outstandin items (usin the la-el in\$ut ca\$a-ilit/)# and math formulas inserted for accurate arithmetic in the reconciliation. 9rintin such a reconciliation is eas/ (and much \$rettier than most accountants< handwritin U). 1&. >ith either data -ase or s\$readsheet software \$acka es# macros (sets of instructions) can -e develo\$ed for retrievin data from the workin trial -alance and convertin this data into classified financial statements. If one or more

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

su-sidiaries are to -e included# the consolidated \$rocess can also -e automated -/ the inclusion of s\$ecial modules desi ned for that \$ur\$ose. 1he standard audit re\$ort# as well as recurrin footnotes# can -e included in the data -ase# and modified to fit the circumstances of the current /ear<s audit results.

1%. Relational data -ase \$acka es have all the advanta es of s\$readsheets# and# in addition# have the ca\$acit/ to store and handle lar er 2uantities of data. 1he/ are es\$eciall/ useful in mani\$ulatin lar e data -ases# such as customer accounts receiva-le# \$lant assets# and inventories. II. Multiple Choice Questions 1. +. ). &. a c c d %. (. '. *. d d c ". 1!. 11. 1+. d 1). 1&. 1%. 1(. c a d 1'. 1*. c 1". d

III. Comprehensive Cases Case 1. a. Auditin .around0 the com\$uter enerall/ refers to examinations of transactions in which a re\$resentative sam\$le of transactions is traced from the ori inal source documents# \$erha\$s throu h existin intermediate records in hard co\$/# to out\$ut re\$orts or records# or from re\$orts -ack to source documents. 4ittle or no attem\$t is made to audit the com\$uter \$ro ram or \$rocedures em\$lo/ed -/ the com\$uter to \$rocess the data. 1his audit a\$\$roach is -ased on the \$remise that the method of \$rocessin data is irrelevant as lon as the results can -e traced -ack to the in\$ut of data and the in\$ut can -e validated. If the sam\$le of transactions has -een handled correctl/# then the s/stem out\$uts can -e considered to -e correct within a satisfactor/ de ree of confidence. 1he C9A would decide to audit .throu h0 the com\$uter instead of .around0 the com\$uter (1) when the com\$uter a\$\$lications -ecome com\$lex or (+) when audit trails -ecome \$artl/ o-scured and external evidence is not availa-le. Auditin .around0 the com\$uter would -e ina\$\$ro\$riate and inefficient in the examination of transactions when the ma,or \$ortion of the internal control s/stem is em-odied in the com\$uter s/stem and when accountin information is intermixed with o\$eration information in a com\$uter \$ro ram that is too com\$lex to \$ermit the read/ identification of data in\$uts and out\$uts. Auditin .around0 the com\$uter will also -e ineffective if the

-.

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## A Risk'based A\$dit A""roach 4 #art ((

sam\$le of transactions selected for auditin transactions that re2uire s\$ecial treatment. c.

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## does not cover unusual

(1) .1est data0 is usuall/ a set of data in the form of \$unched cards or ma netic ta\$e re\$resentin a full ran e of simulated transactions# some of which ma/ -e erroneous# to test the effectiveness of the \$ro rammed controls and to ascertain how transactions would -e handled (acce\$ted or re,ected) and if acce\$ted# the effect the/ would have on the accumulated accountin data. (+) 1he auditor ma/ use test data to ain a -etter understandin of what the data \$rocessin s/stem does# and to check its conformit/ to desired o-,ectives. 1est data ma/ -e used to test the accurac/ of \$ro rammin -/ com\$arin com\$uter results with results \$redetermined manuall/. 1est data ma/ also -e used to determine whether errors can occur without o-servation and thus test the s/stem<s a-ilit/ to detect noncom\$liance with \$rescri-ed \$rocedures and methods. Assurance is \$rovided -/ the fact that if one transaction of a iven t/\$e \$asses a test# then all transactions containin the identical test characteristics will ; if the a\$\$ro\$riate control features are functionin ; \$ass the same test. Accordin l/# the volume of test transactions of a iven t/\$e is not im\$ortant.

d.

In addition to actuall/ o-servin the \$rocessin of data -/ the client# the C9A can satisf/ himself that the com\$uter \$ro ram ta\$es \$resented to him are actuall/ -ein used -/ the client to \$rocess its accountin data -/ re2uestin the \$ro ram of a sur\$rise -asis from a com\$uter li-rarian and usin it to \$rocess test data. 1he C9A ma/ also re2uest# on a sur\$rise -asis# that the \$ro ram -e left in the com\$uter at the com\$letion of \$rocessin data so that he can use the \$ro ram to \$rocess his test data. 1his \$rocedure ma/ reveal com\$uter o\$eration intervention. If# so# ensures that a current version of the \$ro ram is -ein audited# an im\$ortant \$rocedure in com\$uter installations newl/ installed and under oin man/ \$ro ram chan es. 1o ain further assurance a-out this matter# the C9A should in2uire into the client<s \$rocedures and controls for makin \$ro ram chan es and erasin su\$erseded \$ro ram ta\$es# and should examine lo ta\$es where availa-le.

Case 2. a.

Doc\$ment retention IC9AC1 7E 1=G IE1GREA4 C7E1R74 6L61GC8 In onFline real time s/stems and GDI s/stems# the audit trail is fre2uentl/ modified in the form of reduced documentation. 1o com\$ensate# internal controls should \$rovide

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

for ade2uate in\$ut editin # as well as some form of transaction lo as documentation at the in\$ut sta e. IC9AC1 7E 1=G IEDG9GEDGE1 AUDI18 In examinin internal control# under these circumstances# the auditor must rel/ more on o-servation# in2uir/# and re\$rocessin of transactions for control testin \$ur\$oses# and less on document testin . If documents are retained for onl/ a short \$eriod# the auditor should also consider the feasi-ilit/ of fre2uent visits for -oth su-stantive and control testin \$ur\$oses. -. Uniformity of "rocessing IC9AC1 7E 1=G IE1GREA4 C7E1R74 6L61GC8 1he im\$act of this internal control characteristic is to enerall/ stren then control -/ increasin the consistenc/ of \$rocessin . 7nce the \$ro\$er controls are installed and tested# \$rocessin consistenc/ increases the accurac/ of transaction \$rocessin over that which exists in manual s/stems. IC9AC1 7E 1=G IEDG9GEDGE1 AUDI18 1he auditor must em\$hasi3e control stud/ and testin at the \$oint of transaction in\$ut and \$rocessin to determine that the necessar/ controls exist and are functionin . U\$on determinin that the necessar/ in\$ut and \$rocessin controls are in \$lace and functionin \$ro\$erl/# the auditor ma/ elect to \$erform little or no document testin . c. Concentration of f\$nctions IC9AC1 7E 1=G IE1GREA4 C7E1R74 6L61GC8 In manual s/stems# se\$aration of functional res\$onsi-ilities \$rovides a dou-leFcheck for the \$ur\$ose of enhancin \$rocessin accurac/. In GD9 accountin s/stems# consistenc/ of \$rocessin removes the need for dou-leFcheck. IC9AC1 7E 1=G IEDG9GEDGE1 AUDI18 1he auditor must determine that the necessar/ in\$ut editin controls are in \$lace and functionin to ensure that transactions are accuratel/ introduced into the \$rocessin stream. Coreover# to ensure checks and -alances within the electronic data \$rocessin function# the auditor should stud/ the or ani3ational structure of the GD9 rou\$ to ascertain \$ro\$er se\$aration amon the followin functions8 6/stems anal/sis and desi n 9ro ram desi n# develo\$ment# and testin Com\$uter o\$erations involvin data \$rocessin Distri-ution of GD9 out\$ut and re\$rocessin of errors d. Access to data bases

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IC9AC1 7E 1=G IE1GREA4 C7E1R74 6L61GC8 1he reater the num-er of in\$ut terminals \$rovidin access to data -ases# and the more inte rated the data -ase# the reater the dan er of unauthori3ed access. 1o \$rotect the data -ases under these circumstances# the internal control \$olicies and \$rocedures should \$rovide for effective control over identification codes and \$asswords \$ermittin access to data -asesH and the control \$olicies should also fix res\$onsi-ilit/ in desi nated individuals for s\$ecified elements of data -ases. In -atch s/stems# access to ma netic ta\$e and disk files and \$ro rams should -e secured -/ assi nin res\$onsi-ilit/ over these files to one or more individuals desi nated as .li-rarians#0 and institutin a formal .checkout0 s/stem for releasin and reac2uirin files and \$ro rams. IC9AC1 7E 1=G IEDG9GEDGE1 AUDI18 1he auditor should determine that \$ro\$er control over I.D. codes and \$asswords exists# that codes and \$asswords are chan ed fre2uentl/ and voided u\$on termination of em\$lo/ment# and that res\$onsi-ilit/ for elements of data -ases has -een a\$\$ro\$riatel/ fixed. In -atch s/stems# the auditors should determine that ta\$e and disk files and \$ro rams stored offFline are \$ro\$erl/ secured. Case 3. a. T&"t 4#t# #%%'o#3\$8 1he auditor \$re\$ares simulated in\$ut data (-oth valid and invalid transactions) that are \$rocessed# under the auditor<s control# -/ the client<s \$rocessin s/stem. Advantage8 A ood wa/ of testin existin controls for \$ro\$er functionin . Disadvantage8 Difficult/ in desi nin com\$rehensive test dataH Difficult/ in ascertainin whether the \$ro rams tested are the same \$ro rams used -/ the client in \$rocessin actual transactions and events durin the /ear. IT+ #%%'o#3\$8 1he auditor creates a fictitious entit/ within the client<s actual data files# and \$rocesses simulated data durin live \$rocessin -/ client. 1he auditor then com\$ares the results of \$rocessin with antici\$ated results. Advantage8 Ireater assurance that \$ro rams tested are \$ro rams used -/ the client (the a\$\$roach can -e a\$\$lied at different \$oints in time durin the /ear). Disadvantage8 Difficult to remove test data from the s/stem without harmin client<s files. T#55 !5 #!4 t'#3 !58 1his is a techni2ue where-/ an identifier or .ta 0 is affixed to a transaction recordH and the ta tri ers .sna\$shots0 durin the

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c.

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## A Risk'based A\$dit A""roach 4 #art ((

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understandin of how the com\$uter \$rocesses data# nor of the controls which have -een incor\$orated into the com\$uter \$ro rams. In auditin thro\$gh the com\$uter# the auditor actuall/ tests the \$ro rammed controls used in \$rocessin s\$ecific a\$\$lications. 6uch techni2ues as desi n \$hase auditin # I15# ta in and tracin # 6CAR5# test data# and sur\$rise audit are exam\$les of auditin throu h the com\$uter. d. 9arallel simulation is an automated version of auditin around the com\$uter in that the auditor creates a set of a\$\$lication \$ro rams that simulate the \$rocessin s/stem# and com\$ares out\$ut from the real and simulated s/stems. Com\$arison of in\$ut with out\$ut i nores the essential characteristics of the \$rocessin s/stem and assumes that if the out\$uts are identical# the s/stem is \$rocessin transactions accuratel/. 1he auditor mi ht elect to use \$arallel simulation in com-ination with desi n \$hase auditin . Desi n \$hase auditin ensures that the necessar/ controls are installed durin s/stem desi n. ?/ \$ermittin the auditor to test lar e volumes of transactions# \$arallel simulation hel\$s to confirm whether these controls are workin .

