HOMEWORK CHAPTERS 14 thru 18

14-27

(a)
The confirmation of accounts receivable is a generally accepted auditing
procedure. In contrast, the confirmation of accounts payable is not a generally accepted
auditing procedure, although the procedure is often followed.
Two reasons may be given for the foregoing differences. First, management fraud
would tend to overstate the assets and understate the liabilities. Confirmation is generally
more effective for tests of existence (overstatement) than completeness (understatement).
Second, the evidence supporting accounts receivable records is usually supplied by the
company's internally produced documents, whereas the evidence supporting accounts
payable, such as vendors' invoices and statements, is produced by outside sources.
For these reasons, the emphasis of the accounts receivable audit is to obtain
evidence supporting the amount recorded. On the other hand, determining that all
payables are recorded is the primary objective of the accounts payable audit. It follows
that confirmations are very useful in supplying supporting evidence for receivables but
that auditing procedures other than confirmation are required to verify that all payables
are recorded.
(b)

The number of confirmation requests to be made for both accounts receivable and
accounts payable would be determined by the auditors' assessments of control risk.
Accounts receivable to be confirmed on a positive basis would be selected from the
following groups:
(1)
(2)
(3)
(4)
(5)
(6)
(7)

Accounts with large balances to account for a major part of the dollar value of
receivables.
Accounts placed with collection agencies or accounts with customers that are
bankrupt, in receivership, or in other financial difficulties.
Accounts in dispute.
Old or inactive accounts.
A representative number of accounts with small balances.
Accounts that have been written off as uncollectible.
Accounts with credit balances.

The selection of accounts payable for confirmation would be from the following groups:
(1)
(2)
(3)
(4)

14-34

Large accounts including important suppliers even though the account balance is
small at balance sheet date.
Accounts for which monthly statements are unavailable.
Accounts with unusual transactions.
Accounts with zero balances that had substantial activity earlier in the year.

(a)
(2)
Because a significant portion of the search for unrecorded
liabilities deals with transactions recorded after year-end, it is least likely to be
completed before the balance sheet date.
(b)

(1)
The auditors do not have as an objective the determination of whether
accounts payable are past due.

(c)

(4)
Examining selected cash disbursements in the period subsequent to the
year-end is the best audit procedure for determining the existence of unrecorded
liabilities. All liabilities must eventually be paid, and will therefore be reflected
in the accounts when paid if not when incurred. By close study of payments
made subsequent to the balance sheet date, the auditors may find items that
should have appeared in the balance sheet.

(d)

(4)
Auditors will usually find in the client's possession externally created
evidence such as vendors' invoices and statements that substantiate the accounts
payable. No such external evidence is on hand to support accounts receivable.

(e)

(2)
The most efficient way in which the duplicate recording of a purchase
transaction may be detected is by reconciling the related payable accounts with
vendors' statements.

(f)

(1)
Each vendor's invoice should be compared with the receiving report (to
determine that it was received) and the purchase order (to determine that it was
ordered). Answer (2) is incomplete because of the omission of the purchase
order. Answers (3) and (4) are incorrect because the receiving report, prepared
by the company itself, provides better evidence of what has been received than
the vendor's packing slip.

(g)

(2)
Accounts payable confirmations are ordinarily sent to suppliers with
whom the client has done the most business. This is because the largest potential
for an understatement may exist due to the client having established high levels
of credit. A sample of other accounts will ordinarily also be selected.

(h)

(1)
The best procedure to determine valuation of payables is confirmation.
Examination of cash disbursements in the subsequent period is more directed
towards completeness of payables. Analytical procedures may be useful but
would not be as effective as confirmation with respect to the valuation assertion.

(i)

(1)
Because an understatement of liabilities overstates income, auditors are
ordinarily most concerned with the completeness assertion for payables. Note,
however, that in circumstances in which a client may be motivated to understate
income (e.g., to minimize taxes), existence becomes a bigger concern.

(j)

(4)
Auditors audit estimates through (1) independently developing an
estimate, (2) reviewing managements process, and (3) reviewing subsequent
events. There often is no one to send a confirmation related to the estimate.

(k)

(3)
The individual who signs the checks should ordinarily be provided with
supporting documents that provide support for the disbursement. That individual
should then manually or electronically cancel the documents so that the
amount isnt paid a second time.
(2)
Vouching from the purchases journal to the supporting documents
provides evidence with respect to the existence assertion for purchases.

