The Lakeside Company: Auditing Cases

SOLUTIONS MANUAL 11e

Table of Contents
John M. Trussel and J. Douglas Frazer A Not on Ethics, Fraud and Sox Questions 2 A Note on Research Assignments 4 Introductory Case 6 Case 1 Case 2 Case Case 4 Case " Case 6 Case # Case $ Case ! Case 1% Case 11 Case 12 Case 1 1 1 21 2! ! "1 6# #4 $ !2 1%% 1%" 11" 12#

A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS The Lakeside Company: Auditing Cases, 11th edition, has een updated in light o! the a""ounting s"andals o! the early #$$$s and the passage o! the %ar anes&'(ley A"t o! #$$#, and the rene)ed interest in ethi"s )ithin the a""ounting and auditing pro!ession. *thi"s +uestions are no) spe"i!i"ally identi!ied )ith an ethi"s logo. The ethi"s +uestions are o!ten open ended, and this solutions manual does not try to gi,e e(a"t ans)ers to these +uestions. -ather, )e intend to gi,e some ideas !or "lassroom dis"ussion, and to help )ith student resear"h on these +uestions. Fraud +uestions are no) spe"i!i"ally identi!ied )ith a !raud triangle The introdu"tion o! %ar anes&'(ley issues has een a""omplished in t)o )ays. First, "ase "ontent has een altered to in"lude Lakeside.s "onsideration o! !inan"ing e(pansio n through an initial pu li" o!!ering, and the resulting impa"t su"h a de"ision )ould ha,e on Lakeside and on A ernathy and Chapman, C/As. %e"ond, the dis"ussion +uestions and e(er"ises ha,e een e(panded to in"lude "onsideration o! %ar anes& '(ley and ne) auditing and independen"e standards, oth y adding a se"tion in the end&o!&"hapter material and y re!eren"e in the other +uestions )here appropriate. The !ollo)ing list in"ludes all the +uestions )ith the lo"ation o! the +uestion and a rie! learning o 0e"ti,e. 12ntr&13 The "ase states that the !irm o! A ernethy and Chapman is "onsidering the a""eptan"e o! "lients that are pu li"ly traded. 4hat spe"i!i" steps )ould the !irm ha,e to take e!ore they "ould a""ept an audit "lient that is pu li"ly traded5 ' 0e"ti,e 6 2nitial /CA'7 registration. 11&13 A""ording to this "ase, the Lakeside Company is "onsidering a pu li" o!!ering o! sto"k to !inan"e its gro)th. 4hat steps )ould the Lakeside Company ha,e to take e!ore issuing sto"k to the pu li"5 2n parti"ular, ho) )ould the p ro,isions o! the %ar anes&'(ley A"t impa"t this de"ision5 8o) does the possi le pu li" sale o! sto"ks impa"t the Lakeside Company !inan"ial reporting re+uirements5 ' 0e"ti,e 6 /u li" reporting re+uirements in the /CA'7 "onte(t. 11&#3 *(plain ho) the a""eptan"e o! a pu li" "ompany )ould impa"t a C/A !irm. 2n parti"ular, ho) )ould -oger9s de"ision a out o!!ering sto"k to the pu li" impa"t A ernethy and Chapman9s de"ision o! )hether or not to a""ept Lakeside as a "lient5 ' 0e"ti,e 6 Client

a""eptan"e in the /CA'7 and in this "ase the e!!e"t o! an initial pu li" "lient. 1#&13 A""ording t o Case 1, the Lakeside Company is "onsidering a pu li" o!!ering o! sto"k to !inan"e its gro)th. The !irm o! A ernethy and Chapman does not presently ha,e any audit "lients that are pu li" "ompanies. 8o) )ould the %ar anes&'(ley A"t impa"t the !irm9s de"ision to a""ept su"h a "ompany as an audit "lient5 4hat additional re+uirements are there !or a C/A !irm that is registered to pra"ti"e e!ore the %*C "ompared )ith a C/A !irm that is not registered5 2s the !irm o! A ernethy and Chapman "apa le o! meeting these standards5 ' 0e"ti,e& Client a""eptan"e in general "ompared to pu li" "lients. 1#&#3 A""ording to Case 1, the Lakeside Company is "onsidering a pu li" o!!ering o! sto"k to !inan"e its gro)th. 4hat additional re+uirements are there !or a pu li"ly traded "ompany "ompared )ith a nonpu li" "ompany5 4hat issues ha,e arisen so !ar in the "ase that should e addressed as Lakeside "onsiders going pu li"5 ' 0e"ti,e& Lakeside issues related to pu li" reporting re+uirements. 1:&13 Lakeside.s "onsideration o! an initial pu li" o!!ering )ould re+uire signi!i"ant "hanges in Lakeside.s organizational stru"ture and go,ernan"e, in"luding the stru"ture and operation o! the oard o! dire"tors and the need to assess the !un"tioning o! the "ompany9s internal "ontrol systems. Dis"uss these topi"s and make spe"i!i" re"ommendations to Lakeside. ' 0e"ti,e 6 Corporate go,ernan"e and internal "ontrol in the pu li" reporting "onte(t. 1:&#3 Dis"uss the assessment o! "ontrol risk !or audit "lients that are pu li" "ompanies. 2! Lakeside )ere to e"ome a pu li" "ompany, )hat impa"t )ould that ha,e on A ernethy and Chapman9s assessment o! Lakeside9s "ontrol risk and the e,aluation o! internal "ontrol5 ' 0e"ti,e 6 2nternal "ontrol oth in the pu li" reporting "onte(t. %e"tion :$: audits. 1;&13 As noted in Case 1, Lakeside in "onsidering the issuan"e o! sto"k to the pu li". 4rite a report dis"ussing tests o! "ontrols !or "lients that are pu li" "ompanies "ompared )ith those that are not pu li" "ompanies. 2! Lakeside )ere to e"ome a pu li" "ompany, )hat impa"t )ould that ha,e on A ernethy and Chapman9s tests o! "ontrols5 ' 0e"ti,e 6 Comparison o! internal auditing in the general "ase and in the pu li" "ase.

(7-1) The case assumes that tests of controls have been completed and substantive testing in the payroll area has commenced. During the internal control evaluation and testing what options are available to the C ! to document problems and communicate their effect" #rite a sample of a $material wea%ness& in the area of payroll internal control that would be included in the auditor's report. ' 0e"ti,e 6 Material )eakness e(ample. 1<&13 The %ar anes&'(ley legislation raised the e(pe"tations on the o,ersight pro,ided y the oard o! dire"tors and esta lished the role o! the =!inan"ial e(pert.> 8o) )ould these e(panded responsi ilities a!!e"t the !inan"ial a""ounting +uestions that played a signi!i"ant part in Case <5 ' 0e"ti,e 6 The role o! the audit "ommittee and the !inan"ial e(pert. 1<&#3 ?nder %ar anes&'(ley, management "an no longer "laim to e una)are o! its !inan"ial reporting system. 2n this "ase, ho) do the ans)ers pro,ided y -ogers relate to his anti"ipated plan to take his "ompany pu li"5 ' 0e"ti,e 6 Management responsi ility, and se"tion :$:. 11@&13 A""ording to Case 1, the Lakeside Company is "onsidering a pu li" o!!ering o! sto"k to !inan"e its gro)th. At present, A ernethy and Chapman do not presently ha,e any audit "lients that are pu li" "ompanies. 4rite a report dis"ussing ho) the %ar annes& '(ley A"t impa"ts the !irm9s independen"e regarding the pro,ision o! audit and non&audit ser,i"es5 ' 0e"ti,e 6 The impa"t o! the pros"ri e non&audit ser,i"es in general and in A ernathy and Chapman "ase.