Case 4. (a) Test decks# also called .test data#0 are sets of com\$uter in\$ut data which reflect a variet/ of auditorFidentified transactions for verification throu h actual com\$uter \$rocessin to detect invalid \$rocessin of results (i.e.# existin \$ro rams run test data). Ideal test data should \$resent the a\$\$lication under examination with ever/ \$ossi-le com-ination of transactions# master file situations# and \$rocessin lo ic which could -e encountered durin actual com\$rehensive \$rocessin . 1est data are usuall/ \$rocessed se\$aratel/ from actual data usin co\$ies of master files. 1est decks are most feasi-le when the variet/ of transactions \$rocessin and controls is relativel/ limited (i.e.# fairl/ sim\$le files). Uses include checkin and verif/in 8 (1) in\$ut transaction validation routines# error detection# and a\$\$lication s/stem controls# (+) \$rocessin lo ic# and controls associated with creation and maintenance of master files# ()) com\$utational routines such as interest and asset de\$reciation# and (&) incor\$oration of \$ro ram chan es. (-) #arallel sim\$lation consists of the \$re\$aration of a se\$arate com\$uter a\$\$lication that \$erforms the same functions as those used -/ the actual a\$\$lication \$ro rams. 1he simulation \$ro rams read the same in\$ut data as the a\$\$lication \$ro rams# use the same files# and attem\$t to \$roduce the same results (e. .# real data run throu h test \$ro rams). 1hese simulated

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

results are matched with those from the live \$ro rams# \$rovidin a means for testing thro\$gh com"arison. Uses include all those cited for test decks. (c) 1he integrated test facility a\$\$roach \$ermits the introduction of auditorF selected test data into a com\$uter s/stem with actual or .live0 data and then traces the flow of transactions throu h the various s/stem \$rocessin functions for com\$arison to \$redetermined actual results. An I15 involves the creation or esta-lishment of a .dumm/0 entit/ (e. .# a -ranch or division) to receive the results of the test \$rocessin . 1herefore# transactions are \$rocessed a ainst the test entit/ to ether with actual transactions. 1est data must -e removed from the entit/<s records u\$on com\$letion of the test. Uses are identical to the test deck techni2ue. (d) Tagging and tracing and %CAR- are forms of transaction trackin \$rovided onl/ for auditor selected com\$uter in\$uts carr/in a s\$ecial code. If the ca\$a-ilit/ is \$rovided in the a\$\$lication s/stem in advance# the attachment of a code to an/ in\$ut transaction can -e made to enerate a \$rinted transaction trail for that item followin each ste\$ of the a\$\$lication \$rocessin . Uses include8 (1) determinin the im\$act of s\$ecific transactions on master records or calculations in hi h volume s/stems# (+) .fla in 0 unusual or a-normal transactions# and ()) .de-u in 0 a\$\$lication \$ro rams.

Case 5. In an audit of a com\$uterF-ased s/stem# ade2uate trainin and ex\$erience must -e directl/ related to GD9. In \$articular# the auditor should -e knowled ea-le of what com\$uter s/stems do# how to test the o\$erations of an GD9 s/stem# and how to use GD9Funi2ue documentation. 1he trainin and \$roficienc/ standard contri-utes to satisfaction of the inde\$endence standard -/ ena-lin the auditor to make his own decisions and ,ud ments. 7therwise# he mi ht tend to su-ordinate his ,ud ment to other \$ersons# \$ossi-l/ to client \$ersonnel. >hen the auditor lacks trainin and \$roficienc/# it is virtuall/ im\$ossi-le to maintain an o\$erational inde\$endence over audit decisions. An inde\$endence of mental attitude is futile if actual decisions are su-ordinated to others. 1he exercise of due audit care re2uires a critical review at ever/ level of audit su\$ervision of the work done and the decisions made -/ auditors. 4ackin the re2uisite skills and lackin inde\$endent decisions# the due care ex\$ected of an auditor at o\$erational# su\$ervisor# and review levels cannot -e delivered.

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1he 9hili\$\$ine 6tandards on Auditin re2uire ade2uate \$lannin and su\$ervision of assistants. 1rainin and \$roficienc/ in com\$uter s/stems auditin is necessar/ in order to \$lan access to com\$uteri3ed records# \$ro rams# and to o-tain machine time for conductin audit \$rocedures. 1he \$lannin should \$rovide for an earl/ examination of the com\$uter s/stem so that further \$rocedures involvin nonFcom\$uter control and accountin features ma/ -e \$lanned should the/ de\$end u\$on com\$uter control \$rocedures. 1rainin and \$roficienc/ are ver/ im\$ortant for -ein a-le to o-tain an understandin of the internal control structure in a com\$uter s/stem. Client \$ersonnel will ex\$ect audit \$ersonnel to -e ca\$a-le of workin with a com\$uter s/stem. 1he 9hili\$\$ine 6tandards on Auditin also re2uire the auditor to o-tain sufficient com\$etent evidential matter to \$rovide a -asis for an o\$inion on financial statements. Documentar/ evidence relatin to a com\$uter s/stem includes \$ro ram flow charts# lo ic dia rams# and decision ta-les that are not normall/ used in nonFcom\$uter s/stems. 6ince these t/\$es of documentation are a \$art of the evidence# the/ must -e understood -/ the auditor# and understandin of them comes throu h trainin and \$roficienc/ in their use.

## CHAPTER 23 TESTS O* CO'TRO(S

I. Review Questions 1. Directl/. =i her levels of control risk induce auditors to audit lar er sam\$les of receiva-les# with confirmation date closer to the fiscal /ear end date. As for nature of the \$rocedures8 hi her levels of control risk induce auditors to use \$ositive confirmations instead of ne ative confirmations# and to consider vouchin su-se2uent \$a/ments -/ the customers. A .walk throu h0 is the \$rocess of followin a transaction from its initiation (customer order in the Revenue C/cle) throu h all the various \$rocessin ste\$s until it is recorded in the formal accountin records (accounts receiva-le and sales). Usuall/ sam\$les of all documents are collected (sales order# sales invoices# sales return sli\$# credit memo# shi\$\$in document# remittance advice and dail/ remittance re\$ort) and notes are made of \$rocedures each \$erson \$erforms.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

1he \$ur\$ose of the .walk throu h0 is to o-tain an understandin of the transaction flow# the control \$rocedures and \$o\$ulations of documents that ma/ -e utili3ed in test of controls auditin .

).

1he review (o-tainin an understandin ) of the control structure is \$rimaril/ a \$rocess of identif/in control \$rocedures (stren ths) and lack of controls (weaknesses) which will affect su-se2uent su-stantive \$rocedures. 1he internal auditors should# throu h \$eriodic checks# ensure that the control account is \$eriodicall/ reconciled to the customer su-sidiar/ accounts# -ank statements are reconciled and that all \$renum-ered documents# es\$eciall/ invoices# have all num-ers accounted for. 6ome internal auditors also confirm accounts receiva-le. Internal auditors also mi ht review and evaluate customer com\$laints for si ns of weaknesses in the \$rocedures leadin to errors in accounts receiva-le. 1he features of a cash recei\$ts internal control s/stem which would -e ex\$ected to \$revent an em\$lo/ee from a-scondin with com\$an/ funds and coverin with funds from the em\$lo/ee \$ension fund is the \$rohi-ition a ainst one em\$lo/ee havin custod/ of com\$an/ funds and noncom\$an/ funds. 1he auditor can detect such transfers -/ controllin and countin -oth funds simultaneousl/. 1o \$revent the cash recei\$ts ,ournal and recorded cash sales from reflectin more than the amount shown on the dail/ de\$osit sli\$# the internal control s/stem should \$rovide that recei\$ts -e recorded dail/ and intact. A careful -ank reconciliation -/ an inde\$endent \$erson could detect such errors.

&.

%.

(.

1he evaluation after the review \$hase was to determine which controls a""eared ade2uate as a -asis for ,ustif/in a low control risk assessment. 1he final assessment after test of controls auditin is to determine if the controls are act\$ally o\$eratin as well as the/ a\$\$eared to -e. 1he o-,ectives of internal control relate to transactions# and -/ cate or/ are8 validit/# com\$leteness# authori3ation# accurac/# classification# accountin and \$ro\$er \$eriod. 1he o-,ectives ex\$ensed in eneral terms and s\$ecific terms a\$\$lied to cash recei\$ts are as follows8 !am"le of Cash Recei"ts 9eneral Ob)ective %"ecific Ob)ective 1. Recorded transactions are valid and documented. +. All valid transactions are recorded and none omitted. 1. Recorded cash recei\$ts are su\$\$orted -/ remittance advices. +. All cash recei\$ts are entered in the dail/ remittance list# de\$osited intact and recorded in the accounts receiva-le control account.

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## A Risk'based A\$dit A""roach 4 #art ((

). 1ransactions are authori3ed -/ com\$an/ \$olic/.

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&. 1ransaction \$eso amounts are \$ro\$erl/ calculated. %. 1ransactions are \$ro\$erl/ classified in the accounts. (. 1ransaction accountin is com\$lete. '. 1ransactions are accounted in the \$ro\$er \$eriod. *. ".

). Cash recei\$ts for transactions other than merchandise sales (scra\$ sales# sales of fixed assets) are \$ro\$erl/ authori3ed. &. Cash recei\$ts are com\$ared to invoice terms to determine \$ro\$er cash discounts. %. Cash recei\$ts for nonmerchandise sales are \$osted to \$ro\$er accounts. (. All cash recei\$ts for credit sales are \$osted to customer individual accounts. '. Cash recei\$ts are de\$osited dail/ intact and recorded as of date received.

If the credit limits are set and entered incorrectl/# the credit a\$\$roval \$rocess will -e s/stematicall/ deficient. 1he functions which should -e se\$arated to maintain internal control in a \$urchasin s/stem include (1) custod/ of the oods (receivin and stores de\$artments)# (+) authorit/ to initiate a transaction (\$urchasin de\$artment) and ()) -ookkee\$in (accounts \$a/a-le de\$artment# inventor/ recordFkee\$in de\$artment).

1!. 1he .walk throu h0 of a \$urchase transaction would -e in with the \$re\$aration of the re2uisition -/ the 6tores de\$artment# throu h the -iddin \$rocess and \$re\$aration of the \$urchase order -/ the \$urchasin a ent# to recei\$t of vendor<s invoices and receivin re\$ort -/ the \$urchasin a ent and finall/ to accounts \$a/a-le voucher \$re\$aration. 9rocedures would -e o-served and notations made on document sam\$les of \$rocedures followed. Documents are collected to note where documentar/ evidence exists or control \$rocedures -ein followed. 1he followin documents would -e collected8 re2uisition# \$urchase order# receivin re\$ort and voucher. 1he .walk throu h0 and sam\$le documents would assist the auditor in understandin the flow of transactions. 11. a. -. ?lank vouchers ke\$t in secure location availa-le onl/ to authori3ed \$ersonnel. ?lank su\$\$ortin documents (invoices# receivin re\$orts# re2uisitions# \$urchase orders) ke\$t in secure locations availa-le onl/ to authori3ed \$ersonnel.

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c. d. e. f.

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

6u\$\$ortin documents canceled -/ Cash Dis-ursement function when checks are \$re\$ared. 6e\$aration of duties of \$re\$arers of su\$\$ortin documents# \$re\$aration of vouchers# check \$re\$aration# and check si nin . Douchers and other su\$\$ortin documents reviewed -/ check si ners. Checks mailed directl/ -/ si ner and not returned to accounts \$a/a-le.

1+. Authori3ation for vouchers \$a/a-le recordin mainl/ consist of an a\$\$roved \$urchase order# a receivin re\$ort# and an accurate vendor invoice. Auditors should look for \$urchase a\$\$roval si natures# receivin a\$\$roval si natures# and a\$\$roval of the vendor invoice ; checks -/ client for \$ro\$er 2uantit/# \$rice# and discount. 1). 1he \$oint of this 2uotation is to enerate discussion on the source of errors and therefore the controls necessar/ when an accountin \$rocess is com\$uteri3ed. Discussion items mi ht include the followin 8 1. +. ). &. %. (. '. *. 9eo\$le have -ad da/s and make mistakesH com\$uters do not have -ad da/s. Cur\$h/<s 4aw ; If it is \$ossi-le to make an error# someone will find a wa/ to do it. 9eo\$le initiate the transactions and will make errors. All controls should -e considered to ether (manual and com\$uter). Gxcellent com\$uter controls cannot -e relied u\$on if the related manual controls are weak. In com\$uter s/stems# it is extremel/ im\$ortant to esta-lish extensive in\$ut validation controls to \$revent \$eo\$le errors from ettin into the \$rocessin (III7 ; ar-a e in# ar-a e out). 9eo\$le can \$revent a ood com\$uter s/stem from workin well if the/ are not convinced it is in their -est interests. 9eo\$le will rarel/ 2uestion com\$uter \$rinted out\$ut# even thou h it ma/ not -e correct. Cost com\$uter controls are to \$revent# detect# or correct errors made -/ \$eo\$le.