(l)

14-38 SOLUTION: Rex Wholesaling (Estimated time: 20 minutes)

Taylor should perform, the following additional substantive audit procedures:

15-33

(1)

Foot the client-prepared schedule.

(2)

Tie the general ledger accounts payable controlling account to the client-prepared
accounts payable schedule.

(3)

Examine vendors' statements in support of items on the client-prepared schedule.

(4)

Examine other documents (such as approved vouchers) in support of items on the clientprepared schedule.

(5)

Review the general ledger controlling account for non-cash debits or unusual items, and
investigate them.

(6)

Confirm, with positive confirmation requests, account balances from selected vendors.

(7)

Examine unpaid invoices on hand (to ascertain whether any were erroneously omitted
from the client-prepared schedule of accounts payable).

(8)

Examine documents in support of invoices paid subsequent to the year end (to ascertain
whether the payable was recorded in the appropriate year).

(9)

Inspect receiving reports (to test the accuracy of the year-end cutoff).

(10)

Ascertain whether year-end outstanding checks to vendors were returned with the cutoff
bank statement.

(11)

Review correspondence files with respect to disputed items.

(12)

Review open purchase orders for unusual or old items that may have been received but
not recorded.

(13)

Examine unmatched receiving reports.

(14)

Make certain that the client representation letter includes the proper assertions concerning
accounts payable.

(15)

Investigate and resolve confirmation exceptions and other matters requiring follow-up.
(a)
Despite the fact that the options have a higher option price than the stocks
current price, they may well have value. Call options with option prices that are higher
than the related stock prices are traded on option markets every day. Management
should have a business valuation expert (specialist) value the options to determine the
appropriate amount of compensation cost to be recognized.
(b)
(1)
Obtain a copy of the stock option plan for the auditors'
permanent file and become thoroughly familiar with its provisions.

(2)
Trace the approval of the plan to minutes of directors' and stockholders'
meetings.
(3)
Prepare a working paper for the permanent file showing the
number of shares authorized by the plan, and the number granted, exercised, and
expired each year. Design the working paper so that data can be added each year.
(4)
Verify the number of shares granted in the current year by
reference to minutes of directors' meetings. Verify market price at date of grant
by reference to financial publications.
(5)
Compute the number of options expired during the year and the number
outstanding at the balance sheet date.
(6)
Engage a specialist or use managements specialist to value the stock options.
(7)
Evaluate the reasonableness of the estimated value of the options used to
compute compensation cost. This would include evaluating the qualifications and
objectivity of the specialist. The auditors should also obtain and understanding of the
methods and assumptions used by the specialist, make appropriate tests of data provided
to the specialist, and evaluate whether the specialists findings support the related
assertions in the financials statements.
15-34

(a)
(3)
The client will not receive proceeds related to redemption of its interestbearing
debtit will pay off the debt.
(b)

(1)
Auditors will test the relationship between interest payments and
recorded long term liabilities. When interest payments seem too high, it may be
due to the existence of unrecorded liabilities. Also, the process of performing
procedures to determine who interest is paid to may reveal unrecorded debt.

(c)

(2)
When debt provisions are violated, long term debt often becomes
immediately payable, and therefore, a current liability.

(d)

(2)
A registrar and transfer agent keep information on the shares issued,
outstanding, and the owners of that stock.

(e)

(2)
It is not customary to confirm stockholdings by direct communication
with individual stockholders. For an actively traded stock, contacting individual
stockholders would be very costly and not likely to produce a satisfactory
proportion of replies.

(f)

(1)
The auditors should trace treasury stock purchase transactions to the
certificates on hand. If the certificates are not on hand, they should be confirmed
directly with the custodian. The articles of incorporation, answer (2), will not
provide information on the details of specific stock issuances and treasury stock
transactions. There is no interest on the treasury stock, and accordingly, answer
(3) doesn't relate directly to treasury stock. Finally, it is far more likely that the
overall board of directors, not the audit committee, will approve treasury stock
transactions. Therefore, answer (4) is not correct.

(g)

(1)
Transactions in the owners' equity accounts are very few in comparison
with the volume of entries in the other three groups. Consequently, the audit time

required for owners' equity is usually much smaller than for revenue, assets, or
liabilities.
(h)

(3)
The bond trustee will be able to provide information on both the sinking
fund transactions and the year-end balance.