A NOTE ON RESEARCH ASSIGNMENTS The (!pply )our *esearch( and (Consulting artner *eview( assignments included at the end of several cases do not lend themselves to definitive solutions that could be included in an instructor's manual. The assignments are simply not intended to be e+ercises in arriving at a predetermined answer. *ather, the applications of the suggested readings have the following ob-ectives. To provide a means for improving the writing s%ills of students. /rom all reports, accounting ma-ors too often leave college lac%ing in the basic ability to compose and construct sentences and paragraphs. !ccounting and auditing (especially as one moves up in an organi0ation) obviously re1uire s%ills other than the purely 1uantitative. 2emos, reports, footnotes, audit and accounting guides, etc., all re1uire accountants and auditors to be effective communicators of the written word. 3ndeed, the instructor may want to team up with a member of the school's 4nglish or communications department to enhance the effectiveness of these assignments. The auditing instructor can then evaluate the technical and research portions of the assignment, while the 4nglish instructor would ma%e suggestions as to grammar, synta+, construction of sentences and paragraphs, logic of the thought process, etc. !s a preliminary step, the instructor may want to assign articles such as (#ord Crunching. ! rimer for !ccountants( from the 2arch 1556 issue of the Journal of Accountancy. To introduce students to accounting and business -ournals as well as other important publications. !fter college, students must be able to (%eep current( or their effectiveness will 1uic%ly decline. 3n most cases, this continuation of their education is provided by the regular reading of publications such as The Wall Street Journal, Journal of Accountancy, CPA Journal and Forbes. These assignments re1uire the students to begin reading these -ournals prior to graduation. The students should become comfortable with their ability to understand and use the materials in professional publications. 3n addition, real-world aspects of many accounting issues are presented through these various readings. To develop the students' ability to derive viable solutions to auditing problems. 7nfortunately, students in college often come to the belief that all auditing issues can be resolved simply by applying the pronouncements of various authoritative bodies. Te+tboo%s too often present problems that have one ultimate answer. 8owever, in many real cases, no definitive solutions actually e+ist. Thus, when faced with such problems, students must be capable of reviewing the available literature and then using that information as a basis for arriving at a wor%able

decision. To promote auditing research. 3n most of these library assignments, students are provided with one or more resources as starting points for their research. 8owever, the instructor should always push the students to loo% for more and different types of information. The ultimate purpose of these assignments is to force the students into the library and online sources to do the searching for themselves. 9ne e+cellent method of introducing the assignments is to use some class time to illustrate the various methods of research that are available to them, including electronic resources, such as the following. o http.::www.sec.gov o http.::www. C!9;7<.org o http.::www.!3C !.org o http.::www./!<;.org o )our state society of C !s also operates sites. 3f possible, a business librarian or a research librarian may be enlisted to discuss the various search techni1ues that can be used at the school's library for research purposes. Developing the ability to find information is one of the most important s%ills that can be achieved by an accounting ma-or.

INTRODUCTORY CASE SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) The staff auditor performs many of the detailed audit procedures, such as preparing and controlling accounts receivable confirmations. 3n general the wor% of the staff auditor is controlled by audit program and supervised by the senior auditor The senior auditor coordinates the audit at the client's location and performs many of the more difficult audit procedures, such as analytical review procedures. 7sually the detailed wor% performed by the audit senior is more sophisticated and re1uires the e+perience gained by someone holding that ran%. The audit senior is supervised by the manager. The manager and the partner have supervisory roles. 2anagers and partners often have more than one audit team under supervision at any given time. The partner is the person who has responsibility for determining whether the firm=s signature can be attached to audit report. (>) The partner-in-charge of an audit is the definitive decision-ma%ing position on the audit team. !lthough the manager and senior auditor ma%e several decisions, they must get ultimate approval from the partner-in-charge of the audit. The consulting partner's role is to add a further degree of ob-ectivity to the audit. The consulting partner reviews and criti1ues certain crucial decisions made by the audit team, such as the final audit report. The partners should be rotated to assure independence. <arbanes-9+ley (<9?-<>6@) re1uires the identification of a Aeading artner and a *eviewing artner. ;oth partners must be rotated every five years. (@) !n accounting firm is a business li%e any other, and its management must recogni0e that a mar%eting strategy is probably necessary to generate a continual flow of sufficient operating revenues. 8owever, in the accounting profession, disagreement e+ists as to the e+tent that such mar%eting should ta%e. 3n the past, overt mar%eting was not permitted since it was considered to be unprofessional. This position was supported based on the reasoning that a firm

should be selected based solely on the 1uality of its service. Bo reliable system e+isted, though, for conveying such information to potential clients. 8ence, firms with many clients tended to remain large, while smaller firms often found growth to be nearly impossible. 3n the free mar%et system espoused by the 7nited <tates, restrictions on such practices as advertising and solicitation were inevitably overturned. 9ver the past three decades, attitudes toward mar%eting have changed dramatically as competition has become much more intense. !dvertisements by C ! firms in newspapers and maga0ines are now common. Bewsletters such as that distributed by !bernethy and Chapman are also fre1uently used to increase a firm's name recognition in the business community. 3n the current world of business, some type of mar%eting strategy seems imperative if an accounting firm is to compete. #hether that mar%eting should e+tend to formal advertising is often a 1uestion of firm policy. 2ost importantly, the firm must ensure that potential clients %now of its presence and the services that it offers. ! client will probably not select a C ! firm based on advertising. 8owever, the client may initially become aware of the firm only through some type of mar%eting. 3nterestingly, some members of the accounting profession view mar%eting as having had a negative impact on the profession as a whole. rice competition for new clients is often associated with the mar%eting of a firm. These critics assert that lowered fees result in sloppy and hurried audit wor% that can decrease the overall reputation of the profession. C!dditional resources discussing this issue can be found in the (<uggested *eadings( at the end of this case.D (E) ! national or international C ! firm might consider ac1uiring !bernethy and Chapman for several reasons. !lthough only a regional firm, !bernethy and Chapman apparently has a client base that includes a number of large clients in several different industries. ;y ac1uiring the local firm, the larger organi0ation will fre1uently be able to retain these customers, thus increasing its own client list. The larger firm may be interested in moving into this geographical region, and buying the local firm will provide an instant base on which to build a practice in the area. The larger firm may already have an office in this location and feels that combining the practices will reduce e+penses.

!bernethy and Chapman might have several reasons for viewing an ac1uisition in a favorable light.

/re1uently, the purchase price will be a considerable amount of money because of the goodwill inherent in an established accounting firm. The offer to sell may be especially tempting if the partners are nearing retirement age and the future of the firm appears uncertain. The smaller firm may have trouble dealing with increased competition from bigger firms. 9ften clients may decide that a change to a nationally %nown C ! firm should be made to add e+tra stature to the audit report. 3f a local organi0ation has only a few large clients, it cannot economically afford to lose a significant amount of revenue in this way. ! merger may help the firm to %eep its clients. The regional firm may also desire the additional bac%up services offered by large organi0ations. Bational C ! firms usually have e+perts in many industries as well as in specific audit areas who are available for consultation. 3n a smaller firm, this degree of assistance is not always available when a difficult accounting or auditing problem is encountered. C!9; registration and <4C practice presents hurdles that might be overcome through a merger with a larger firm.

2any mergers have occurred in the auditing profession during recent years. Critics assert that this trend has reduced competition and will inevitably lead to a decrease in audit 1uality. roponents counter by stating that mergers lead to more efficient operations and, thus, improve audit 1uality. 9bviously, mergers will create a drastic change in the profession as more of the smaller firms disappear. !udit wor% in this country may possibly become concentrated within the largest C ! firms. #hether this result is good for the auditing profession may be merely a 1uestion of perspective. To the smaller firms struggling to survive and grow, the mergers are usually considered a threat as the bigger firms become more competitive. To the larger firms, the chance for continued growth and more efficient operations is always an important ob-ective. <ee the <arbanes-9+ley section below for a follow up 1uestion related to the impact of <9? on the auditing profession. (F) 2oving staff from one area of a C ! firm to another can cause the perception of an independence problem. /or e+ample, the appearance of independence may be in 1uestion if a member of the consulting staff helps to install a new accounting system for a client and then she moves to the audit staff to audit this same client. <ee the <arbanes-9+ley section below for a follow up 1uestion:answer related to

the impact of <9?, in particular the list of proscribed activities for registered C ! firms. SU!!"ST"# ANS$"%S TO "'"%CIS" (1) The 1uestion re1uires students to address all the elements of a 1uality control system, as included in Statement on Quality Control Standards No. 2. 3n some cases, students should recogni0e the need for additional information. - nde!endence, nte"rity, and #b$ecti%ity. !bernethy and Chapman re1uires its employees to sever all financial ties to audit clients. The !3C !'s Code of Professional Conduct does not re1uire all employees to sever ties with all audit clients. /or e+ample, staff auditors not wor%ing on a particular engagement need not sever ties. 3n this case, the firm e+ceeds the minimum level of conduct for independence. 8owever, the case does not mention spouses or dependents of the employees. <pouses and dependents must also be independent, as defined by <ection 166--*ule 161 of the Code. 3n this case, the firm should strengthen its re1uirements. -Personnel &ana"ement. The firm considers e+perience and technical competence in assigning personnel to audit engagements. This appears to be a reasonable 1uality control. The firm hires only college graduates with a ma-or in accounting and re1uires that each professional sit for the C ! e+am with one year of employment. This seems to be a more than ade1uate 1uality control procedure. 3n fact, many firms hire professionals, such as computer e+perts, who were not accounting ma-ors. The firm re1uires E6 hours of continuing education per yearG however, the case does not address the issue of the type of education (e.g., accounting and auditing versus other courses). 2any states re1uire that a minimum number of continuing professional education hours be in accounting- and auditing-related courses. The firm promotion procedures consider seniority and technical competence, which seems to be an ade1uate control. 8owever, the case does not address the issue of assessment of technical competence. 2any firms re1uire a written assessment of performance after each engagement. '(n"a"ement Performance) The firm re1uires that a consulting partner be assigned to each audit engagement. The consulting partner assures that the wor% performed by the engagement team meets applicable professional