1&. 1he \$ur\$ose of the auditor<s search for unrecorded lia-ilities is to ather evidence as to whether the lia-ilit/ assertion is true. 1he same concern exists in the internal control o-,ective .all valid transactions are recorded and none are omitted.0 5rom an evidence atherin \$ers\$ective# it is much more difficult to ather evidence on unrecorded transactions than to ather evidence that recorded transactions (and account -alances) are \$ro\$er. 1he search for unrecorded lia-ilities includes \$rocedures in other audit areas such as 2uestions on -ank and insurance confirmations and vouchin the source of funds for asset additions. 6\$ecific audit \$rocedures in the search for unrecorded lia-ilities include8

18-82

## A Risk'based A\$dit A""roach 4 #art ((

1. +.

11-83

). &. %.

7-tain vendor<s invoices (or accounts \$a/a-le vouchers) recorded for several da/s after the -alance sheet date to determine if the lia-ilit/ relates to the -alance sheet \$eriod under audit. 6can cash dis-ursements for several da/s su-se2uent to /earFend and vouch to su\$\$ort to determine if cutoff was \$ro\$er. 6can all cash dis-ursements until the end of field work for unusual amounts and \$a/ees to determine if amounts \$aid re\$resent lia-ilities of the -alance sheet \$eriod. Gxamine ?IR tax re\$orts and corres\$ondence and the audit re\$orts of tax authorities and trace additional tax assessments to the accounts. Confirmation of accounts \$a/a-le. Use anal/tical \$rocedures such as trend com\$arisons of accounts \$a/a-le to sales# sales taxes to sales# \$a/roll taxes to ross \$a/roll and interest ex\$ense to avera e notes \$a/a-le.

1%. A .walk throu h0 involves followin a transaction from initiation throu h the various ste\$s until the transaction is recorded in the formal accountin records. In the conversion c/cle# the followin would constitute a com\$lete .walk throu h80 %te" Doc\$ments Collected Controls /oted 9re\$are \$roduction 9roduction 7rder (9.7.) 6u\$\$ort for 9.7. orders 9re\$are -ill of materials and man\$ower needs Assi n ,o- order and foreman @o- tickets and material re2uisitions \$re\$ared Raw material records u\$dated# issue sli\$s \$re\$ared 7-serve time entered and foreman a\$\$roval on @1 Direct la-or re\$ort \$re\$ared 7-serve timekee\$in # com\$are ,o- tickets to clock cards Caterial used re\$ort Caterial used re\$ort 4a-or re\$ort (4R) ?ill of materials (?.C.) Can\$ower needs (C.E.) 6e\$aration \$lannin from \$roduction. Eote se\$aration \$roduction su\$ervisor from foreman duties. @o- tickets (@1) 9roduction foreman Caterial re2uisition (CR) duties se\$arated from authori3ation. Issue sli\$ (I6) Caterials not issued without CR. I6 \$re\$ared for all materials released. A\$\$roval -/ foreman of hours. @o- tickets su\$\$ort 4.R. Reconciliation hours \$er clock cards to hours \$er @.1. Issue sli\$s and

18-83

11-84
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

\$re\$ared 7-serve matchin issue sli\$s and material used re\$ort 7-serve matchin ,otime tickets (or la-or distri-ution) to la-or re\$ort Gnter costs in ,o- cost sheets 6ummar/ entr/ \$re\$ared. 1race summar/ entr/ to Ieneral 4ed er \$ostin 9re\$aration of com\$letion re\$ort 7-serve units com\$ared to RUC# \$ost finished records 9roducts received re\$ort \$re\$ared 7-serve com\$arison RUC and 9RR @o- sheets closed out# summar/ entr/ \$re\$ared 1race summar/ entr/ to Ieneral 4ed er \$ostin 6ummar/ entr/ form 9roducts received re\$ort (9RR) Re\$ort of units com\$leted (RUC) @o- cost sheets (@C6) 6ummar/ entr/ form (CUR) re2uisitions su\$\$ort CUR. Records from sources reconciled. Records from se\$arate sources reconciled.

6u\$\$ort for all entries in @C6. @o- cost sheets su\$\$ort summar/ entries. 6e\$aration of dutiesH cost accountin and eneral led er. Inde\$endent re\$ort of \$roduction com\$leted. Inde\$endent check of RUC. Inde\$endent records of units \$ut into finished oods inventor/. Records from se\$arate sources reconciled. Closed ,o- sheets# RUC and 9RR su\$\$ort summar/ entries. 6e\$aration of dutiesH cost accountin and eneral led er.

1(. >eaknesses (lack of control where auditors -elieve one is necessar/) are not audited -ecause auditors do not rel/ u\$on weaknesses to \$revent# detect or correct material errors. Auditors must consider the financial im\$act of weaknesses on financial statements and \$lan su-stantive tests accordin l/. A control stren th ma/ -e identified in interviews durin the review \$hase (or in \$re\$arin the flowcharts or 2uestionnaires)# -ut durin test of controls auditin #

18-84

## A Risk'based A\$dit A""roach 4 #art ((

11-85

found to -e nonexistent or o\$eratin ineffectivel/. 5or exam\$le# in the conversion c/cle the \$roduction mana ement ma/ state that foremen a\$\$rove workers< ,o- time tickets. =owever# when a sam\$le of ,o- time tickets are examined -/ auditors for evidence of a\$\$roval# none is found. 1hus# a weakness is not found until the control is tested. 1herefore# control risk should not -e assessed low until evidence is athered that the control is o\$eratin effectivel/. 1'. 1he \$ur\$ose of this review 2uestion is to foster discussion toward what information an inde\$endent auditor needs to know. Items relevant to the 2uotation mi ht include8 1. Reference to the standard re ardin .ade2uate technical trainin and \$roficienc/ as an auditor.0 +. Reference to the standard re ardin .due \$rofessional care.0 ). 7-viousl/# the auditor must -e knowled ea-le a-out cost accountin to audit a manufacturin com\$an/. &. In a manufacturin com\$an/# the inventories most likel/ will -e a ma,or asset which will re2uire su-stantial audit work. %. A \$roficient auditor must -e knowled ea-le in all \$hases of the -usiness# includin \$roduction# marketin # finance as well as accountin data \$rocessin . 1*. 1he sur\$rise o-servation ena-les the auditor to see how the distri-ution s/stem reall/ works and increases his chances of detectin fraud. 6uch an o-servation involves takin control of \$a/checks# then accom\$an/in a client re\$resentative as the distri-ution takes \$lace. 1he auditor checks to see that each em\$lo/ee is identified and that onl/ one check is iven to each individual. Unclaimed checks are controlled and examined to detect an/ fictitious \$ersons on the \$a/roll. 1". A .walk throu h0 of a \$ersonnel and \$a/roll transaction would include discussions with each \$erson handlin \$ersonnel and \$a/roll records. 1he followin illustrates the ste\$s and documents collected. %te"s =irin ; \$ersonnel de\$t. Deductions ; \$ersonnel de\$t. 1imekee\$in 6ho\$s Cost distri-ution Accounts \$a/a-le Cash dis-ursement Doc\$ment2s3 Collected Authori3ation to hire and rate assi nment 9ersonnel forms# em\$lo/ee authori3ation for deductions Clock card @o- time ticket 4a-or distri-ution sheet 9a/roll voucher 9a/roll checks

If the \$a/roll is \$rocessed -/ com\$uter# the clock cards and ,o- time tickets would -e traced to -atch control in the timekee\$in and \$roduction de\$artments#

18-85

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%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

to data \$re\$aration (ke/in to machine sensi-le form)# to edit and validation error re\$orts and other com\$uter out\$ut indicatin control and finall/ to com\$uter \$re\$ared checks# la-or distri-ution re\$orts and summar/ eneral led er entries.

II. Multiple Choice Questions 1. +. ). &. c c c %. (. '. *. a c c ". 1!. 11. 1+. d a a 1). 1&. 1%. 1(. a c d 1'. 1*. 1". +!. d d c -

III. Comprehensive Cases Case 1. 1. Controlled access to -lank sales invoices. a. 7-servation. Disit the stora e location /ourself and see if unauthori3ed \$ersons could o-tain -lank sales invoices. 9ick some u\$ /ourself to see what ha\$\$ens. -. 6omeone could \$ick u\$ a -lank and make out a fictitious sale. =owever# ettin it recorded would -e difficult -ecause of the other controls such as matchin with a co\$/ from the shi\$\$in de\$artment. (1hus a control access deficienc/ ma/ -e com"ensated -/ other control \$rocedures.) 6ales invoices check for accurac/. a. Douchin and Recalculation. 6elect a sam\$le of recorded sales invoices and vouch 2uantities thereon to -ills of ladin # vouch \$rices to \$rice lists# and recalculate the math. -. Grrors on the invoice could cause lost -illin s and lost revenue or overchar es to customers which are not collecti-le (thus overstatin sales and accounts receiva-le). Duties of accounts receiva-le -ookkee\$er. a. 7-servation and In2uir/. 4ook to see who is \$erformin -ookkee\$in and cash functions. Determine who is assi ned to each function -/ readin or ani3ation charts. Ask other em\$lo/ees. -. 1he -ookkee\$er mi ht -e a-le to steal cash and mani\$ulate the accountin records to ive the customer credit and hide the theft. (De-it a customer<s \$a/ment to Returns and Allowances instead of to cash# or ,ust char e the control total im\$ro\$erl/). Customer accounts re ularl/ -alanced with the control account. a. Recalculation. Review the client<s workin \$a\$er showin -alancin Areconciliation. Do the -alancin /ourself. the

+.

).

&.

18-86

## A Risk'based A\$dit A""roach 4 #art ((

-.

11-87

Accountin entries could -e made inaccuratel/ or incom\$letel/ and the control account ma/ -e overstated or understated. some or all of the

## Case 2. 1he discussion could take several directions# includin followin 8 1.

Caterial >eakness. 1he facts seem to su est .a condition in which s\$ecific control features (few or none are descri-ed) or the de ree of com\$liance with them do not reduce to a relativel/ low level the risk that errors or irre ularities in amounts that could -e material to the financial statements ma/ occur and not -e detected within a timel/ \$eriod -/ em\$lo/ees in the normal course of \$erformin their assi ned functions.0 Castro has authorit/ and influence over too man/ interrelated activities. Eothin he does seems to -e su-,ect to review or su\$ervision. =e even is a-le to exclude the internal auditor. An identification of the \$otential irre ularities will illustrate the misdeeds he can \$er\$etrate almost sin leFhandedl/.

+.

9otential irre ularities include8 a. -. Castro can collude with customers to ri low -ids and take kick-acks# there-/ de\$rivin the com\$an/ of le itimate revenue. Castro can direct \$urchases to favored su\$\$liers# \$a/ unnecessaril/ hi h \$rices and take kick-acks. =e mi ht even set u\$ a controlled dumm/ com\$an/ to sell over\$riced materials to the com\$an/. Eo com\$etitive -iddin control \$revents these activities. Castro# throu h the control of \$h/sical inventor/# can (i) remove materials for himself# and (ii) mani\$ulate the inventor/ accounts to conceal shorta es. Castro can order truck shi\$\$in services for his own \$ur\$oses and cause the char es to -e \$aid -/ the com\$an/. Castro can mani\$ulate the customer -illin (similar to a a-ove) to de\$rive the com\$an/ of le itimate revenue while takin an unauthori3ed commission or kick-ack. ood internal control has -een

c. d. e.

).

## Almost ever/ desira-le characteristic of circumvented8 a. -.

c.

6e re ation of 5unctional Res\$onsi-ilities. Castro has authori3ation and custodial res\$onsi-ilities. Authori3ation# 6u\$ervision. Castro is a\$\$arentl/ su-,ect to no su\$ervision or review. 1he accountin staff is \$ro-a-l/ \$owerless to challen e transactions -ecause of 6amuel<s a\$\$arent a\$\$roval of Castro<s \$owers. Controlled Access. 1he whole situation ives Castro access to necessar/ \$a\$ers# records# and assets to carr/ out his oneFman show.