(i)

(2)
The auditors' examination of long-term debt always includes an
examination of copies of debt agreements to ensure the client is not in violation
of the covenants of these agreements. Answer (1) describes a procedure that is
not performed. Answers (3) and (4) describe procedures that may be performed
but they pertain more directly to other accounts.
(1)
Capital stock transactions should all be approved by the client's board of
directors. Answer (2) is incorrect because there will be no cash receipt for stock
repurchase transactions. Answers (c) and (d) are incorrect because cash
disbursements will not be recorded and numbered stock certificates will not be on
hand after stock sales.

(j)

(k)

(3)
An audit objective for owners equity is to determine that presentation
and disclosure is appropriate. Answer (1) is incorrect because owners equity
does not include long-term debt. Answer (2) is incorrect because common stock
should not be valued at current market value. Answer (4) is incorrect because the
term equity accounting rule valuations is of uncertain meaning.

(l)

(1)
A common difficulty for a sole proprietorship is segregating personal and
business assets and personal net worth. For example, credit cards and cash
accounts may be used for both personal and business use, thus complicating the
accounting process.

16-36

(a)
(4)
Testing whether employee time reports are approved by
supervisors is an example of a test of a control, not a substantive procedure.
(b)
(3)
The best procedure for the detection of a fictitious employee is a
surprise observation of the distribution of paychecks. The fictitious employees
paycheck will ordinarily not be picked up, and further audit procedures
performed by the auditors may reveal that this is a fictitious employee.
(c)

(4)
The purpose of analytical procedures is to locate potential misstatements
in the financial statements. The auditors should investigate this significant
fluctuation to determine whether it results from a financial statement
misstatement.
(d)
(1)
The three sections of a statement of cash flows relate to
operations, financing, and investing. Capitalization is not one of the sections.

(e)

(3)
The search for unrecorded liabilities should be completed as of the last
day possibleordinarily near the date of the audit report.

(f)

(1)
The total likely misstatements composed of(a) known misstatements, (b)
projected misstatements and (c) other misstatements.

(g)

(2)
A loss contingency is a possible loss stemming form past events that will
be resolved in the future.

(h)

(3)
A Type 1 subsequent event relates to a condition that came into effect
before year-end; Type 1 subsequent events result in an adjusting journal entry.
In this situation, the customers check may be assumed to have been
uncollectible at year-end, and therefore it would be considered to be a Type 1
subsequent event. The other three replies refer to events most ordinarily
considered to be Type 2 eventsthe events came into existence after year-end.

(i)

(3)
The representation letter should be dated as of the date the audit was
completed.

(j)

(4)
The performance of analytical procedures is a required part of the final
review stage of an audit and is therefore most likely to be included in that stage
of the audit.

(k)

(2)
When the auditor becomes aware of facts existing at the report date that
would have affected the report, s/he should next determine whether there are
persons relying or likely to rely on the financial statements who would attach
importance to the information. If such persons are believed to exist, the next step
is to determine the best manner in which to disclose the information.

(l)

(3)
The settlement of litigation is most likely to result in an adjusting entry
(i.e., be a "Type 1 subsequent event) because the cause of the litigation most
likely occurred before 20X2.

16-39 SOLUTION: Internal Control, Tests of Controls, Substantive Procedures (Estimated time: 20
minutes)
(a)

(1)
Separation of the human resources and approval functions is designed to
prevent overpayment of payroll amounts or payments to fictitious employees.
(2)
If the same employees perform the functions of timekeeping and
distribution, they have an opportunity to report the attendance of individuals who
have resigned, and divert their payroll checks to their own use.

(b)(1) and (2)

17-26

Segregation of duties is tested by making inquiries as to which employees

performed specific tasks throughout the year, and observing personnel
performing those tasks. The auditors also should make inquiries as to who
performs assigned tasks under unusual circumstances, such as prolonged illness
of an employee.

(c)(1) and (2) To test for fictitious payroll transactions, the auditors might observe the
distribution of paychecks on a surprise basis. Analytical procedures applied to
payroll expenses, such as comparisons of this year's amounts to budgeted
amounts or comparable amounts for prior years, might reveal a significant
overstatement of payroll expenses.
(a)
(3)
When the auditors take exception to the application of
accounting principles in the client's financial statements, they will issue either an

"except for" qualified, or adverse opinion, depending on the materiality of the

problem.
(b)

(2)
The audit report should be dated no earlier than when the auditors have
accumulated
sufficient competent evidence. This date is often the last day of fieldwork.