standards and regulatory re1uirements. This helps to ensure ob-ectivity, as the consulting auditor is not a direct part of the engagement. The firm should have a mechanism for consultation with authoritative literature and other sources, including outside e+perts, if its professional staff lac%s e+pertise in a particular area. The firm seems to have a clear chain of command and ade1uate supervision on the audit. The staff auditors report to the senior auditor, who in turn reports to the manager. The partner-in-charge has an overall supervisory position. -Acce!tance and Continuation of Clients and (n"a"ements. This case does not address this control standard. 3t does note that the firm is attempting to gain more clients through an e+tensive mar%eting program. 3t is important to have many controls when considering a potential client, so that the potential ris%s of legal e+posure are not too great. (Bote. This topic is addressed in Case >.) -&onitorin". The firm has a partner, De!nna 2alott, assigned to monitor the 1uality control standards. The case does not mention what types of documents are re1uired to support these controls, but documentation is e+tremely important. /or e+ample, many firms re1uire employees to submit a listing of all financial ties to companies so that the firm can monitor its independence. SU!!"ST"# ANS$"%S TO SA%(AN"S)O'L"* &U"STIONS (1) <tudents should be encouraged to visit the (http.::www.pcaobus.org) when answering this 1uestion. C!9; website

*egistration H C ! firms must be registered to be associated with public companies. The application for registration is an on-line process. There is a fee, it is small relative to other costs of maintaining the registered status and changing the nature of the firm to comply with C!9; rules. 8ere is the fee structure from their website.

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3nspection - The C!9; operates a system of inspections and publici0es the results, per its authority under the <9? act.

& The A"t pro,ides that an inspe"tion shall in"lude at least the !ollo)ing three general "omponents: A An inspe"tion and re,ie) o! sele"ted audit and re,ie) engagements o! the !irm, per!ormed at ,arious o!!i"es and y ,arious asso"iated persons o! the !irmB A An e,aluation o! the su!!i"ien"y o! the +uality "ontrol system o! the !irm, and the manner o! the do"umentation an "ommuni"ation o! that system y the !irmB and A /er!orman"e o! su"h other testing o! the audit, super,isory, and +uality "ontrol pro"edures o! the !irm as are ne"essary or appropriate in light o! the purpose o! the inspe"tion and the responsi ilities o! the 7oard. & -egular inspe"tion are on a three&year "y"le, although smaller !irms msay e less !re+uent. %pe"ial inspe"tions "an e re+uired y the /CA'7 Maintenan"e o! independen"e under /CA'7 rules and %'C pros"ri ed a"ti,ities: ractice 9f !uditorsG rohibited

roscribed activities under <9? (section >61). <ection >61. <ervices 9utside The <cope 9f !ctivities.

3t shall be (unlawful( for a registered public accounting firm to provide any nonaudit service to an issuer contemporaneously with the audit, including. (1) boo%%eeping or other services related to the accounting records or financial statements of the audit clientG (>) financial information systems design and implementationG (@) appraisal or valuation services, fairness opinions, or contribution-in-%ind reportsG (E) actuarial servicesG (F) internal audit outsourcing servicesG (I) management functions or human resourcesG (7) bro%er or dealer, investment adviser, or investment ban%ing servicesG (J) legal services and e+pert services unrelated to the auditG (5) any other service that the ;oard determines, by regulation, is impermissible. The ;oard may, on a case-by-case basis, e+empt from these prohibitions any person, issuer, public accounting firm, or transaction, sub-ect to review by the Commission. 3t will not be unlawful to provide other non-audit services if they are pre-approved by the audit committee in the following manner. The bill allows an accounting firm to (engage in any non-audit service, including ta+ services,( that is not listed above, only if the activity is pre-approved by the audit committee of the issuer. 11

The audit committee will disclose to investors in periodic reports its decision to pre-approve non-audit services. <tatutory insurance company regulatory audits are treated as an audit service, and thus do not re1uire pre-approval. The pre-approval re1uirement is waived with respect to the provision of non-audit services for an issuer if the aggregate amount of all such non-audit services provided to the issuer constitutes less than F K of the total amount of revenues paid by the issuer to its auditor (calculated on the basis of revenues paid by the issuer during the fiscal year when the non-audit services are performed), such services were not recogni0ed by the issuer at the time of the engagement to be non-audit servicesG and such services are promptly brought to the attention of the audit committee and approved prior to completion of the audit. The authority to pre-approve services can be delegated to 1 or more members of the audit committee, but any decision by the delegate must be presented to the full audit committee. artner rotation- The rotation of the lead partner and the reviewing partners are re1uired by the <9? act. Luality Control <tandars H registered firms must maintain the <4C practice re1uirements. !3C ! Luality Control <tandards for public company audits is summari0ed at. http.::cpcaf.aicpa.org:*esources:

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CASE 1 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) /inancial statements are fre1uently relied on by outside parties such as stoc%holders and ban%s when ma%ing decisions about an enterprise. <hould e1uity securities be bought or sold" <hould a long-term loan be given" 8owever, financial statements are the representations of the management of the company. !s such, these statements will not necessarily be fairly presented. 2aterial misstatements may e+ist in the form of errors, irregularities, or illegal acts. The management might, for e+ample, have an insufficient %nowledge of generally accepted accounting principles to produce appropriate statements. 8uman error or bias is also possible in the gathering and reporting of financial information. 3n addition, the management may have fraudulently manipulated the data in hopes of achieving some ob-ective. 9utside parties are aware that the financial information produced by a company and its management may not always be reliable. 8ence, to add credibility to this reporting process, independent e+perts are retained to audit the financial statements and test the underlying accounting records. These auditors then issue an opinion for the benefit of outside parties as to the fair presentation of the financial statements in conformity with generally accepted accounting principles. This added degree of assuredness allows decision-ma%ers to rely on reported financial information. (>) ! C ! firm could not be e+pected to maintain e+pertise in every potential industry that it might audit. 3n reviewing a potential client, the firm should evaluate its ability to gain the necessary industry e+pertise prior to the actual audit, but no re1uirement e+ists that this %nowledge must be possessed prior to accepting the engagement. 4ach industry may have its own specific accounting practices. 3n addition, certain industries fre1uently offer uni1ue auditing problems. Thus, without a thorough investigation, the auditor cannot ascertain the %nowledge that will be needed in e+amining a potential client. 3n the consumer electronics business, for e+ample, the methods of distribution as well as credit policies would be significantly different from those found in a car dealership. Damaged or obsolete inventory are other problems that might be more important in this specific industry. 8ence, a %nowledge of one type of operation does not necessarily mean that the auditor has the e+pertise needed to e+amine a client operating in a

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different industry. !uditing standards re1uire that auditor have the e+pertise by the completion of the audit, but this e+pertise need not be in place at the beginning. 3t would be unethical to misrepresent a firm=s e+perience, but it need not be volunteered. (@) ! profit-sharing bonus plan gives employees an added incentive to see% increases in company incomeG a larger profit figure will lead to a larger bonus at the end of the year. Conse1uently, employees may be tempted to inflate income artificially by creating false sales or deferring the recording of e+penses. !n auditor must always be alert for situations that can promote the possibility of such irregularities. ! profit-sharing bonus plan may well have only positive effects on company employees. 8owever, the auditor should not be so naive as to fail to recogni0e that some individuals may ta%e advantage of such plans by manipulating the financial records. This problem may be especially significant in the Aa%eside Company because the bonus plan is new and the stores are geographically located at a distance from the home office. Bew plans re1uire adaptation by company controls and such separation always increases potential control concerns. 3n addition, *ogers has already mentioned that some of the internal control systems are no longer ade1uate. Thus, the possibility of inflated income figures is even more of a possibility. (E) Critics of the auditing profession have argued vehemently for a number of years that advisory services such as those discussed in this 1uestion taint the appearance (and possibly the reality) of independence. These services may appear to the public to give the audit firm a financial interest in the success of the company. This argument holds that the firm will now want the client to succeed as proof of the 1uality of the advice that was given. 3n addition, the audit team may be less -udicious in investigating these systems since they are aware that members of their own firm designed and installed them. !udit firms counter by stating that ade1uate safeguards have been put into place to ensure continued independence. /or e+ample, advisory services are fre1uently rendered by a separate division of the firm so that no pro+imity e+ists between this function and the audit staff. 3n addition, firms are not allowed to give many types of advice that might -eopardi0e their independence. /inally, audit firms must ma%e certain that their services are limited to ma%ing recommendations, not carrying out management decisions. The firm cannot ma%e decisions for the client.