18-87

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%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

d. 9eriodic Com\$arison. Eo one else a\$\$arentl/ has an/ access to the materials inventor/ in order to conduct an actual count for com\$arison to the -ook value (recorded accounta-ilit/) of the inventor/.

Case 3. 1he \$ur\$ose of this 2uestion is to et the student to consider where the functions that are considered incom\$ati-le in a manual s/stem occur in a com\$uter s/stem. 1he functions should -e se\$arated in a manual or com\$uter accountin s/stem such that different \$eo\$le a\$thori6e the sales transactions# record the transactions# have c\$stody to the assets (inventor/) and reconcile the -ooks to the assets. Different \$eo\$le should8 indicate the sales order source document (authori3e)# \$re\$are the com\$uter \$ro ram (authori3e and record)# o\$erate the com\$uter (record)# have custod/ of inventor/ and correct errors (reconciliation). Case 4. If the credit limits are set and entered incorrectl/# the credit a\$\$roval \$rocess will -e s/stematicall/ deficient.

Case 5. &emorand\$m
8=D &!=\$D DA8,D SA*J,-8D *oard o) D"rector 3 8he Potter Art 9ea:ue 5Student; na'e6 -ontrol <ea%ne e related to -a h Ad'" "on &ee e "n the e>" t"n: y te' o) ca h the <ea%ne e that e>" t and 'y <ea%ne e . # <"ll be plea ed to )urther e>planat"on that 'ay be

Cou reEue ted a report <h"ch "dent")"e the <ea%ne ad'" "on )ee and 'y reco''endat"on . *elo< are reco''endat"on )or procedure that overco'e the e d" cu the e at the ne>t board 'eet"n: and o))er nece ary.

WeaknessD 8here " no e:re:at"on o) dut"e bet<een per on re pon "ble )or collect"n: ad'" "on )ee and per on re pon "ble )or author"7"n: ad'" "on. RecommendationD =ne cler% 5herea)ter re)erred to a the collect"on cler%6 hould collect ad'" "on )ee and " ue prenu'bered t"c%et . 8he other cler% 5herea)ter re)erred to a the ad'" "on cler%6 hould author"7e ad'" "on upon rece"pt o) the t"c%et or proo) o) 'e'ber h"p.

18-88

## A Risk'based A\$dit A""roach 4 #art ((

WeaknessD An "ndependent count o) pay"n: patron " not 'ade.

11-89

RecommendationD 8he ad'" "on cler% hould reta"n a port"on o) the prenu'bered ad'" "on t"c%et 5ad'" "on t"c%et tub6. WeaknessD 8here " no proo) o) accuracy o) a'ount collected by the cler% . RecommendationD Ad'" "on t"c%et tub trea urer da"ly. hould be reconc"led <"th ca h collected by the

WeaknessD -a h rece"pt are not pro'ptly prepared. RecommendationD 8he ca h collect"on hould be recorded by the collect"on cler% da"ly on a per'anent record that <"ll erve a the )"r t record o) accountab"l"ty. WeaknessD -a h rece"pt are not pro'ptly depo "ted. -a h hould not be le)t undepo "ted )or a <ee%. RecommendationD -a h hould be depo "ted at lea t once each day. WeaknessD 8here " no proo) o) accuracy o) a'ount depo "ted. RecommendationD Authent"cated depo "t l"p hould be co'pared <"th da"ly ca h collect"on record . D" crepanc"e hould be pro'ptly "nve t":ated and re olved. #n add"t"on3 the trea urer hould e tabl" h a pol"cy that "nclude an analyt"cal rev"e< o) ca h collect"on . WeaknessD 8here " no record o) the "nternal accountab"l"ty o) ca h. RecommendationD 8he trea urer hould " ue a ":ned rece"pt o) all proceed rece"ved )ro' the collect"on cler%. 8he e rece"pt hould be 'a"nta"ned and hould be per"od"cally chec%ed a:a"n t ca h collect"on and depo "t record .

Case 6. a.

1he \$ur\$oses of these audit \$rocedures are8 1. 1o su-stantiate the validit/ of the asset .cash0 in the -alance sheet# as it ma/ su-stantiall/ consist of .cash in transit0 from several sales divisions. 1o determine \$ro\$er cash .cutoff0# i.e.# to detect an/ unintentional errors overstatin or understatin cash -etween the current and the followin accountin \$eriod. 1o disclose .kitin 0 (if an/)# e. .# \$er\$etrated -/ the home office cashier in collusion with one or more sales divisions em\$lo/ees.

+.

). -.

A\$dit #rogram for %ales Divisions 4 A\$dit %te"s 1. 9re\$are a schedule of transfer \$a/ments made -/ the -ranch for a \$eriod coverin two weeks \$rior and two weeks after the end of the fiscal \$eriod showin 8 Check num-er Date of entr/ in cash dis-ursements -ook Amount of check

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%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Date of \$erforation -/ \$a/in -ank 1ransfer checks outstandin at the date of cutoff 1ransfer checks outstandin at the date of reconciliation. +. ). &. Com\$are dates of issue on canceled checks and of entries. 1race and com\$are dates of \$erforation and dates of \$a/ment on the -ank statement and the .cutoff0 statement. Com\$are dates of issue of checks to date of \$erforation lookin for8 a. -. %. unusual dela/s in \$a/ment discre\$anc/ in accountin \$eriods for the two dates.

6can cancelled checks and cash dis-ursements records durin the /ear for8 a. -. names of \$a/ees# consecutive num-ers of checks to determine whether an/ \$a/ments other than re ular transfers to main office were made from this account.

(.

Reconcile individuall/ several transfers durin the /ear to corres\$ondin collections \$resumed to -e transferred as of each individual date. Reconcile total collections for the /ear to total transfers.

'.

Case 7. 1.

a. -.

Recorded \$a/roll transactions are valid (no fictitious em\$lo/ees). 9a/checks mi ht -e dela/ed and terminated workers mi ht continue to -e .\$aid0 (with theft of check -/ someone else) if \$a/roll is not \$rom\$tl/ notified of new hires and terminations. Recorded \$a/roll deductions are valid. Incorrect amounts mi ht -e deducted from \$a/. Recorded \$a/roll transactions are valid and a\$thori6ed. If \$a/roll de\$artment \$ersonnel were also res\$onsi-le for time records# the/ would have effective control over transaction a\$thori6ation (i.e.# hours worked a\$\$roval) and could over\$a/ themselves or friends. 9a/roll and la-or cost transactions are com"lete. Cost accountin records mi ht contain more or fewer \$esos than actuall/ \$aid (\$er \$a/roll data). 6im\$le errors in cost anal/ses mi ht occur.

+. ).

a. -. a. -.

&.

a. -.

18-90

11-91

## CHAPTER 24 SUBSTA'TI0E TESTS O* TRA'SACTIO'S A'D BA(A'CES

I. Review Questions 1. 1he c\$toff bank statement is a -ank statement sent -/ the -ank directl/ to the auditor# and it is usuall/ for a fifteen or twent/ da/ \$eriod followin the reconciliation date. 1he -asic use of the statement -/ the auditor is to determine whether outstandin checks were actuall/ mailed -efore the reconciliation date. All cash funds (and ne otia-le investment stock and -ond certificates) should -e counted at the same time (simultaneousl/) so that mone/ (or securities) cannot -e shifted from one location to another to conceal a shorta e. If simultaneous count cannot -e made# as each fund (or each ne otia-le asset) is counted# it should -e locked and sealed until all are counted. ;iting is the \$ractice of recordin a de\$osit of an inter-ank transfer in one \$eriod# -ut dela/in the recordin of the dis-ursement until the next \$eriod ; thus dou-le countin the amount of the transfer. It is used to cover u\$ a cash shorta e. Auditors schedule all -ank transfers around the /earFend and examine the dates de\$osited and dis-ursed \$er -ooks and the dates de\$osited and dis-ursed \$er -ank. 1hus# the auditors can determine if -oth sides of the transfers are recorded in the same \$eriod and the \$ro\$er \$eriod. A .\$ositive0 confirmation is a re2uest for a res\$onse from an inde\$endent \$art/ who the auditor has reason to ex\$ect is a-le to re\$l/. A .ne ative0 confirmation is a re2uest for a res\$onse from the inde\$endent \$art/ only if the information is dis\$uted. Ee ative confirmations should also -e sent onl/ if the reci\$ient can -e ex\$ected to detect error and re\$l/ accordin l/. Ienerall/# vo\$ching of doc\$mentation underl/in receiva-les -alances is deferred until after confirmation. 1hen vouchin is \$erformed in re ard to accounts for which confirmations were mailed -ut no re\$lies received. Additionall/# vo\$ching ma/ -e used to ather evidence a-out account discre\$ancies and dis\$utes indicated on confirmation res\$onses. 6ales cutoff is audited -/ selectin sales invoices# shi\$\$in documents# and contracts created in the \$eriod (usuall/ 1! da/s to two weeks) -efore and after the fiscal /earFend. 1he transactions are traced to the sales and receiva-les accounts to \$rove whether the/ were recorded in the \$ro\$er \$eriod. 6imilarl/#

+.

).

&.

%.

(.

18-91

11-92
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

recorded sales in this \$eriod ma/ -e vo\$ched to underl/in determine whether recordin was in the \$ro\$er \$eriod. documents to

'. *.

Refer to \$a es &%* to &(!H *+& to *+%H *+' to *+*. 1o \$revent em-e33lement throu h creation of fictitious credit memos# the internal control s/stem should \$rovide that all credit memos -e \$renum-ered# controlled# and a\$\$roved -/ a \$art/ inde\$endent of the \$re\$arer. Additionall/# credit memos should -e a\$\$roved onl/ with \$ro\$er su\$\$ortin documentation# e. .# a receivin re\$ort or corres\$ondence. Auditors et in the most trou-le -/ missin overstated assets and understated lia-ilities. 1herefore# the/ need to audit for the existence of assets and the com\$leteness of lia-ilities.

".

1!. Eotes \$a/a-le audit evidence o-tained from a standard -ank confirmation used in the audit cash. 6ales tax lia-ilit/ derived \$artiall/ from the audit of sales revenue (also commissions \$a/a-le and excise taxes \$a/a-le). Income tax lia-ilit/ is derived from the net income num-er (audit of all revenue and ex\$ense accounts). 11. 1he t/\$es of fraud and material misstatement with res\$ect to cash disb\$rsements include8 1. 1he sendin of checks to a fictitious \$erson or com\$an/ to accom\$lices outside (cou\$led with internal record alterations). +. 1he increasin (alterin ) of amounts \$a/a-le to outside accom\$lices. ). 1he interce\$tin of \$a/ments to a -ank (cou\$led with internal record alterations). &. 1he drawin of checks \$a/a-le to cash or -earer for one<s own use.

1he \$rocedures auditors use most fre2uentl/ to detect cash dis-ursement em-e33lement schemes include8 1. A \$roof of cash ; a recalc\$lation ; which reconciles cash recei\$ts and dis-ursements \$er the -ank statement with recei\$ts and dis-ursements recorded in the accounts. 1he auditor will satisf/ himself as to the \$ro\$riet/ of all checks \$a/a-le to .cash0 or -earer# E65 checks# and checks drawn to officers and other em\$lo/ees. +. 1he confirmation with all -ank creditors of amounts owed# terms and activit/ durin the \$eriod. ). 1he auditor<s test of \$urchase transactions ; vo\$ching# tracing and recalc\$lation in re ard to \$urchase orders# su\$\$lier invoices# cash dis-ursement ,ournal and voucher re ister. &. 1he auditor<s o-tainin satisfaction of the \$ro\$er se\$aration of functions8 1o esta-lish that a \$ro\$er se\$aration exist# the auditor will not onl/ examine

18-92

## A Risk'based A\$dit A""roach 4 #art ((

11-93

internal records \$ur\$ortin a \$ro\$er se\$aration# he will also examine documents for com\$liance and o-serve \$ersonall/ the flow of o\$erations and activities. 1+. 1he characteristics that the auditor is lookin for in his review of the client<s inventor/Ftakin instructions include8 1. Eames of client \$ersonnel res\$onsi-le for the count. +. Dates and times of inventor/Ftakin . ). Eames of client \$ersonnel who will \$artici\$ate in the inventor/Ftakin . &. Detail instructions for recordin accurate descri\$tions of inventor/ items# for count and dou-leFcount# and for measurin or translatin \$h/sical 2uantities. %. Detail instructions for makin notes of o-solete or worn items. (. Detail instructions for the use of ta s# \$unched cards# count sheets# or other media devices# and for their collection and control. '. 9lans for shuttin down \$lant o\$erations or for takin inventor/ after store closin hours# and \$lans for havin oods in \$ro\$er \$laces. *. 9lans for countin or controllin movement of oods in receivin and shi\$\$in areas if those o\$erations are not shut down durin the count. ". Detail instructions for com\$ilin the count media (e. .# ta s and \$unched cards) into final inventor/ listin s or summaries. 1!. Detail instructions for \$ricin the inventor/ items. 11. Detail instructions for review and a\$\$roval of the inventor/ count# notations of o-solescence# or other matters -/ su\$ervisor/ \$ersonnel.

