1.

Explain the circumstances under which an auditor should perform audit tests primarily designed
to uncover fraud in the payroll and personnel cycle. List three audit procedures that are primarily
for the detection of fraud and state the type of fraud the procedure is meant to uncover.(20-9)

Why auditor should perform an audit test is primarily designed to uncover fraud in the payroll and
personnel cycle when he or she has determined that internal controls are deficient (or the
opportunity exists for management to override the internal controls) or when there are other reasons
to suspect fraud. Audit procedures that are primarily for the detection of fraud in the payroll and
personnel cycle include:
1. Examine cancelled payroll checks for employee name, authorized signature, and proper
endorsement (especially for second endorsements) to discover checks going to nonexistent
employees. The endorsement should be compared to signatures on W-4 forms.
2. Trace selected transactions recorded in the payroll journal or listing to the human resources
department files to determine whether the employees were actually employed during the period.
3. Select several terminated employees from payroll records to determine whether each former
employee received his or her termination pay in accordance with company policy and to determine
that the employee's pay was discontinued on the date of termination
4. Examine the subsequent payroll periods of terminated employees to ascertain that the employees
are no longer being paid.
5. Request a surprise payroll payoff to observe if any unclaimed checks result, which will necessitate
extensive investigation.

2. The Redford Corporation took out a 20-year mortgage on June 15, 2011, for $2,600,000 and
pledged its only manufacturing building and the land on which the building stands as collateral.
Each month subsequent to the issue of the mortgage, a payment of $20,000 was paid to the
mortgagor. You are in charge of the current year audit for Redford, which has a balance sheet date
of December 31, 2011. The client has been audited previously by your CPA firm, but this is the first
time Redford Corporation has had a mortgage.
a. Explain why it is desirable to prepare an audit schedule for the permanent file for the mortgage.
What type of information should be included in the schedule?
b. Explain why the audit of mortgage payable, interest expense, and interest payable should all be
done together.
c. List the audit procedures that should ordinarily be performed to verify the issue of the mortgage,
the balance in the mortgage and interest payable accounts at December 31, 2011, and the balance
in interest expense for the year 2011.
d. Identify the types of information that should be disclosed in the footnotes for this long-term
note payable to help the auditor determine whether the completeness presentation and disclosure
audit objective is satisfied. (22-27)

It is desirable to prepare an audit schedule for the permanent file for the mortgage so that the
appropriate information concerning the mortgage will be conveniently available for future years'
audits. This information should include all the provisions of the mortgage as well as the purchase
price, date of purchase, and a list of items pledged as collateral. It may also contain an amortization
schedule of principal and interest (especially if the auditor has access to a computer program for
preparation of such a schedule).
b. The audit of mortgage payable, interest expense, and interest payable should all be done together
since these accounts are related and the results of testing each account have a bearing on the other
accounts. The likelihood of misstatement in the client's records is determined faster and more
effectively by doing them together.
c. The audit procedures that should ordinarily be performed to verify the issue of the mortgage, the
balance in the mortgage and interest payable, and the balance in the interest expense accounts are:
1. Determine if the mortgage was properly authorized.
2. Obtain the mortgage agreement and schedule the pertinent provisions in the permanent file,
including the face amount, payments, interest rate, restrictions, and collateral.
3. Confirm the mortgage amount, terms, and collateral with the lending institution.
4. Recompute interest payable at the balance sheet date and reconcile interest expense to the
decrease in principal and the payments made.
5. Test interest expense for reasonableness.
d. Accounting standards require disclosures related to long-term debt. The terms of the debt
agreement are to be disclosed, including interest rates, maturity dates, five-year payment information,
assets pledged as collateral, among other items. Significant restrictions on the activities of the
company, such as maintaining cash or other compensating balances or restricting the amount of
dividends that can be paid, should be disclosed. Thus, auditors obtain copies of long-term debt
agreements to determine that the client’s disclosures are complete and accurate.

3. Why is there a greater emphasis on the detection of fraud in tests of details of cash balances
than for other balance sheet accounts? Give two specific examples that demonstrate how this
emphasis affects the auditor’s evidence accumulation in auditing year-end cash.(23-15)

There is a greater emphasis on the detection of fraud in tests of details of cash balances than for
other balance sheet accounts because the amount of cash flowing into and out of the cash account is
frequently larger than for any other account in the financial statements. Furthermore, the
susceptibility of cash to misappropriation is greater than other types of assets because most other
assets must be converted to cash to make them usable. This emphasis affects the auditor's evidence
accumulation in auditing year end cash as in these examples:

 Verifying whether cash transactions are properly recorded

 Testing of bank reconciliations
 Obtaining bank confirmations

4. In an audit of the Marco Corporation as of December 31, 2011, the following situations exist.
No entries have been made in the accounting records in relation to these items. 1. During the year
2011, the Marco Corporation was named as a defendant in a suit for damages by the Dalton
Company for breach of contract. An adverse decision to the Marco Corporation was rendered and
the Dalton Company was awarded $4,000,000 damages. At the time of the audit, the case was
under appeal to a higher court. 2. On December 23, 2011, the Marco Corporation declared a
common stock dividend of 1,000 shares with a par value of $1,000,000 of its common stock,
payable February 2, 2012, to the common stockholders of record December 30, 2011. 3. The Marco
Corporation has guaranteed the payment of interest on the 10-year, first mortgage bonds of the
Newart Company, an affiliate. Outstanding bonds of the Newart Company amount to $5,500,000
with interest payable at 5% per annum, due June 1 and December 1 of each year. The bonds were
issued by the Newart Company on December 1, 2009, and all interest payments have been met by
that company with the exception of the payment due December 1, 2011. The Marco Corporation
states that it will pay the defaulted interest to the bondholders on January 15, 2012.
a. Define contingent liability.
b. Describe the audit procedures you would use to learn about each of the situations listed.
c. Describe the nature of the adjusting entries or disclosure, if any, you would make for each of
these situations.* (24-27)

A. A contingent liability is a potential future obligation to an outside party for an unknown amount
resulting from activities that have already taken place. The most important characteristic of a
contingent liability is the uncertainty of the amount; if the amount were known it would be included
in the financial statements as an actual liability rather than as a contingency.
B. Audit procedures to learn about these items would be as follows:
The following procedures apply to all three items:
 Discuss the existence and nature of possible contingent liabilities with management and
obtain appropriate written representations.
 Review the minutes of directors' and stockholders' meetings for indication of lawsuits or
other contingencies.
 Analyze legal expense for the period under audit and review invoices and statements of
legal counsel for indications of contingent liabilities.
 Obtain letters from all major attorneys performing legal services for the client as to the
status of pending litigation or other contingent liabilities.
The following are additional procedures for individual items:
Lawsuit Judgment — no additional procedures; see above list of procedures applicable to all three
items.
Stock dividend
 Confirm details of stock transactions with registrar and transfer agent.
 Review records for unusual journal entries subsequent to year-end.
Guarantee of interest payments
 Discuss, specifically, any related party transactions with management and include information in
letter of representation.
 Review financial statements of affiliate, and where related party transactions are apparent,
make direct inquiries of affiliate management, and perhaps even examine records of affiliate if
necessary.

c. Nature of adjusting entries or disclosure, if any, would be as follows:

1. The lawsuit should be described in a footnote to the balance sheet. In view of the court decision,
retained earnings may be restricted for $4,000,000, the amount of the first court decision. Also, in
view of the court decision any reasonable estimate of the amount the company expects to pay as a
result of the suit might be used in lieu of the $4,000,000. A current liability will be set up as soon as a
final decision is rendered or if an agreement as to damages is reached. If liability is admitted to by
Marco, and only the amount is in dispute, a liability can be set up for the amount admitted to by the
company with a corresponding charge to expense or shown as an extraordinary item if the amount is
material.
2. The declaration of such a dividend does not create a liability that affects the aggregate net worth
in any way. The distribution of the dividend will cause a reduction in retained earnings and an
increase in capital stock. No entry is necessary, but an indication of the action taken, and that such a
transfer will subsequently be made, should be shown as a footnote or as a memorandum to Retained
Earnings and Common Stock in the balance sheet.
3. If payment by Newart is uncertain, the $137,500 interest liability for the period June 2 through
December 1, 2011, could be reflected in the Marco Corporation's accounting records by the following
entry:
Interest Payments for Newart Company $137,500 Accrued Interest Payable — Newart Bonds
$137,500
The debit entry should be included as other assets. Collection is uncertain and the Marco Corporation
may not have a right against the Newart Company until all interest payments have been met and the
bonds retired. If this treatment is followed, the balance sheet should be footnoted to the effect that
the Marco Corporation is contingently liable for future interest payments on Newart Company bonds
in the amount of $2,200,000. If the interest has been paid by the time the audit is completed, or if
for other reasons it seems certain that the payment will be made by Newart on January 15, no entry
should be made by Marco. In this circumstance a footnote disclosing the contingent liability of
$2,337,500 and the facts as to the $137,500 should be included with the statements.

5. Distinguish between an unqualified report with an explanatory paragraph or modified wording

and a qualified report. Give examples when an explanatory paragraph or modified wording should
be used in an unqualified opinion.(3-9)

An unqualified report with an explanatory paragraph or modified wording is the same as a standard
unqualified report except that the auditor believes it is necessary to provide additional information
about the audit or the financial statements. For a qualified report, either there is a scope limitation
(condition 1) or a failure to follow generally accepted accounting principles (condition 2). Under either
condition, the auditor concludes that the overall financial statements are fairly presented. Two
examples of an unqualified report with an explanatory paragraph or modified wording are:
1. The entity changed from one generally accepted accounting principle to another generally
accepted accounting principle.
2. 2. A shared report involving the use of other auditors.