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<arbanes-9+ley specifically proscribes various activities that have traditionally been part of the C !=s repertoire. Design of accounting systems is prohibited, although helping a client with selection and implementation of off-the-shelf pac%ages would be acceptable. <o, in this case, it depends on what the client means by $developing.& 3n the event the Aa%eside goes forward with its public offering !bernathy and Chapman will need to decide whether to remain independent so they can continue as Aa%eside=s auditor, or sacrifice independence to do systems consulting. <arbanes-9+ley prevents trying to do both. (F) 3n his article (The 3nitial !udit 4ngagement Conference( in the Journal of Accountancy for <eptember 157I, ;ernard Male% lists a number of steps that can be performed in a plant tour to avoid later (surprises( as well as to assist the firm in establishing an appropriate audit fee. The first three are typical of a plant tour. The others go beyond the typical tour. <tudents should not be e+pected to anticipate each of these procedures but the 1uestion can be used to emphasi0e the importance of the auditor's complete understanding of the audit client. These steps include. N N N N N N N N N N N 3nspect inventory for possible obsolescence and an indication of the ma-or product lines of the company. Merify the presence or absence of a perpetual inventory system. *eview manufacturing facilities for indication of level of activity as well as any idle machinery. *eview -ournals for careful preparation. *eview general ledger activity for unusual entries. *eview monthly financial statements for unusual variations. *eview ban% reconciliations, and compare to general ledger. 4+amine accounts receivable reconciliation to general ledger balance. *eview client physical inventory method. Discuss with client the policy for valuing inventory and identifying obsolete inventory items. Discuss with client the procedures for obtaining a proper year-end cut-off.

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N N N N N N (I)

*eview depreciation schedules, and recalculate a sample of the depreciation e+pense figures. *eview income ta+ returns. 4+amine information relating to any capital stoc% or retained earnings transactions for the past year. *eview minutes of board of directors' meetings and stoc%holders' meetings for unusual or material matters. *ead lease agreements. *eview past audit reports. ! company may not want its C !s to audit a client's records because the auditors gain a substantial amount of competitive information during an audit. 8owever, C !s are bound by confidentiality under the !3C !'s Code of Professional Conduct. !lso, a C !'s %nowledge of the industry gained from having several clients in the same industry provides him or her with insights he:she may not have otherwise had. SU!!"ST"# ANS$"%S TO "'"%CIS"S

(1) (a) and (b) The independent auditor must be able to review massive 1uantities of information and identify the fraud ris% factors that may affect the amount of evidence to be gathered or the opinion to be rendered. This 1uestion calls upon the -udgment abilities of the students. The format used by students for this memo is not important as long as it is clear and understandable. <!< 55 re1uires use a brainstorming session in the planning stage to be sure that everyone associated with the audit understands the nature of the business and the potential ris% of fraud. These sessions can also occur during the audit if additional evidence presents itself. otential problems that students would be e+pected to identify are as follows. N 3nternal Control - The president of the company admits that the company's internal control is anti1uated. Control problems may be heightened in that operations e+tend throughout two states. <ince understanding the internal control is one of the prere1uisites for ultimately determining the amount of substantive testing that will be re1uired, the wea%ness of the various controls may re1uire the e+tensive gathering of evidence, or even preclude an opinion.

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7ncertainty 3nvolved with the <i+th <tore - ! 1ualified opinion was issued by the predecessor auditor in connection with this store. !bernethy and Chapman must face the 1uestion as to whether this issue can be resolved during >66I. 3nventory - The mere si0e of the inventory of a business li%e Aa%eside would ma%e this account a critical audit area. The auditor will face the problem of verifying the e+istence, cost, value, presentation, and ownership of the electronic e1uipment. Distributorship <ales - The case indicates that these sales have risen dramatically during the past two years. !ny sudden change or fluctuation in an account balance will always warrant the auditor's attention. 3n this instance, the auditor will be especially interested in verifying the validity of these sales figures. ;onus <ystem - This system has been recently installed by Aa%eside, so very little is %nown about its effects upon the financial results of the company. This factor alone can cause difficulty in the auditor's e+amination. 3n addition, any bonus system will provide an incentive for the employees to falsify the company's financial records. The auditor must be aware that employees can benefit from producing falsely inflated income figures. *elated arty Transactions - The case indicates that Aa%eside has begun to have financial dealings with the president of the company. 9bviously, nothing is wrong with this arrangement, but such related party transactions are often difficult for the auditor to verify. 3n addition, they re1uire clear disclosure. *ental !greements - /ive of the stores have been leased and, apparently, <tore <even will be rented from *ogers. *ental agreements pose the 1uestion as to the need for capitali0ing the lease. !bernethy and Chapman will have to read the various agreements to see if any of them 1ualify as a capital lease under the criteria established by the /inancial !ccounting <tandards ;oard. !ccounts *eceivable - !ll distributorship sales are made on credit. Thus, the si0e of the receivable account and the problem of determining collectibility will be a critical audit area for the auditor. Aoan !greements - Aa%eside has a number of loans outstanding. The auditor will need to study each loan agreement to ascertain that the company is not violating any of the loan covenants.

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3nventory *eturns - /or distributorship sales, up to >6K of the inventory items can be returned within four months. !s of the end of the year, Aa%eside will have a large contingent liability associated with the inventory items sold during the last four months. Bot only is the potential si0e of this liability a problem but the auditor's ability to estimate the amount must be a concern. ossible public offering of stoc% - ! public offering raises ris% for manipulation of the financial statements in order to attract capital. 3n addition, the number of potential readers of financial statements has changed dramatically, ma%ing the ris% associated with this audit much higher.

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(>) IN#"+"N#"NT AU#ITO%,S %"+O%T To the ;oard of Directors. #e have audited the accompanying balance sheet of the Aa%eside Company as of December @1, >66J, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. 9ur responsibility is to e+press an opinion on these financial statements based on our audit. #e conducted our audit in accordance with auditing standards generally accepted in the 7nited <tates of !merica. Those standards re1uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. !n audit includes e+amining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. !n audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. #e believe that our audit provides a reasonable basis for our opinion. During >667, the company made a O1JI,666 investment in a retail store located in the eastern sector of *ichmond, Mirginia. This store has failed to reach a brea%-even sales point to date and total recovery of the Company's investment is highly uncertain. 3n our opinion, the chances are reasonably possible that the asset's value has been permanently impaired and should be reduced to the net reali0able value in conformity with generally accepted accounting principles. 3n our opinion, e+cept for the effects of not recording or disclosing the impairment of value of the asset, as discussed in the preceding paragraph, the aforementioned financial statements present fairly, in all material respects, the financial position of the Aa%eside Company at December @1, >66J, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the 7nited <tates of !merica. Ping and Company (si"ned*, Certified ublic !ccountants Date. (last day of audit fieldwor%)

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SU!!"ST"# ANS$"%S TO SA%(AN"S)O'L"* &U"STIONS (1) The issuance of stoc% is regulated by the <ecurities and 4+change Commission and the accounting, auditing and reporting is regulated by the C!9; since >66>. ! summary of the regulations follows. 3ssuance of stoc%s are regulated primarily under the <4C acts of 15@@ and 15@E. *egistration with the <4C is re1uired which includes financial reporting. The laws are summari0ed at. http.::www.sec.gov:about:laws.shtml. The financial reporting and auditing for public companies has been regulated by the C!9; since >66>. The C!9; registers, inspects and disciplines the auditors of public companies. 3ts effect on the public companies is indirect, through the regulation of the auditors. 4ncourage students to visit the <4C 4DQ!* site to understand the nature of electronic, public financial information. (>) C ! /irms wishing to be associated with public companies must be registered firms, and accept the inspection process and are sub-ect to the discipline of the the C!9;. C !s in public practice of three choices. 3t is not only public vs private, because some C ! firms are choosing to give up the re1uirement for independence and perform accounting, ta+ and consulting services that are not possible for registered C ! firms. Thus their clients have two C ! firms, one for the non-independent services and one for the audit. 3n the case of !bernathy and Chapman, they will need to choose the nature of their practice. This is a ma-or strategic choice. 2ost C ! firms do not perform public company audits. Aarge international and national firms handle almost all of the companies on the e+changes.