1). As is true in other areas of a financial audit# verbal in*\$iry is a valua-le tool for o-tainin \$reliminar/ evidence in the audit of inventor/ and cost of sales. 5or exam\$le# the auditor can ain information such as the locations of inventor/# dates for the \$h/sical count# inventor/ held -/ consi nees and \$u-lic warehouses# the costFflow assum\$tion used to \$rice cost of oods sold and inventories# and the \$led in of inventor/ as collateral on loans. In addition to \$rovidin \$reliminar/ evidence# verbal in*\$iry fre2uentl/ \$rovides information a-out the status and value of slowFmovin inventor/# a\$\$arentl/ worn# dama ed or o-solete inventor/# and the existence of lar e inventor/ stock\$iles. 1&. Cost of oods sold is enerall/ audited throu h a com-ination of limited vouchin and extensive anal/tical \$rocedures. Inventor/ -alances are enerall/ audited throu h heav/ reliance on o-servation# vouchin and recalculation# with much less em\$hasis on anal/tical \$rocedures. 1%. 1he auditor can o-tain "reliminary evidence throu h "hysically observing \$lant facilities and makin verbal in*\$iriesH for exam\$le# evidence can -e o-tained

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%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

re ardin the 2uantit/ and si3e of assets# their location and a\$\$arent \$h/sical condition# the activit/ surroundin them# and ownershi\$ of the facilities. 5urther \$reliminar/ evidence of existence ma/ -e ained -/ a review of internal mana ement re\$orts. Gxam\$les of such re\$orts include ca\$ital ex\$enditure \$ro\$osals# ca\$ital -ud ets# construction cost or ac2uisition cost \$ostanal/sis# maintenance and re\$air re\$orts# re\$orts of sales or retirements# and insurance and \$ro\$ert/ tax anal/ses. 1he \$reliminar/ evidence should -e corro-orated -/ auditor tracin to the detailed records to ascertain that existin assets are recorded. 5urther# new asset ac2uisitions should -e traced to directors< authori3ations for ex\$enditures and to the ca\$ital -ud et.

1(. 1o o-tain relevant audit data a-out investment securities# auditors< \$rocedures include8 1. Ins\$ectin the securities in the \$resence of a res\$onsi-le client officer. +. 9ersonall/ examinin the securities while other ne otia-le fund sources are sealed off or are -ein examined simultaneousl/. ). 7-tainin a written statement from the client<s re\$resentative that the securities were returned intact. &. 7-tainin the information -/ confirmation from an inde\$endent \$art/ (e. .# trustee) who holds the securities.

1'. Investment cost can -e vouched to -rokers< advices# monthl/ statements and canceled checks. 1he auditors can similarl/ vouch the \$rice of securities sold and investment income to this documentar/ evidence and then trace amounts to income# ain and loss# and cash accounts. 1*. If investments are sold at su-stantial losses earl/ in the \$eriod followin /earF end# there is evidence that the securities were overvalued at the -alance sheet date. Accordin l/# the auditor will consider whether such securities should -e written down in the financial statements of the \$eriod under audit. 1". 1he lon Fterm lia-ilities (and fixed assets and owners< e2uit/) are characteri3ed -/ a few lar e transactions# unlike the current assets and lia-ilities which have numerous small transactions. Gxce\$t for the initial /ear of an audit# the entire -alance is not verified each /ear. 7nl/ the chan es in the account that occurred in the current \$eriod need to -e audited. 1he results of the audit of \$rior /ear<s chan es are recorded in .carr/Fforward0 workin \$a\$ers for these accounts. +!. ?/ vo\$ching o\$en \$urchase orders# in*\$iry of \$urchase \$ersonnel# and confirmation with su\$\$liers# the auditor is seekin to learn of commitments to \$urchase inventories at fixed \$rices. If the client faces si nificant losses on

18-94

## A Risk'based A\$dit A""roach 4 #art ((

11-95

fixedF\$rice \$urchase commitments# a\$\$ro\$riate \$rovision for the losses should -e made in the \$eriod<s financial statements. +1. .7ffF-alance sheet information0 refers to information that relates to o-li ations and commitments assumed -/ the clients that do not a\$\$ear on the -alance sheet as current or lon Fterm lia-ilities. 6uch information should -e disclosed -/ the client in the footnotes to the financial statements. 1herefore# the auditors must -e alert to these items and ather evidence that will allow the auditors to determine if the footnote disclosure is ade2uate. 6uch information includes8 leases# endorsements on discounted notes or others< o-li ations# uarantees# re\$urchase or remarketin a reements# commitments to \$urchase at fixed \$rices# commitments to sell at fixed \$rices# le al ,ud ment# liti ation# \$endin liti ation. ++. 1he followin matters are usuall/ covered durin the conference with the client at audit com\$letion8 a. -. c. d. 9ro\$osed audit ad,ustmentsH Caterial internal financial control weaknessesH Recommended footnote disclosuresH 1/\$e of audit re\$ort to -e rendered.

II. Multiple Choice Questions 1. +. ). &. d d %. (. '. *. c c c ". 1!. 11. 1+. cNd 1). 1&. 1%. 1(. c d d c 1'. 1*. 1". +!. d a a c

III. Comprehensive Cases Case 1. a. 1he C9A<s test of the sales cutoff at @une )! should include the followin ste\$s8 1. +. ). &. Determine what @G17<s cutoff \$olic/ is# review the \$olic/ for reasona-leness# and com\$are it to the \$rior /ear for consistenc/. 6elect a sam\$le of sales invoices (includin the last serial invoice num-er) from those recorded in the last few da/s of @une and the first few da/s of @ul/. 1race these sales invoices to shi\$\$in documents and determine that sales have -een recorded in the \$ro\$er \$eriod in accordance with com\$an/ cutoff \$olic/. Determine that the cost of oods sold has -een recorded in the \$eriod of sale.

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%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

%. (. 6elect a sam\$le of shi\$\$in documents for the same \$eriod and trace these to the sales invoice. Determine that the sale and the cost of oods sold have -een recorded in the \$ro\$er \$eriod. Review the cutoff for sales returns and allowances# determine that it has -een -ased u\$on a consistent \$olic/ and that there have not -een a-normal sales returns and allowances in @ul/H this mi ht indicate either an overstatement of sales durin the audit \$eriod or the need for a valuation account at @une )! to \$rovide for future returns and allowances.

-.

(1) 1he C9A will use the @ul/ 1! cutoff -ank statement in his review of the @une )! -ank reconciliation to determine whether8 (a) 1he o\$enin -alance on the cutoff -ank statement a rees with the .-alance \$er -ank0 on the @une )! reconciliation. (-) 1he @une )! -ank reconciliation includes those canceled checks that were returned with the cutoff -ank statement and are dated or -ear -ank endorsements \$rior to @ul/ 1. (c) De\$osits in transit cleared within a reasona-le time. (d) Inter-ank transfers have -een considered \$ro\$erl/ in determinin the @une )! ad,usted -ank -alance. (e) 7ther reconcilin items which had not cleared the -ank at @une )! (such as -ank errors) clear durin the cutoff \$eriod. (+) 1he C9A ma/ o-tain other audit information -/8 (a) Investi atin unusual entries on the cutoff -ank statement. (-) Gxaminin canceled checks# \$articularl/ notin unusual \$a/ees or endorsements. (c) Reviewin other documentation su\$\$ortin the cutoff -ank statement.

Case 2. 1he \$rocedure followed a\$\$ears to -e a\$\$ro\$riate exce\$t that the examination of detail transactions for three months mi ht -e considered to -e excessive in view of the exce\$tionall/ ood internal control. A li hter test of such transactions# desi ned to test the effectiveness of the control \$rocedures# mi ht -e devised. 1he \$rocedures followed should -e su\$\$lemented -/ the followin 8 1. +. ). Review the com\$an/<s method of sales cutoff at /earFend and test -illin s and shi\$ments (includin returns) for an ade2uate \$eriod -efore and after /earFend to esta-lish that cutFoff \$rocedures have -een adhered to. Gxamine collections in earl/ \$art of su-se2uent \$eriod to determine if a su-stantial \$ortion of the receiva-les has -een collected. Gxamine a reements entered into with the distri-utors. If \$rice \$rotection clauses are included# review the current \$rice \$osition and distri-utor

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## A Risk'based A\$dit A""roach 4 #art ((

11-97

&. %. Case 3. 1.

inventor/ \$ositions to determine whether a reserve for such \$rotection is needed. >hen a com\$an/ deals with a limited num-er of customers# it is de\$endent u\$on the continued solvenc/ of all such customers. 7-tain a re\$resentation letter from a\$\$ro\$riate com\$an/ officials coverin the receiva-les. a. -. c. Eotes \$a/a-le are a\$thori6ed accordin to com\$an/ \$olic/ (\$ro\$er authori3ation). 5or each note outstandin or \$aid durin the /ear# vouch to written authori3in document. 5unds mi ht -e -orrowed in the com\$an/<s name without the knowled e of res\$onsi-le officers. Recorded notes \$a/a-le are valid and documented (se\$aration of duties). 7-serve the client \$ersonnel recordFkee\$in duties. 6omeone mi ht interce\$t a check made out to a -ank and convert com\$an/ funds to his or her own use. Eotes \$a/a-le records could -e falsified for a short time to hide the theft. Dalid lia-ilities are recorded and none omitted (sound error checkin \$ractices). 7-serve client \$ersonnel makin com\$arisons. Review correctin ,ournal entries that result from the com\$arison. 9urchases or other lia-ilities ma/ fail to -e recorded and the error not detected -/ an/ other means. Recorded lia-ilities and cash dis-ursements valid and documented (sound record kee\$in ). Ins\$ect notes to see if the/ are marked .\$aid.0 Eotes ma/ et .\$aid0 a second time if \$ut -ack throu h the cash dis-ursements s/stem (intentionall/ or inadvertentl/).

+.

a. -. c.

).

a. -. c.

&.

a. -. c.

Case 4. a.

1he fact that the client made a ,ournal entr/ to record vendors< invoices which were received late should sim\$lif/ the C9A<s audit for unrecorded lia-ilities and reduce the \$ossi-ilit/ of a need for a further ad,ustment# -ut the C9A<s audit is nevertheless re2uired. If the client has not ,ournali3ed late invoices# the C9A is com\$elled in his testin to su-stantiate what will ultimatel/ -e recorded as an ad,ustin entr/. In this examination the C9A should audit entries in the +!!& voucher re ister to ascertain that all items which accordin to dates of receivin re\$orts or vendors< invoices were a\$\$lica-le to +!!& have -een included in the ,ournal entr/ recorded -/ the client.

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11-98
%ervices
-.