(c)

(1)
Reference to the work of another auditor is not, in itself, a qualification
of the auditors' report. This reference does not lessen the auditors' collective
responsibility. Rather, it merely divides this responsibility among two or more
CPA firms.

(d)

(4)
This phrase violates the fourth standard of reporting, because it does not
give the reader of the report a clear-cut indication of the auditors' opinion. The
phrase appears to modify the standard opinion paragraph, but is not forceful
enough to constitute qualifying language.

(e)

(1)
The auditor communicates through the auditors' report, and therefore
only answer (1) is correct. Note that the client will include a discussion of the
related party transactions in a note to the financial statements.

(f)

(2)
A disclaimer is appropriate because auditors must generally disclaim an
opinion when a significant client imposed scope limitation is involved. Note
here that if the limitation were circumstance imposed the auditors would have to
decide between an "except for" qualified and disclaimer of opinion.

(g)

(3)
No explanatory paragraph is added when part of the audit is performed
by other auditors. If the CPA wishes to take responsibility for the work of the
other auditors, no modification is necessary. If the CPA does not wish to take
such responsibility, each of the existing three paragraphs of the report are
modified.

(h)

(2)
An audit report of a public client indicates that the audit was performed
in accordance with standards of the Public Company Accounting Oversight
Board (United States).

(i)

(3)
An audit report for a public client indicates that the financial statements
were prepared in conformity with generally accepted accounting principles
(United States). The PCAOB does not issue accounting standards.

(j)

(3)
Substantial doubt about a clients ability to continue as a going concern
results in either an unqualified report with explanatory language or a disclaimer
of opinion. Accordingly answer (3) is correct since a qualified report is not
appropriate.

(k)

(2)
When an unjustified change in accounting principles occurs, either a
qualified or adverse opinion is appropriate as this represents a departure from
generally accepted accounting principles. Accordingly, answer (2) is correct
since an adverse opinion, but not a disclaimer of opinion is appropriate.

(l)

(3)
An emphasis of a matter paragraph is appropriate when an auditor wishes
to emphasize a matter concerning the financial statements, but not a matter
concerning the scope of the audit engagement. Accordingly, answer (3) is not a
situation in which an emphasis of a matter paragraph is appropriate since
confirming accounts receivable relates to the scope of the

1832(a)
(1) PCAOBStandardNo.2requiresthattheauditors
tocommunicatebothmaterial
weaknessesandsignificantdeficienciestotheaudit
committee.
(b)

(2) Anauditreportoninternalcontrolismodifiedfor
materialweaknesses,not
significantdeficiencies.

(c) (1) Managementmustcommunicatebothmaterialweaknesses

andsignificant
deficienciestotheauditcommittee.
(d) (1) PCAOBStandardNo.2includesIneffectiveoversightof
financialreportingbythe
auditcommitteeisconsideredan
indicatorofamaterialweaknessininternalcontrol.
(e) (2) Amaterialweaknessinvolvesareasonablepossibility
ofamaterialmisstatement.
(f) (3) Anunqualifiedopinionwithnoexplanatorylanguageis
appropriatewhenthe
materialweaknesshasbeeneliminated(remediated)
priortotheasofdate,yearend.
(g) (4) ManagementsreportoninternalcontrolunderSection
404aoftheSarbanesOxley
Actof2002neednotstatethatithasa
responsibilitytoestablishandmaintaininternal
controlthatdetectsallsignificantdeficiencies.
(h) (2) Managementsdocumentationmustincludeinformationon
controlsdesignedto
preventfraud,butnotoncontrolsdesignedtoensure
employeepersonalintegrity.
(i)

(4) Amaterialweaknessinvolvesamaterialamount.

(j)

(4) Awalkthroughinvolvestracingatransactionfrom
originationthroughacompanys
informationsystemsuntilitisreflectedinthe

financialreportingsystem.
(k)

(3) Auditorswillnotordinarilyaskwhatwasthelargest
fraudulenttransactionan
individualeverprocessed.Theotherthreereplies
arerecommendedquestions.

(l) (1) Anauditofinternalcontroloverfinancialreporting

ordinarilyassessinternalcontrol
atanasofdateordinarilythelastdayofthe
fiscalperiod.