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CASE 2 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) The 1uestion of materiality is certainly one of the most comple+ issues in all of auditing. Bo clear-cut guidelines have ever been established to aid the auditor in deciding whether a specific balance or transaction is (material.( This lac% of an official standard provides the auditor with the freedom to base all final decisions on professional -udgment. 7nfortunately, without a formal rule, the auditor has little guidance in applying -udgment to a particular situation. 2ateriality has traditionally been held to be any factor that would influence the decisions of those parties relying on the financial statements. 3dentifying a proper basis of comparison is an important aspect in determining whether an uncertainty is material. Bet income is the most obvious standard of comparison, although another consideration is which of the statements is affected (e.g., ;alance <heet, 3ncome <tatement, or both"). The situation 1uestioned by Ping and Company involves an investment in fi+ed assets. Comparing the potential loss to total assets, investment in stores, and owners' e1uity would seem a reasonable basis for -udging materiality. !nother possible basis is the effect of the asset write-off on net income. 3n the Aa%eside case, each auditor would have to decide independently as to whether <tore <i+ represents a material contingency for this client. The potential closing of <tore <i+ is certainly an unusual occurrence and for that reason should be evaluated against the client's OF66,666 net worth and the O1.J million in total assets reported in the case. 3n ma%ing these comparisons, the auditor needs to anticipate the potential loss. !lthough the total loss could amount to O1JI,666, *ogers has suggested O1@I,666 as a ma+imum figure. 7nfortunately, estimates provided by the president of the client company are circumstantial evidence, having little power to persuade. 3n the view of the authors, this potential loss (of over O166,666) for a company with a net worth of only OF66,666 would certainly appear to be material. 9ther comparisons based on total assets or income would give similar results. (>) The C ! firm must tal% with the predecessor auditor before accepting the engagement. The new auditors can learn about the integrity of the potential client's management as well as about any accounting or auditing problems that might be encountered. 3f *ogers prohibits this meeting, !bernethy should

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carefully e+plain the necessity of the procedure. The client may not be fully aware of audit practices and fail to understand that such discussions are a normal part of investigating new clients. <hould the client still insist that no communication be made with the previous auditor, !bernethy would normally have to re-ect the new engagement unless very unusual circumstances surrounded the client's re1uest. (@) The information given by the predecessor auditor as to the integrity of the client's management must weigh heavily in the decision to see% a new client. ;ecause of the potential legal liability faced by independent auditors, the decision to accept a client has become 1uite important. Bo auditor wants to perform an engagement for a company with a management that cannot be trusted. 8owever, in evaluating the assertions of Ping and Company, !bernethy must reali0e that this firm has -ust been fired from the Aa%eside audit. <ome potential bitterness toward the client is certainly possible. Thus, auditors usually see% references from other than -ust the predecessor auditor before deciding whether to actively pursue a new audit client. (E) 3n a peer review, a team of outside auditors is hired by a C ! firm to review its system of 1uality controls, the policies and procedures utili0ed by that organi0ation to ensure that its members are following all professional standards audit, accounting and review, ethics, etc. This review helps to ensure that the firm is fulfilling its professional responsibilities. 3f the peer review team discovers practices that are unprofessional or inade1uate, the firm can ma%e immediate corrections to rectify the problems. eer reviews originated in the 1576s when litigation of C ! firms became rampant, and congressional investigations of the profession indicated that drastic improvements were needed. The peer review process was instigated to provide firms with a means of getting outside consultation about their professional practices. *ather than discovering problems only after losing a lawsuit, the firms were periodically reviewed by these outside teams to catch problems before they grew to be too large. ! peer review team loo%s at the means by which the public accountant ensures 1uality control within its practice. /or e+ample, the acceptance of new clients should be properly monitored by the firm. !de1uate consultation needs to be made available to all staff members so that audit problems can be properly resolved. 8iring and promotion practices should be established and in place to provide sufficient staffing for all engagements. The peer review team loo%s at all areas of 1uality control to ascertain that problems do not e+ist that could lead to substandard wor%. 3n addition, the team reviews the audit documents for a

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selected number of engagements to see if sufficient, competent evidence is being gathered and properly documented. (F) !udit documents are intended to provide a record of the auditor's e+amination and the evidence accumulated. Thus, all testing done in each audit area should be documented and included within the wor%ing paper file. 3n addition, the audit documents must verify that the e+amination was planned and the auditing staff was properly supervised. !ny auditing or accounting problems encountered during the engagement have to be spelled out in the audit documents along with an e+planation of the resolution of each issue. The permanent file will hold all data about the client that is not anticipated to change dramatically from year to year. 3t can be reviewed by the auditor prior to beginning the engagement to gain insight into the organi0ation of the company. ! permanent file will normally include items such as the articles of incorporation, organi0ation chart, chart of accounts, contracts, other long-term legal agreements, and a written description of the company as well as its organi0ation and history. The annual wor%ing paper ((current() file contains documentation of the evidence gathered during a specific audit. Thus, the results of confirmations, in1uiry, observations, inspection, calculations, and all other testing are placed within these audit documents. The contents of this file must substantiate the audit opinion and also that the auditor followed generally accepted auditing standards on this particular engagement. (I) !s a professional, the independent auditor has a responsibility to ensure that a prospective client understands the function of an audit prior to accepting an engagement. Bot every member of the business community will have the bac%ground %nowledge to comprehend the purpose of the attest function and the e+tensive testing procedures that it re1uires. 3n addition, many possible clients do not re1uire the degree of assurance provided by an audit but are not aware of alternatives such as compilations and reviews. <ince independent auditors have %nowledge of the attest function and are offering these services to the public, responsibility for a full understanding by the client lies with the firm. 3n addition, the firm is re1uired to reach an understanding of the audit function with the firm and the engagement letter is used to document this understanding. (7) The providing of ade1uate service to a client would always re1uire that the C ! firm suggest a review rather than an audit whenever it might meet the company's

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intended ob-ectives. The client must understand, though, that a review is substantially less than an audit. rocedures are limited primarily to in1uiries of the client's management along with analytical procedures applied to the financial statements. The report then states that the firm was not aware of any material modifications to the financial statements that re1uire ad-ustment to be in conformity with generally accepted accounting principles (a limited or (negative( assurance). 3n a review, control ris% is not assessed, tests of controls are not made, and ade1uate substantive testing procedures are not performed on which to base an opinion as to the fair presentation of the financial statements. ;ecause these procedures are omitted, a review is less e+pensive than an audit. 8owever, the ban%s and stoc%holders must be willing to accept the lesser degree of assurance being provided by the independent auditor. The client should be made aware of this option but also the potential problems of not having a complete e+amination. 9f course, if Aa%eside pursues the public offering a review will not be ade1uate. (J) 2any students may want to re-ect this engagement based on the internal control problems, the impairment of value issue, and *ogers' arguments with the predecessor auditors, but such situations are not uncommon occurrences in auditing. ublic accounting is not a ris%-free professionG no perfect audit client ever e+ists. Thus, a firm must be able to assess the problems involved and weigh them against potential rewards. !bernethy and Chapman has an opportunity here to pic% up a new client in a new industry. 3n addition, Aa%eside has demonstrated the possibility of significant growth in the future. 8owever, the auditing firm needs to see% some resolution for the uncertainty before becoming involved. <ince that problem is already obvious, an understanding should be reached with Aa%eside prior to beginning the engagement. 3f this issue can be successfully resolved, the auditor should see% this new client.

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SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) !nswers to 4+hibit >-1. 1. >. rivately held The basic liability to the client is for losses occurring as a result of any firm negligence. 3f !bernethy and Chapman performs the engagement as an average, prudent auditor would, no problem e+ists. 3f not, the client may sue for return of its audit fee as well as any other resulting losses. ! special problem area e+ists in the Aa%eside case. the client's wea% internal control. <uch wea%nesses increase the li%elihood of fraud or embe00lement. The control problems also ma%e discovery of such defalcations more difficult. 3n addition, proving that the firm is innocent of negligence is often difficult to do if the client loses money through defalcations not discovered by the auditor. The current stoc%holders Cypress roducts Two ban%s financing the inventory Bational 3nsurance Company of Mirginia (mortgage loans) ossibly other creditors !s *ogers has e+pressed considerable interest in e+pansion, the C ! firm should anticipate that the financial statements could be presented to potential stoc%holders or lenders. !s a privately held business, this audit does not fall under federal security laws. Thus, the auditor is bound by common law and is -udged under such precedents as the 7ltramares case, the C3T /inancial Corp. case, and the *usch /actors case. 3n the Aa%eside audit, the C ! firm should have no liability to third parties unless the audit is performed in a grossly negligent manner or the firm is negligently responsible for careless financial misrepresentations. 3n a few -urisdictions, they may be held liable to foreseen or foreseeable beneficiaries for ordinary negligence.