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Eo. 1he C9A should o-tain a letter in which res\$onsi-le executives of the client<s or ani3ation re\$resent that to the -est of their knowled e all lia-ilities have -een or ani3ed. =owever# this is done as a normal audit \$rocedure to afford additional assurance to the C9A and it does not relieve him of the res\$onsi-ilit/ for doin his own audit work. >henever a C9A is ,ustified in rel/in on work done -/ an internal auditor# he should curtail (-ut not eliminate) his own audit work. In this case# the C9A should have ascertained earl/ in his examination that 73one<s internal auditor is 2ualified -/ -ein -oth technicall/ com\$etent and reasona-l/ inde\$endent. 7nce satisfied as to these \$oints# the C9A should discuss the nature and sco\$e of the internal audit \$ro ram with the internal auditor and review his workin \$a\$ers in order that the C9A ma/ \$ro\$erl/ coordinate his own \$ro ram with that of the internal auditor. If the 73one internal auditor is 2ualified and has made tests for unrecorded lia-ilities# the C9A ma/ limit his work in this audit area. In addition to the +!!% voucher re ister# the C9A should consider the followin sources for \$ossi-le unrecorded lia-ilities8 1. +. ). &. %. (. '. *. ". 1!. 11. 1+. Unentered vendors< invoice file. 6tatus of tax returns for \$rior /ears still o\$en. Discussions with em\$lo/ees. Re\$resentations from mana ement. Com\$arison of account -alances with \$recedin /ear. Gxamination of individual accounts durin the /ear. Gxistin contracts and a reements. Cinutes. Attorne/<s -ills and letter of re\$resentation. 6tatus of rene otia-le -usiness. Corres\$ondence with \$rinci\$al su\$\$liers. Audit testin of cutoff date for reci\$rocal accounts# e. .# inventor/ and fixed assets.

c.

d.

Case 5. a.

4ourdes should find in the audit workin \$a\$ers a \$lannin memo descri-in the client<s inventor/Ftakin \$lan and notes a-out the auditor<s firstFhand o-servation of the instructions -ein iven to counters# alon with a memo a-out the auditors< o-servation of the countin . 1his memo should tell a-out su\$ervision of the audit staff# and the workin \$a\$ers (test counts) should show the review si natures of the su\$ervisin auditors. >orkin \$a\$ers should document \$erformance of these su-stantive \$rocedures for the e!istence and com"leteness assertions8 1. Conduct an o-servation of the com\$an/<s \$h/sical inventor/ count.

-.

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## A Risk'based A\$dit A""roach 4 #art ((

+. ). &.

11-99

6can the inventor/ com\$ilation for items added from sources other than the \$h/sical inventor/ count. . . At /ear end# o-tain the num-er of the last shi\$\$in and receivin documents . . . Use these to scan the sales# inventor/Acost of sales# and accounts \$a/a-le entries for \$ro\$er cutoff. Confirm or ins\$ect inventories held in \$u-lic warehouses.

Case 6. 1he three cate ories of ma,or losses or mani\$ulations in the area of investments are8 theft of diversion of funds# mani\$ulation of accountin # and -usiness es\$iona e. ?usiness es\$iona e is enerall/ outside the s\$here of inde\$endent auditors< interest. Case 7. a. 1he o-,ectives (s\$ecific assertions) for the audit of nonFcurrent investment securities are to o-tain evidence re ardin the8 -. Gxistence of the investment securities at the -alance sheet date. 7wnershi\$ of the investment securities. Cost and carr/in value of the investment securities. 9ro\$er \$resentation and disclosure of the investment securities in the financial statement. 9ro\$er reco nition of interest income. 9ro\$er reco nition of investment ains and losses.

1he followin audit \$rocedures should -e undertaken with res\$ect to the audit of 1ess< investment securities8 Ins\$ect and count securities in the com\$an/<s safe and safe de\$osit -ox. Gxamine -rokers< statements to o-tain assurance that all transactions were recorded. Gxamine documents in su\$\$ort of \$urchases and sales of investment securities. Ins\$ect the minutes of the -oard of directors meetin s. Review the audited financial statements of the (+% \$ercent) investee. Derif/ the e2uit/ method of accountin was used for carr/in value of the investment in Dee Industrial. 7-tain a client re\$resentation letter that confirms the client<s re\$resentations concernin the noncurrent investment securities. Derif/ the calculation of interest income. Review the \$ro\$riet/ of the \$resentation and disclosure of the securities in the financial statements. Cake certain that the client re\$resentation letter includes the \$ro\$er assertions concernin accounts \$a/a-le.

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%ervices
Case 8. a.

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

Investi ate and resolve confirmation exce\$tions and other matters re2uirin followFu\$. 1he audit o-,ectives in the examination of lon Fterm de-t are to determine that8 1. +. ). &. %. (. '. All lia-ilities were \$ro\$erl/ recorded. Items recorded as lia-ilities are -ona fide o-li ations. Interest ex\$ense andAor amorti3ation was \$ro\$erl/ com\$uted and recorded. 1he client is not in violation of restrictions or re2uirements im\$osed on it -/ the terms of the loan a reement. 6atisfactor/ authorit/ existed to enter into lon Fterm o-li ation a reements. All lon Fterm o-li ations are \$ro\$erl/ classified in the -alance sheet. Assets \$led ed as securit/ are ade2uatel/ disclosed.

-.

1he followin \$rocedures should -e included in an audit \$ro ram for the examination of the lon Fterm note -etween 7dette and 5irst Eational ?ank8 1. +. Confirm the loan and terms of the a reement with the -ank. Review the a reement -etween 7dette and the -ank to determine that8 a. 1he de-t is lon Fterm (-/ reference to dates). -. 9rovisions of the a reement have not -een violated# e. .# that 7dette is com\$l/in with an/ restrictions on the \$a/ment of dividends# on the amount of workin ca\$ital to -e maintained# or on the uses to which the funds ma/ -e em\$lo/ed and is maintainin the \$lant \$led ed as securit/ for the loan. c. 1he a reement was si ned -/ \$erson(s) havin authorit/. 1race the recei\$t of funds into the -ank account and cash recei\$ts -ook. Check the com\$utation of interest ex\$ense for the \$eriod Ca/ 1 to @une )!# and trace the recordin of the ex\$ense and the accrual on the -ooks. Determine that authorit/ to -orrow was ranted and is recorded in the -oard of directors< minutes.

). &. %.

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## A Risk'based A\$dit A""roach 4 #art ((

11-101

I. Review Questions 1. Refer to \$a e *%(# \$ara ra\$h 1 of the text-ook. +. Refer to \$a e *%&# \$ara ra\$h & of the text-ook. ). Refer to \$a e *%(# \$ara ra\$h 1 of the text-ook. &. Refer to \$a e *%'# \$ara ra\$h ) of the text-ook. %. Refer to \$a es *%* to *'+ of the text-ook.
(. '. Refer to \$a e *(1# no. % of the text-ook. Refer to \$a e *()# no. * of the text-ook.

*. Refer to \$a e *(&# no. "# )rd \$ara ra\$h of the text-ook. ". Refer to \$a es *(% to *(( of the text-ook. II. Multiple Choice Questions 1. +. ). &. %. d d c CHAPTER 2+ USI'- THE 5ORK O* OTHERS
I. Review Questions 1. An auditor who re\$orts on the financial statements of a com-ined entit/ when he or she audited the ma,or \$art of the com-ined entit/ is the "rinci"al a\$ditor. Auditin standards identif/ \$rocedures to -e followed -/ a \$rinci\$al auditor. 1o -e a-le to serve as auditor of a com-ined entit/# an auditor must determine that he or she is a-le to -e the \$rinci\$al auditor -ased on the materialit/ of

18-101

11-102
%ervices

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

the \$ortion of the financial statements that he or she has examined# his or her knowled e of the overall financial statements# and the im\$ortance of the com\$onents he or she has audited.

+.

1he \$rinci\$al auditors must \$erform one or more of the followin \$rocedures8 Disit the auditor. Review the audit \$ro rams. Review audit work \$a\$ers. 9erform additional audit \$rocedures.

).

Refer to \$a e *'".

## &. Refer to \$a es *'" to **!.

%. >hile the external auditor has sole res\$onsi-ilit/ for the audit o\$inion ex\$ressed and for determinin the nature# timin # and extent of external audit \$rocedures# certain \$arts of internal auditin work ma/ -e useful to the external auditor. 1he external auditor should o-tain a sufficient understandin of internal audit activities to assist in \$lannin the audit and develo\$in an effective audit a\$\$roach. Gffective internal auditin will often allow a modification in the nature and timin # and a reduction in the extent of \$rocedures \$erformed -/ the external auditor -ut cannot eliminate them entirel/. In some cases# however# havin considered the activities of internal auditin # the external auditor ma/ decide that internal auditin will have no effect on external audit \$rocedures. 1he external auditor<s \$reliminar/ assessment of the internal audit function will influence the external auditor<s ,ud ment a-out the use which ma/ -e made of internal auditin in modif/in the nature# timin and extent of external audit \$rocedures. II. Multiple Choice Questions 1. +. c ). &. d %. (. c

III. Comprehensive Cases a. 1an should ask 6an Eicolas to authori3e Andres to res\$ond full/ to her in2uiries. If 6an Eicolas refuses or limits the res\$onses# 1an should re2uest 6an Eicolas to ex\$lain the reasons. After o-tainin the ex\$lanation# 1an should consider whether to continue \$ursuin the en a ement.

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## A Risk'based A\$dit A""roach 4 #art ((

11-103

-. 1an will have to (1) o-tain additional information a-out the client and \$ossi-l/ a-out the industr/# which Andres would have o-tained in \$rior /ears# (+) make a more detailed evaluation of whether to acce\$t this client# ()) o-tain information a-out the client<s internal control# which Andres would have o-tained in \$rior /ears# and (&) o-tain evidence a-out -e innin -alance sheet -alances# which Andres would have o-tained in \$rior /ears.

CHAPTER 2.

## THE AUDITOR6S REPORT O' *I'A'CIA( STATE)E'TS

I. Review Questions 1. 6co\$e \$ara ra\$h

(a) 1he o-,ects of the audit are the financial statements ; -alance sheet(s)# income statement(s)# and cash flow statement(s)# and related footnote disclos\$re# not the .-ooks and records.0 (-) 1he descri\$tion of the audit means8 (1) (+) ()) (&) (%) (() (') J +. the auditors were trained and \$roficient. the auditors were inde\$endent. due \$rofessional care was exercised. the work was \$lanned and su\$ervised. internal controls was \$ro\$erl/ studied and evaluated. sufficient com\$etent evidential matter was o-tained. the IAA6 re\$ortin standards were followed.

9rofessional ,ud ment was exercised in \$erformin the tests and choosin the \$rocedures to \$erform in the circumstances. Re\$ort and the evidence dimension -\$lly s\$fficient com"etent evidence Q Q Q (solated evidence deficiency #ervasive lack of evidence

Un2ualified o\$inion Adverse o\$inion 7\$inion 2ualified for a de\$arture from 65A6 9ara ra\$h for inconsistent IAA9

18-103

11-104
%ervices

Q Q Q

## a\$\$lication 9ara ra\$h for an uncertaint/ Disclaimer of o\$inion

). 1.

Ca,or reasons for de\$arture from the standard un2ualified re\$ort Disa reement with mana ement re ardin the acce\$ta-ilit/ of the accountin \$olicies selected# the method of their a\$\$lication or the ade2uac/ of financial statement disclosure. +. 4imitation on sco\$e of the audit (resultin in a lack of evidence). ). Usin extra \$ara ra\$h(s) to em\$hasi3e si nificant matters. &. Different o\$inion on \$rior /ear com\$arative statements. %. Rel/in on the work and re\$orts of other inde\$endent auditors. (. Re2uired su\$\$lementar/ data omitted or de\$arts from uidelines. '. .7ther information0 inconsistent with financial statements or contains material misstatement of fact. *. Auditor is not inde\$endent. 6tudents ma/ identif/ more than one descri\$tion of the .most im\$ortant0 distinction -etween an o\$inion and a disclaimer. All the followin are valid# althou h (a) is intended to -e the .Cost Im\$ortant80 An o\$inion (un2ualified# 2ualified or adverse) is an ex\$licit statement of the auditor<s conclusion(s)# while a disclaimer is an (em\$t/) assertion of .no conclusion.0 -. An (un2ualified) o\$inion is the hi hest level of assurance# while a disclaimer is the lowest level (no assurance). c. An o\$inion re2uires evidence as a -asis# while a disclaimer results from lack of evidence. d. Auditors must -e inde\$endent to ive an o\$inion# while a disclaimer can result from a C9A<s lack of inde\$endence. A material sco"e restriction occurs when the auditor is una-le to ather sufficient com\$etent evidence to su\$\$ort an un2ualified o\$inion on the financial statements. 6co\$e restrictions ma/ -e clientFim\$osed or the/ ma/ result from other circumstances# e. .# a\$\$ointment of the auditor after the client<s \$h/sical inventor/ has -een taken. A material sco\$e restriction need not result in a modification of the auditor<s o\$inion \$rovided the auditor can o-tain satisfaction -/ alternate means. A "rinci"al a\$ditor is one who has examined the ma,or \$ortion of the com-ined entit/.