@.

E.

F.

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!nswers to 4+hibit >->. 1. >. redecessor auditor indicated no problems with the integrity of the Aa%eside management. ! ma-or problem e+isted between Aa%eside and the predecessor auditor involving an e+planatory paragraph included in the >66F report. This uncertainty issue revolved around the potential loss foreseen in the possible closing of one of Aa%eside's stores. redecessor auditor stated that the firm was discharged over the wording of the previous audit opinion. The predecessor auditor also mentioned wea%nesses in Aa%eside's internal control and *ogers' unwillingness to improve these systems. redecessor auditor stated that the audit audit documents could be reviewed. Bo limitation was indicated.

@. E. F. I. (>)

The auditor will perform a number of steps in reviewing the audit documents of the predecessor auditor. The ma-or ob-ective is to e+amine the types of information that would be available to an auditor in an ongoing engagement. Through this review, the auditor can gain satisfaction as to the validity of beginning account balances as well as accounting principles applied in the previous audits. ;y relying on the wor% of the predecessor auditor, the e+tensive review necessary in an initial audit can be held to a minimum. The audit wor%ing paper review should include the following steps. N Determine that satisfactory evidence has been obtained to verify beginning-of-year balances in such accounts as inventory, land, buildings, e1uipment, paid-in capital, and retained earnings. !scertain the specific accounting principles applied in the previous fiscal year. *eview internal control evaluations for obvious wea% areas and for strengths. *eview the analysis of contingencies.

N N N

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N N (@)

#atch for any problem areas (such as slow collection of accounts receivable) that were singled out in the previous year. *eview the ad-usting entries proposed by the auditors to determine the type and materiality of these ad-ustments.

This answer assumes that Ping and Company, the predecessor auditor, has no reason to believe that their previous report is not still appropriate. /urthermore, that firm has reviewed the current financial statements and obtained a representation letter from !bernethy and Chapman, the successor auditor, stating that the current year's audit has not revealed anything that would have a material effect on the prior year's audit.

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IN#"+"N#"NT AU#ITO%,S %"+O%T To the <toc%holders. #e have audited the accompanying balance sheet of the Aa%eside Company as of December @1, >665, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. 9ur responsibility is to e+press an opinion on these financial statements based on our audit. The financial statements of Aa%eside Company as of December @1, >66J, were audited by other auditors whose report dated Cgive dateD, on those statements included a 1ualified opinion because of inade1uate disclosure of an impairment of value. The impairment of value concerned the Company's investment in one of its stores. #e conducted our audit in accordance with auditing standards generally accepted in the 7nited <tates of !merica. Those standards re1uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. !n audit includes e+amining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. !n audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. #e believe that our audit provides a reasonable basis for our opinion. 3n our opinion, the >665 financial statements referred to above present fairly, in all material respects, the financial position of the Aa%eside Company as of December @1, >665, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the 7nited <tates of !merica. !bernethy and Chapman Certified ublic !ccountants Date. (last day of audit fieldwor%)

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CASE 3 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) !lthough this 1uestion can be answered by a simple reading of 4+hibit @-1, it does force the student to consider the contractual obligations being assumed by both parties. 9ne portion of this letter that might warrant discussion is the C ! firm's declaration that absolute assurance is not being given in regard to ma-or misstatements. The students can be 1ueried as to the reasons for including this statement. 3n addition, the students can be as%ed to discuss the method by which the client company can draw the distinction between reasonable assurance and absolute assurance. !s a different line of 1uestioning, the students can discuss other responsibilities that could have been accepted by either party. The engagement letter is re1uired. *esponsibilities of the C ! firm found in the engagement letter. N N N N N To perform an audit in order to e+press an opinion on the client's financial statements, To ma%e a search for material misstatements, To report any internal control wea%nesses, To report any potential fee changes, To provide the final audit report by /ebruary >>, >616.

*esponsibilities of the client. N N N (>) 3n performing analytical procedures, auditor e+pectations should be derived from a wide variety of sources. /or cost of goods sold, !bernethy and Chapman To pay the audit fee, To provide a year-end trial balance by Ranuary 17, >616, and an interim trial balance by 9ctober 17, >665, To provide audit documents to the C ! firm as specified.

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should consider each of the following in arriving at an anticipated total. ast figures. 3f cost of goods sold has always been a certain percentage of Aa%eside's sales, that same relationship would be e+pected to continue unless other factors have changed. 8ad Aa%eside, for e+ample, switched from cheaper products to more e+pensive ones, the relationship between cost of goods sold and sales would possibly be affected. 9r, if Aa%eside has dropped the Cypress line in order to sell the products of some other manufacturer, a similar change might have been anticipated. 8owever, without an ad-ustment of this type, cost of goods sold as a percentage of sales would be e+pected to remain stable. 3ndustry averages. ;y studying trade publications, !bernethy and Chapman can determine an industry average for cost of goods sold as a percentage of sales. !lthough Aa%eside's results could not be e+pected to be e+actly the same as this average, the auditors should not anticipate a significant variation to occur without some ade1uate e+planation. Competitors. 3f available, the financial statements of competing companies can be used to determine the normal relationship of cost of goods sold to sales. !lthough no two companies are ever ali%e, important comparisons such as this one should be made between similar companies. ;udgeted figures. 3f Aa%eside has an annual budget, the numbers estimated by the company at the beginning of the period can be used by the auditor in establishing an e+pected cost of goods sold.

(@) Aa%eside holds an inventory of high technology items. consumer electronic e1uipment. 9bsolescence of a portion of this merchandise is an everpresent danger because of new innovations. The inventory can also be easily damaged, a problem that is not always visually obvious. Aa%eside distributes merchandise to retail stores. ! generous return policy is providedG thus, an estimate must be made of the sales returns that will be received by the company after the audit is concluded. Aa%eside sells on credit throughout two states. collections from accounts receivable may be difficult. 8ence, estimating

Aa%eside rents a number of its stores. The auditor must determine whether capitali0ation of these leases is re1uired. Aa%eside has a large amount of debt. The auditor has to ensure that all debt is being properly reported and disclosed. The interest e+pense associated with these liabilities must also be correctly calculated and recogni0ed. 3n addition, the auditors need to verify that all loan covenants

30

are being met. Aa%eside is considering going public. ! company attempting to raise significant capital may be tempted to over-estimate assets and revenues. The auditor needs to be particularly careful on accounts that lend themselves to significant estimate.

(E) The auditor must be satisfied that sufficient, competent evidence has been obtained to substantiate an opinion concerning the fair presentation of the client's financial statements. The decision as to the sufficiency of this evidence is left solely to the -udgment of the auditor. 9nly through years of e+perience can the auditor develop the ability to ma%e this determination. !lthough specific guidelines for this decision are not available, all significant problems must be resolved and all suspicious occurrences should be investigated. 4vidence needs to be accumulated for each significant area of the financial statements to substantiate the assertions made by the client about its reported balances. #here inherent ris% and control ris% are -udged to be high, the auditor must ta%e steps to reduce detection ris% to an acceptable level. 3n such cases, several steps are possible. performing additional substantive testing, using more e+perienced staff personnel, performing testing procedures closer to the balance sheet date, or relying on more effective testing procedures. !nother factor that influences the auditor's decision is the 1uality of evidence being accumulated. <ome information may come directly to the auditors from outside parties, data that is usually considered to be of a higher 1uality than evidence prepared by the client company. Aess evidence is re1uired if it is -udged by the auditor to be of a high 1uality. !lthough each of these factors is considered, the ultimate decision still must rest with the auditor's -udgment. This individual is ta%ing responsibility for the audit opinion as well as accepting the ris%s involved in circulating this report. Thus, the auditor must be satisfied that, based upon the wisdom gained through years of audit e+perience, sufficient evidence has been obtained. (F) !ny discussion as to the (1uality( of evidence being gathered by analytical procedures must be based on the ob-ective of the testing. !nalytical procedures performed in the planning stage are not primarily designed for the purpose of indicating the fair presentation of financial information. 3nstead, they are used in the assessment of ris%, to alert the auditor to potential problem areas that may re1uire additional substantive testing. 3n that respect, analytical procedures serve a vital audit purpose. <tudents should always be reminded, though, that this testing is only one component of the overall substantive testing being

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performed by the independent auditor. /urthermore, analytical procedures provide circumstantial evidence which, ta%en alone, is not a high 1uality type of evidence. (I) Pnowledge of the consumer electronics business is -ust one aspect of Cline's e+pertise that will allow him to evaluate the fair presentation of Aa%eside's financial statements. 9verall %nowledge of the client company and the industry in which it operates should also allow the auditor to identify areas that may need special considerationG assess conditions under which accounting data are produced, processed, reviewed, and accumulated within the organi0ationG evaluate the reasonableness of estimatesG evaluate the accuracy of management representationsG ma%e -udgments about the appropriateness of the accounting principles applied and the ade1uacy of disclosures.

Pnowledge of a business and the industry in which it operates may be obtained from e+amining the client company's accounting records and in1uiry of the client personnel. This information can be supplemented through review of the prior years' audit documents, !3C ! !ccounting and !udit Quides, industry publications, financial statements from other companies in the same industry, college te+tboo%s, maga0ines, and other trade periodicals. <ince the students may not be familiar with the !3C ! 3ndustry !udit Quides, the instructor may want to bring an e+ample or two to class for this discussion. 4+amples of the industries covered by these audit guides include. (7) ! number of the current concerns faced by auditing firms as well as the auditing profession as a whole relate either directly or indirectly to increased price competition. Through class discussion of this particular 1uestion, students should be able to ascertain at least three of these problems. N rice competition forces narrow time constraints on the wor% of the independent auditor. 3n order to finish an audit engagement in a short enough time so that a reasonable profit can be made, a danger e+ists that !irlines /inance Companies 3nvestment Companies roviders of 8ealth Care <ervices

32

the auditor will 1) accept less than sufficient evidence, >) fail to recogni0e critical audit areas, or @) not be able to ac1uire the depth of %nowledge necessary for essential audit -udgments. Thus, the argument is fre1uently raised that price competition leads to a decrease in overall audit 1uality. N ;ecause the initial year of an audit will often re1uire significantly more time than e+aminations of subse1uent years, price competition can lead a firm to actually lose money in the first year of an engagement. Therefore, the C ! firm must wor% to %eep a client for several years to offset this initial loss and produce a reasonable profit. The necessity of retaining an engagement for a number of years may force the firm to be subservient to management's demands to avoid being fired. This argument has lost much of its impact over the last few years as client companies have established audit committees comprised of outside members of the board of directors to ensure the independence of the auditing firm. 2any auditors also feel that price competition is generally detrimental to the public accounting profession. The main thrust of this argument is that price competition encourages companies to select their independent auditors based primarily on cost rather than on the 1uality of audit wor%. This type of selection process would favor firms offering cheap rates over auditing firms offering 1uality services.

!fter the students have been allowed to discuss the problems associated with price competition, the instructor may want to as% whether these problems outweigh the advantages of having the auditing profession participate in the free mar%et system. <ince most business students in the 7nited <tates appear to advocate free mar%ets within the country, some interesting discussion can be stimulated as to whether the auditing profession should be e+empt from price competition. (J) !ccording to the audit ris% model, planned detection ris% ( D*) e1uals acceptable audit ris% (!!*) divided by the product of inherent ris% (3*) and control ris% (C*). 8olding inherent ris% and acceptable audit ris% constant, there is an inverse relationship between control ris% and planned detection ris%. Thus, an increase (decrease) in control ris% leads to a decrease (increase) in planned detection ris%. !lso, as planned detection ris% decreases (increases), the amount of substantive tests and other audit procedures increases (decreases). That is, if the auditor determines the level of detection ris% to be low, he or she wants the chance of not detecting an error too small. 3n order to have a small chance of not detecting an error, the auditor must do more testing. /or e+ample, given !!*S16K and 3*SJ6K, and assuming an J6K C* (high), then using the audit ris% model, planned detection ris% is a relatively low 1F.IK C.16:(.J6+.J6)D, but assuming a >6K C* (low), then planned detection ris% is a relatively high I>.FK

33

C.16:(.J6+.>6)D. (5) !ccording to <!< 55 the assessment of the ris% of fraud begins with a meeting of the entire team for such purpose. This brainstorming session needs to encourage the involvement of all team members and cannot be -ust a staff training session. The ob-ective is to solicit the ideas from all team members and to sensiti0e the entire team to the particular problem areas that this client presents. The process begins with such a session, but does not end there. During the audit the entire team needs to consider how the information being developed relates to the areas already identified, noting new areas that need attention, or ad-usting e+pectations on the areas already identified. The areas identified by fraud ris% are primarily in the areas of inherent ris% and control ris%. 3ncreased fraud ris% represents an increase in inherent ris% (the ris% that errors e+ist) or will also increase the control ris% (the ris% that the client=s internal control system will not detect the error or irregularity). (16) The registration process is not difficult. 2aintaining the status of a registered C ! firm is more difficult and re1uires that the firm be willing to ad-ust its operations including independence and staffing 1uality control standards to meet the higher e+pectations of the C!9;. They may also be re1uired to change the nature of their practice, at least as far as publicly traded clients because of the list of proscribed activities. !bernathy and Chapman have sufficient time to become registered and therefore need only be concerned about accepting Aa%eside as a client if there is some obstacle to their registration. 3f Aa%eside as%s if they are currently registered, then the answer has to be, $no, but we are pursing registration.& SU!!"ST"# ANS$"%S TO "'"%CIS" (1) erforming analytical procedures is one aspect of an auditing course that traditionally generates a lot of student interest and enthusiasm. 9ne method of approaching this 1uestion is to have the class list the potential problems that were discovered and then discuss the relative severity of each. The students can be as%ed to consider the appropriate response that should be made by the audit team to each of the elements listed. ;y discussing the various possible responses, students are better able to recogni0e the attest function as a fluid process that must be fle+ible enough to adapt to a specific set of circumstances. 3t should be noted to students that, in practice, several years (rather than two) would be analy0ed for trends.

34

a)

*atio analysis from >667 to >66J.

2,,1.@F 5@ >1 7E.EK 2,,. 1.@I 161 >F 7E.FK Si"nificance Bo significant change 3ncrease may indicate obsolete or slow moving inventory on hand <light increase may indicate rela+ing of credit policies and:or possible understatement of allowance Bo significant changeG however, the high ratio indicates significant leverage and potential solvency problems if additional debt is needed Decline indicates reduced ability to meet interest payments through operations Bo significant change Declining return results from a combination of declining net income and increasing total asset base. Decline in return results from a combination of declining net income and increasing e1uity base.

+atio Current T Days inventory on hand *eceivable collection period (days) Debt-to-total-assets

Times interest earned rofit 2argin *eturn on !ssets *eturn on 41uity

@.I times >.75K J.E7K @@.>K

>.J times >.>7K I.7@K >I.EK

Conclusion. Aa%eside had no significant changes in its li1uidity or solvency levelsG however, the company appears to be e+periencing a decline in its profitability level. The audit staff should pay particular attention to revenueenhancing or e+pense-reducing areas, such as fictitious sales or improper capitali0ation of e+penses to halt this downward trend. b) *atio analysis. comparison to industry.
ndustry A%e. 1.7@ inventory on IF 11 1@K @6 times >.5@K I.65K 1@.>7K /a0eside 2,,. 1.@I 161 >F 7E.FK >.J times >.>7K I.7@K >I.EK Si"nificance Aa%eside is below the industry average. This may indicate short-term solvency (li1uidity) problems. Aa%eside is well above the industry average. This may indicate short-term solvency problems. Aa%eside is well above the industry average. This may indicate short-term solvency problems. Aa%eside is significantly above the industry averageG this may indicate long-term solvency problems. Aa%eside is significantly below the industry averageG this may indicate solvency problems. Aa%eside is only slightly below the industry average. Aa%eside is only slightly above the industry average. Aa%eside is significantly above the

+atio Current Days hand

*eceivables collection period Debt-to-total-assets Times interest earned rofit 2argin *eturn on !ssets *eturn on 41uity

35

+atio

ndustry A%e.

/a0eside 2,,.

Si"nificance industry average.

Conclusion. Aa%eside is well below the li1uidity level of the industry, and the company is in a significantly worse solvency level than the industry. !uditors should be aware of methods to enhance the li1uidity and solvency levels, such as unrecorded liabilities. Aa%eside profitability is about the same as the industry average, e+cept for return on e1uity, in which it is more than double that of the industry (primarily due to the high level of leverage). c. <can the financial statements and the trial balances.
+esults The company's stores continue to report an overall loss which is increasing in amount. Bothing unusual Si"nificance These losses suggest the possibility that the stores will eventually be discontinued by Aa%eside or drastically altered in some manner.