&.

a.

%.

(.

18-104

## A Risk'based A\$dit A""roach 4 #art ((

'.

11-105

>hen financial statements of the \$rior /ear are \$resented to ether with those of the current /ear# a continuin auditor must re\$ort on -oth /ears. In .u\$datin 0 the \$rior /ear<s re\$ort# the auditor must decide whether to restate the re\$ort in its same form or modif/ it to reflect current information not availa-le at the date of issuance of the \$rior re\$ort. A contin\$ing a\$ditor can \$"date a \$reviousl/Fissued re\$ort -/ o-tainin and evaluatin information durin the current en a ement. 1hus# an \$"dated re"ort is a \$reviousl/Fissued re\$ort that has -een reevaluated in li ht of current information and evidence. (1he u\$dated re\$ort itself ma/ -e a com\$ilation re\$ort# a review re\$ort# or an audit re\$ort). 1he reevaluation ma/ cause the u\$dated version to -e different from the re\$ort \$reviousl/ issued (for exam\$le# a new reason to write a 2ualification ma/ -e found). An u\$dated re\$ort carries a current date# not the date of the \$revious re\$ort. A "redecessor a\$ditor usuall/ does not have the current information necessar/ to u\$date a re\$ort. Gither a continuin auditor or a \$redecessor auditor can reiss\$e \$reviousl/F reissued re\$ort. 1he \$rocess does not contem\$late consideration of information and evidence o-tained durin a current en a ement. 1hus# a reiss\$ed re"ort is a current release of a \$reviousl/Fissued re\$ort without -enefit of an/ additional examination or review of the su-,ect financial statements. 1he re\$ort date should -e the date of the end of field work for the ori inal issue of the re\$ort.

*.

".

A \$rinci\$al auditor is the one who (a) audits a material \$ortion of a re\$ortin entit/<s assets# lia-ilities# revenues and ex\$enses (usuall/ over %! \$ercent) and (-) knows enou h a-out the whole entit/ to si n the audit re\$ort.

1!. 1he \$rinci\$al auditor<s reference in his re\$ort to another auditor is not a 2ualification in sco\$e. 1he reference onl/ shows the divided res\$onsi-ilit/ for the audit work. 11. >hen an auditor is not inde\$endent with res\$ect to a client# a disclaimer of o"inion must -e rendered. 1he disclaimer must -e issued -ecause the statements cannot -e audited in accordance with enerall/ acce\$ted auditin standards. (An acco\$ntant# not an a\$ditor# is the \$erson associated with com\$iled and reviewed financial statements. An accountant can ive a com\$ilation ; disclaimer ; re\$ort on com\$iled unaudited financial statements). 1+. >hen the . oin concern assum\$tion0 is in dou-t# auditors have serious reservations a-out the recovera-ilit/ and amounts of re\$orted assets and the

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

amount and classification of re\$orted lia-ilities. 1hese o\$inions ma/ -e used# de\$endin on the circumstances8 a. 6tandard un2ualified re\$ort with an uncertaint/ notice \$ara ra\$h callin attention to the oin concern \$ro-lem. -. Disclaimer of o\$inion to ex\$ress unwillin ness to ive an o\$inion on the \$resentation. c. 7\$inion 2ualified or adverse for de\$arture from IAA9 if all a\$\$ro\$riate disclosures are not made.

1). Accordin to 96A '!!# .In certain circumstances# an auditor<s re\$ort ma/ -e modified -/ addin an em\$hasis of matter \$ara ra\$h to hi hli ht a matter affectin the financial statements which is included in a note to the financial statements that more extensivel/ discusses the matter. 1he addition of such an em\$hasis of matter \$ara ra\$h does not affect the auditor<s o\$inion. 1he \$ara ra\$h would \$refera-l/ -e included after the o\$inion \$ara ra\$h and would ordinaril/ refer to the fact that the auditor<s o\$inion is not 2ualified in this res\$ect. 1he auditor should modif/ the auditor<s re\$ort -/ addin a \$ara ra\$h to hi hli ht a material matter re ardin a oin concern \$ro-lem. 1he auditor should consider modif/in the auditor<s re\$ort -/ addin a \$ara ra\$h if there is a si nificant uncertaint/ (other than a oin concern \$ro-lem)# the resolution of which is de\$endent u\$on future events and which ma/ affect the financial statements. An uncertaint/ is a matter whose outcome de\$ends on future actions or events not under the direct control of the entit/ -ut that ma/ affect the financial statements.0 1&. >hether to divide res\$onsi-ilit/ or acce\$t full res\$onsi-ilit/ is a function of8 a. -. Relationshi\$ of the \$rinci\$al auditor to the other auditorsH and Caterialit/ of the com\$onent(s) examined -/ other auditors.

1%. 1he auditor ma/ decide to disclaim an o\$inion when confronted -/ a material sco\$e limitation that \$recludes atherin sufficient evidence to su\$\$ort an o\$inion as to overall fairness of financial \$resentation. 1he auditor ma/ also disclaim an o\$inion if hisAher name is associated with financial statements for which an audit was not intended (e. .# com\$ilations and reviews)# or if the auditor is not inde\$endent. 1(. 1wo conditions are necessar/ for an un2ualified o\$inion8 a. Eo material sco\$e restrictions have \$revented the auditor from collectin sufficient# com\$etent evidenceH and

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## A Risk'based A\$dit A""roach 4 #art ((

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1he financial statements# includin footnote disclosures# contain no material de\$artures from IAA9.

1'. An auditor ma/ a ree with a de\$arture from a desi nated \$rinci\$le onl/ when# in hisAher ,ud ment# a\$\$lication of the desi nated \$rinci\$le would make the financial statements materiall/ misleadin . 1*. 1he audit o\$inion does not extend to the other information# and therefore# the o\$inion is not affected -/ omission or inconsistenc/ or incorrect su\$\$lemental information. 1". 1he auditor must evaluate# on ever/ audit# the a-ilit/ of the entit/ to meet its o-li ations on a continuin -asis durin a reasona-le \$eriod (usuall/ 1+ months) followin the -alance sheet date. Althou h the auditor is not re2uired to a\$\$l/ additional \$rocedures in makin the initial evaluation# if heAshe has su-stantial dou-t as to a-ilit/ of the client to continue# added \$rocedures ma/ have to -e a\$\$lied to resolve the issues. +!. 1he auditor should add an ex\$lanator/ \$ara ra\$h re ardin a material uncertaint/# \$rovided the outcome of the events surroundin the uncertaint/ cannot -e reasona-l/ estimated -/ mana ement. If the \$ro-a-ilit/ of an unfavora-le outcome is remote# the ex\$lanator/ \$ara ra\$h is not needed. If a material loss is \$ro-a-le# -ut is not susce\$ti-le to reasona-le measurement# and is \$ro\$erl/ footnoted# the auditor should add an ex\$lanator/ \$ara ra\$h directin the reader<s attention to the footnote. 1he reater the materialit/# and the hi her the \$ro-a-ilit/ of loss# the more inclined will -e the auditor to add the ex\$lanator/ \$ara ra\$h. +1. U\$on learnin of a chan e in accountin \$rinci\$le# the auditor should first determine the materialit/ and a\$\$ro\$riateness of the chan e. If material and the auditor a ree with the client<s ,ustification for the chan e# an ex\$lanator/ \$ara ra\$h should -e added followin the o\$inion \$ara ra\$h. 1he \$ara ra\$h will refer to the footnote descri-in the chan e. If the chan e is not \$ro\$erl/ accounted for or is inade2uatel/ disclosed# the auditor should consider issuin a 2ualified or adverse o\$inion. II. Multiple Choice Questions 1. +. ). &. %. (. c d a c c c 11. 1+. 1). 1&. 1%. 1(. c d a d +1. ++. +). +&. +%. +(. c c a d c a )1. )+. )). )&. )%. )(. c c d -

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'. *. ". 1!. c a d c

## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

1'. 1*. 1". +!. d a c +'. +*. +". )!. a c c )'. )*. )". &!. d a d -

III. Comprehensive Cases Case 1. Lou must determine whether an un2ualified o\$inion satisfies the IAA6 re\$ortin standard# in \$articular8 a. Determine whether the financial statements are \$resented in conformit/ with IAA9. 1. +. ). Read the footnote descri\$tion of accountin \$olicies. Use a IAA9 checklist. Review the workin \$a\$ers for an/ indication of accountin \$olicies not descri-ed in the footnote or ones a\$\$arentl/ not in conformit/ with IAA9. Determine if8 (i) 1he accountin \$rinci\$les are authoritative su\$\$ort. enerall/ acce\$ta-le# havin

&.

(ii) 1he accountin \$rinci\$les are a\$\$ro\$riate in the circumstances. (iii) 1he financial statements are informative. (iv) 1he information is reasona-l/ summari3ed. (v) Caterial ad,ustments have not -een waived without ood reasons. -. c. Case 2. 1. Determine whether an/ accountin chan es have -een made and whether accountin \$rinci\$les have -een a\$\$lied consistentl/. Determine whether the footnote disclosures are ade2uate to inform users of an/ material information evident in the workin \$a\$ers. 1he auditor is re\$ortin to the -od/ that has en a ed the auditin services. >hile the re\$ort ma/ -e read and used -/ others who are indirect -eneficiaries of the audit# current custom is not to address the re\$ort to the unknown class of users. 1he sco\$e \$ara ra\$h should s\$ecificall/ identif/ the audited statements -/ name so that there can -e no mistake a-out the su-,ect of the re\$ort. 1he alternative lan ua e is not as \$recise.

+.

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1he standard lan ua e effectivel/ -ases the audit on an extensive -od/ of written auditin standards that are known to others and can -e cited in case of controvers/. 1he alternative lan ua e# on the other hand# seems to -reak loose from \$rofessionFwide 2ualit/ norms and make the audit 2ualit/ de\$end more on .the circumstances#0 which introduces an element of m/ster/ and lack of definition into the re\$ort. 1he alternative wordin is similar to the t/\$ical ?ritish audit re\$ort# and the/ seem to -e a-le to live with it# -ut American auditors -elieve that .o\$inion0 connotes -elief or ,ud ment stron er than im\$ression -ut less stron than \$ositive knowled e. American auditors do not wish to a\$\$ear to have full# \$ositive knowled e a-out the statements on the rounds that it<s not feasi-le to know all there is to know a-out the financial statements. Also# the standard lan ua e leans heavil/ on IAA9 as the criteria for fair \$resentation whereas the alternative lan ua e contains no reference to authoritative accountin criteria. 1itle. 1he re\$ort needs a title referrin to Rose as the inde\$endent auditor or inde\$endent accountant. Eotice of audit. 1he re\$ort does not ive the \$ro\$er declaration of an audit of the financial statements# es\$eciall/ the \$art a-out .in accordance with /our instructions#0 which su est that Rose surrendered some audit inde\$endence. 1he reference to a .com\$lete audit0 is ill advised -ecause it su ests a 1!!B investi ation# which is contradicted -/ the sentence a-out .tests of the sales records.0 Res\$onsi-ilities. 1he re\$ort sa/s nothin a-out the auditor<s res\$onsi-ilit/ for the audit re\$ort. 7\$inion. 1he o\$inion sentence should not -e modified with the \$hrase .with the ex\$lanation iven a-ove.0 7\$inion. 1he o\$inion sentence should not mention .minor errors we consider immaterial#0 -ut it should contain the \$hrase .\$resents fairl/ in all material res"ects.0 7\$inionAIdentification of 5inancial 6tatements. 1he o\$inion should not include reference to cash flows -ecause the introductor/ \$ara ra\$h did not state that the cash flow statement was audited. 1his ma/ -e a deficienc/ in the identification of the financial statements that were actuall/ audited. 7\$inion. 1he o\$inion \$ara ra\$h refers im\$ro\$erl/ to A6C \$ronouncements. It should refer to . enerall/ acce\$ted accountin \$rinci\$les.0 Date. 1he date accom\$an/in Rose<s si nature should -e 6e\$tem-er +) ; the da/ the field work was com\$leted ; not the com\$an/<s fiscal /earFend date.

&.

Case 3. 1. +.

). &. %.

(.

'.

*.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

7ther. 1he commentar/ on the econom/ and the strike are not enerall/ a\$\$ro\$riate for an audit re\$ort. Gven if the auditor wanted to draw attention to these matters# their relevance for understandin the financial statements and their manner of ex\$ression are -oth 2uestiona-le.

1!. 7ther. 1he ne ative assurance (concernin the recordin of sales) is not \$ermitted in audit re\$orts. Case 4. I45e&e45e4% A253%-'6s Re&-'% To the shareholders and board of directors of Various Fabrics, Inc.: We have audited the accom an!ing balance sheets of Various Fabrics, Inc. as of "anuar! #\$, %&&' and %&&# and the related statements of income, retained earnings, and cash flo(s for the !ears then ended. These financial statements are the res onsibilit! of the com an!)s management. *ur res onsibilit! is to e+ ress an o inion on these financial statements based on our audits. We conducted our audits in accordance (ith generall! acce ted auditing standards. Those standards re,uire that (e lan and erform the audit to obtain reasonable assurance about (hether the financial statements are free of material misstatement. -n audit includes e+amining, on a test basis, evidence su orting the amounts and disclosures in the financial statements. -n audit also includes assessing the accounting rinci les used and significant estimates made b! management, as (ell as evaluating the overall financial statement resentation. We believe that our audits rovide a reasonable basis for our o inion. In our o inion, the financial statements referred to above resent fairl!, in all material res ects, the financial osition of Various Fabrics, Inc. as of "anuar! #\$, %&&' and %&&# and the results of its o erations and its cash flo(s for the !ears then ended in conformit! (ith generall! acce ted accounting rinci les. -!a de "esus, ./)a!c7 21 2334 Case 5. 1. +. ). &. Case 6. A. ?. C. D. G. 5. 5# 4 ?# I ?# M A# @ 1# +# &. 1. (. %. 'c. 'a. %. (. '. ?# I ?# I G# @

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## A Risk'based A\$dit A""roach 4 #art ((

I. + =. I. @. K. 4. C. )# +# )# (. 1# 1#

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(Eote8 1he chan e in \$rinci\$le should -e descri-ed in the descri\$tive \$ara ra\$h followin the sco\$e \$ara ra\$h.) 'c. '-. 'd. ( iven the materialit/ of \$ro\$ert/# \$lant# and e2ui\$ment) 'e. '- and 'e.

## CHAPTER 22 PROCEDURES A'D REPORTS O' SPECIA( PURPOSE AUDIT E'-A-E)E'TS

I. Review Questions 1. 1he re\$ort sim\$l/ states8 .1he financial statements are not intended to -e \$resented in conformit/ with enerall/ acce\$ted accountin \$rinci\$les.0 1he o\$inion ex\$ression thereafter refers to a descri\$tion of the com\$rehensive -asis used. EonFIAA9 accountin -ases include8 1. +. ). &. %. 6tatutor/ or re ulator/ accountin re2uirements 1ax -asis accountin Cash and modified cash -ases Ieneral \$rice levelFad,usted statements An/ other -asis havin .su-stantial su\$\$ort0 (Auditin standards do not ex\$lain how nonFIAA9 accountin can have .su-stantial su\$\$ort.0 In \$ractice# accountants will re\$ort on an/ reasona-le accountin -asis# which ex\$lains wh/ re\$orts exist on diverse t/\$es of current value financial statements.)

+. 1.

1he followin are four com\$rehensive -ases of accountin other than IAA98 A -asis of accountin to com\$l/ with the re2uirements of a overnmental re ulator/ a enc/ (for exam\$le# insurance com\$anies use a -asis of accountin \$ursuant to the rules of the insurance commission) +. ). A -asis of accountin used to file an income tax return 1he cash recei\$ts and dis-ursements -asis of accountin (cash -asis) and modifications to the cash -asis# such as recordin de\$reciation on fixed assets or accruin income tax.

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

A definite set of criteria havin su-stantial su\$\$ort that is a\$\$lied to all material items in the financial statements# such as the \$riceFlevel -asis of accountin .

).

A C9A ma/ -e asked to re\$ort on the a\$\$lication of IAA9 -/ another auditor<s client who disa rees with the auditor<s view of \$ro\$er accountin for the transaction. Auditin standards a\$\$l/ when a C9A in \$u-lic \$ractice# either in connection with a \$ro\$osal to o-tain a new client or otherwise# \$rovides oral or written advice on the a\$\$lication of accountin \$rinci\$les to a s\$ecific transaction or the t/\$e of o\$inion that ma/ -e rendered on an entit/<s financial statements. In formin a ,ud ment# the C9A should \$erform the followin \$rocedures8 7-tain an understandin transaction(s). Review a\$\$lica-le IAA9. If a\$\$ro\$riate# consult with other \$rofessionals or ex\$erts. If a\$\$ro\$riate# \$erform research or other \$rocedures to ascertain and consider the existence of credita-le \$recedents or analo ies. 1he re\$ortin C9A is re2uired to consult with an entit/<s continuin C9A to ascertain all the relevant facts. 1he continuin C9A can \$rovide information a-out the form and su-stance of the transaction# how mana ement has a\$\$lied accountin \$rinci\$les to similar transactions# and whether the method of accountin recommended -/ the continuin C9A is dis\$uted -/ mana ement. of the form and su-stance of the

&.

1he followin difficulties mi ht arise8 #rior'year statements were \$na\$dited8 1he auditor should la-el the \$riorF/ear columns .Unaudited0 and modif/ the re\$ort -/ addin a \$ara ra\$h that disclaims an o\$inion on the statements. A\$dited by another a\$ditor5 Alternative 18 9redecessor auditor reissues re\$ort. Alternative +8 If \$redecessor<s re\$ort is not \$resented# the auditor indicates in the introductor/ \$ara ra\$h (1) that the financial statements of the \$rior \$eriod were audited -/ another auditor (-ut does not name the \$redecessor auditor)# (+) the date of the re\$ort# ()) the t/\$e of re\$ort issued -/ the \$redecessor auditor# and (&) if the re\$ort was not a standard un2ualified re\$ort# the su-stantive reasons therefor. >hen the \$redecessor auditor<s re\$ort is not \$resented# the audit re\$ort would

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have an added sentence at the end of the first \$ara ra\$h# and the o\$inion \$ara ra\$h would refer onl/ to the currentF/ear statements. Different re"orts on com"arative statements 8 An auditor ma/ issue modified re\$orts on either of the financial statements re\$orted on com\$arativel/. In this situation# the auditor must exercise care to relate the o\$inion to the a\$\$ro\$riate /ear<s financial statements. II. Multiple Choice Questions 1. +. ). &. a c a %. (. '. *. a a a ". 1!. 11. 1+. a a d d 1). 1&. 1%. 1(. d a a a 1'. 1*. 1". +!. c a

## III. Comprehensive Cases Case 1.

To the 0oard of 1irectors of 2ein! 3td.: We have revie(ed the accom an!ing balance sheet of 2ein! 3td. as of 1ecember #\$, %&&', and the related statements of income, retained earnings, and cash flo(s for the !ear then ended, in accordance (ith standards established b! the -uditing 4tandards and /ractices .ouncil. -ll information included in these financial statements is the re resentation of the management of 2ein! 3td. - revie( consists rinci all! of in,uiries of com an! ersonnel and anal!tical rocedures a lied to financial data. It is substantiall! less in sco e than an e+amination in accordance (ith generall! acce ted auditing standards, the ob5ective of (hich is the e+ ression of an o inion regarding the financial statements taken as a (hole. -ccordingl!, (e do not e+ ress such an o inion. 0ased on our revie(, (e are not a(are of an! material modifications that should be made to the accom an!ing %&&' financial statements in order for them to be in conformit! (ith generall! acce ted accounting rinci les. The financial statements for the !ear ended 1ecember #\$, %&&#, (ere audited b! us, and (e e+ ressed an un,ualified o inion on them in our re ort dated Februar! %6, %&&', but (e have not erformed an! auditing rocedures since that date. Modelle 7 .o. March #, %&&8

Case 2. a.

1he assertions that are incorrect and should otherwise -e deleted are the followin 8

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## %ol\$tions &an\$al ' #rinci"les of A\$diting and Other Ass\$rance

1. +. ). &. Re\$ort should -e addressed to Cs. Clean Cor\$oration<s ?oard of Directors. Delete the entire \$ara ra\$h descri-in the sco\$e exce\$t for the reference to cash in -anks and accounts receiva-le. Delete the o\$inion rendered on cash in -anks and accounts receiva-le. Delete the recommendation to ac2uire A,acks.

-.

1he assertions that are missin and should -e inserted are the followin 8 1. Date of the re\$ort. +. 6tatement limitin the distri-ution of the re\$ort to Cs. Clean<s mana ement. ). Descri\$tion of the \$rocedures \$erformed. &. 6tatement that the a reedFu\$on \$rocedures a\$\$lied are not ade2uate to constitute a IAA6 audit. %. Descri\$tion of the accountant<s findin s. (. Disclaimer of an o\$inion concernin cash in -anks and accounts receiva-le. '. 6tatement limitin the re\$ort onl/ to cash in -anks and accounts receiva-le and indicatin that the re\$ort does not extend to the financials taken as a whole.
Inde\$endent Audit !6% Re\$ !t

Case 3.
9-ddressee:

We have audited the statement of assets, liabilities, and ca ital ;income ta+ 9cash: basis< of Vanda 7 .orona, a artnershi , as of 1ecember #\$, %&&', and the related statements of revenue and e+ enses ;income ta+ 9cash: basis< and statement of changes in artners) ca ital accounts ;income ta+ 9cash: basis< for the !ear then ended. These financial statements are the res onsibilit! of the com an!)s management. *ur res onsibilit! is to e+ ress an o inion on these financial statements based on our audits. We conducted our audits in accordance (ith generall! acce ted auditing standards. Those standards re,uire that (e lan and erform the audit to obtain reasonable assurance about (hether the financial statements are free of material misstatement. -n audit includes e+amining, on a test basis, evidence su orting the amounts and disclosures in the financial statements. -n audit also includes assessing the accounting rinci les used and significant estimates made b! management, as (ell as evaluating the overall financial statement resentation. We believe that our audits rovide a reasonable basis for our o inion. -s described in 2ote =, the artnershi )s olic! is to re are its financial statements on the accounting basis used for income ta+ ur oses> conse,uentl!, certain revenue and related assets are recogni?ed (hen received rather than (hen earned, and certain e+ enses are recogni?ed (hen aid rather than (hen the obligation is incurred. -ccordingl!, the accom an!ing financial statements are not intended to resent financial osition and results of o erations in conformit! (ith generall! acce ted accounting rinci les.

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In addition, the com an! is involved in continuing litigation relating to atent infringement. The amount of damages resulting from this litigation, if an!, cannot be determined at this time. In our o inion, the financial statements referred to above resent fairl! the assets, liabilities, and ca ital of the Vanda 7 .orona artnershi as of 1ecember #\$, %&&', and its revenue and e+ enses and changes in its artners) ca ital accounts for the !ear then ended, on the income ta+ ;cash< basis of accounting as described in 2ote =, (hich basis has been a lied in a manner consistent (ith that of the receding !ear. 94terling 7 .o.: 91ate:

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