Procedure <can the income statement CBote. instructors may want to suggest that students prepare a common si0e income statementD <can the balance sheet CBote. instructors may want to suggest that students prepare a common si0e balance sheetD <can the cash flow statement

Cash flow from operations declined significantly in >66J.

<can the trial balance

<can the trial balance

<can the trial balance <can the trial balance

<omething appears to be wrong with the information generated by <tore Three. The sales for that store have increased by appro+imately 5EK since the previous year. !t the same time, the cost of the goods sold has dropped from FJ.FK of sales (which is consistent with the other stores) to only F6.@K of sales. !lso, the inventory held by this store has risen by over F6K. <ales Commissions for District D in >665 appear to be slightly out of line. !ll of the other commissions are appro+imately F.7K of sales, while this account is nearly 7K of the applicable sales figure. *ent e+pense on vehicles and e1uipment has decreased in >665. The *epairs and 2aintenance account has increased by over 1F6K since >66J.

The cash flow problems, combined with the solvency problems may indicate a problem with the company's ability to continue as a going concern. These fluctuations could indicate recording errors or an employee attempting to inflate the earnings being reported for <tore Three. This problem is more germane than might be encountered normally because of the profitsharing bonus system that rewards employees for reporting high income figures.

!lthough not necessarily a material figure, the potential error should be investigated so that Aa%eside can ma%e the appropriate corrections if needed. <uch a decrease often serves to indicate that the company has ac1uired new property. This significant increment may indicate a posting error that will re1uire correction. Conversely,

36

Procedure

+esults

<can the trial balance

The (Qain on Disposition of /i+ed !sset( balance of O1E,666 warrants investigation.

<can the trial balance

The !llowance for Doubtful !ccounts balance shows a debit balance on <eptember @6, >665, compared to a credit balance one year earlier. The company's two ban% credit lines now have a total balance that e+ceeds the O7F6,666 ma+imum that was indicated in an earlier case.

<can the trial balance

<can the trial balance

<can the trial balance

The long-term notes payable have increased by OF6,666. The auditor would certainly be interested in the application of those funds as well as the loan agreement signed by the company. <ales returns have increased significantly for both the company stores and the distributorship. The e1uipment account shows an increase from the previous year.

Si"nificance actual repairs may have been made by Aa%eside. 3n that situation, the auditor needs to verify that all capitali0ed costs have been segregated and properly accounted for within the company records. 9ften a company will fail to remove the appropriate cost and related accumulated depreciation when a plant asset is sold. The auditor should also ascertain that the current year depreciation e+pense has been properly recogni0ed. /inally, the sale of an asset can lead to the ac1uisition of a new asset as a replacement. The independent auditor should follow up on this possibility to assure that any replacement is appropriately capitali0ed. The auditor should determine if the client has written off an especially large group of accounts. erhaps bad debt e+perience is changing and a larger allowance is re1uired. The auditor should verify that no loan covenants have been bro%en. 3n addition, because of disclosure re1uirements as well as the effects on the interest e+pense account, the auditors will need to review any new borrowing agreement. The auditor should determine the application of those funds as well as the loan agreement signed by the company.

<can the trial balance

The auditors need to ascertain the reasons for such an increase. !ny change in the trend for sales returns would lead the auditors to reevaluate year-end accruals. 3f the company has ac1uired additional e1uipment during the year, the auditor needs to verify that capitali0ation and depreciation were given proper treatment.

37

Procedure <can the trial balance

+esults The estimated bonus e+pense has increased.

Si"nificance That increase is probably due to the profit-sharing plan having been in effect for all nine months of >665, but the increase should be investigated.

38

CASE 4 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) Statement on Auditin" Standards -., (Consideration of 3nternal Control in a /inancial <tatement !udit. !n !mendment to <!< Bo. FF,( identifies the five elements of internal control as the Control 4nvironment, *is% !ssessment, Control !ctivities, 3nformation and Communication, and 2onitoring. Cline's 1uestions appear to be designed to determine the degree of information that has been established to date about each of these elements. Luestion (@) as%s about the information that the auditors could have loo%ed at within the Aa%eside Company in order to respond ade1uately to these 1ueries. !uditors must be able to gather sufficient data in the early stages of an audit to assess the various ris%s involved in the e+amination. 3n studying the control environment of a company, <!< 7J recommends that a number of factors should be assessed including those listed below. /or several of these factors, the types of information that the !bernethy and Chapman auditors might use to ma%e their evaluation is also discussed. ! 1uic% loo% at the control environment will probably lead the auditors to the decision that Aa%eside has not established the environment needed for ade1uate internal control. 3ntegrity and ethical values. The auditors should in1uire as to policy statements and a code of ethics. They should also be aware of any actions by Aa%eside's management to remove or reduce incentives and temptations that might prompt its employees to engage in dishonest, illegal, or unethical acts. Commitment to competence. Aa%eside should have a training program to ensure that its employees have the %nowledge and s%ills necessary to accomplish tas%s. The auditors should in1uire as to any such programs. ;oard of directors or audit committee participation. !bernethy and Chapman will need to determine the oversight role (if any) played by the board of directors. ;y loo%ing at the minutes of the meetings, the auditors should be able to determine whether the board is actually serving in a control capacity. The case mentions that the board of directors had to approve of the hiring of new independent auditors. Thus, a separate audit committee probably does not e+ist. 3n addition, *ogers' assurance that the board would approve this re1uest would seem to imply that the board does not provide significant control over the management of the company. 2anagement's philosophy and operating style. ;y tal%ing with *ogers and the other members of management, the auditors should be able to determine 39

the actual priority placed on internal control by the company. Documentation of this should also be available for inspection. *ogers seems to understand that better systems are needed but has invested neither the time nor the money to develop such policies and procedures. This lac% of support may indicate that the management is not serious about establishing ade1uate control within the company. ;ecause of the company's growth, improvements in the future may be forthcoming, but at the present time the management appears (from what has been said) to have let the company outgrow its control policies and procedures. 9rgani0ational structure. 3f Aa%eside has a chart presenting the various officials and their -obs, the auditors can assess whether control policies would be easy to circumvent. !lthough 4+hibit @-> shows the company divided into clearly distinct areas, the !ssistant to the resident does seem to be in a position to operate without proper control supervision. 3n addition, the resident seems to hold a significant amount of power in this company, with very little control having been established. !ssignment of authority and responsibility. This factor includes how authority and responsibility for operating activities are assigned and how reporting relationships and authori0ation hierarchies are established. <ince Aa%eside is not a huge organi0ation, *ogers tends to intervene in many of the operating activities. 8owever, as Aa%eside continues to grow, this may become a ma-or concern to the auditors. 8uman resource policies and practices. These policies and practices relate to hiring, orientation, training, evaluating, counseling, promoting, compensating, and remedial actions. The auditors should in1uire and observe Aa%eside's policies, including any standards for hiring the most 1ualified individuals, training, and performance appraisals.

*is% assessment is the second component of internal control. The auditors will determine and evaluate how Aa%eside identifies, analy0es, and manages ris%s relevant to the preparation of the financial statements. The auditors will want to pay particular attention to several changes occurring at Aa%eside and how the management deals with these changes. These changes include the e+pansion of the company's stores, the concentration on the Cypress product line, and the relatively new bonus system. Be+t, the auditors will loo% at the actual control activities in place to see that specific control ob-ectives are being met. #ithin this testing, the auditors should loo% at the following as goals of the company's internal control. erformance reviews. 3ndependent chec%s on both performance and proper valuation of recorded amounts should be conducted. The auditors will want to verify that reconciliations and other comparisons are made at important -unctures in the various systems. 3nformation processing. The auditors will want to verify that Aa%eside has both general controls and application controls. They will especially verify that 40

proper authori0ation of transactions e+ist. The auditors can e+amine the documentation produced for a variety of transactions to ensure that each was authori0ed by the appropriate individual within the company. /urther, the auditors will verify that Aa%eside properly designs and uses ade1uate documents. ;y wal%ing through the various systems, the auditors can determine if ade1uate documentation is re1uired at each point and if those documents are preprinted and prenumbered to ensure that the proper information is gathered and retained. hysical controls. ;y physical observation of the warehouse, the stores, and other assets, the auditor can determine if Aa%eside has ade1uate safeguards over its assets. <egregation of duties. ;y loo%ing at the organi0ation of a company, the auditors can determine if the necessary separation of responsibilities is in place to facilitate ade1uate control. /or e+ample, since Aa%eside has a chart showing the various officials and their -obs, the auditors can assess whether a true system of chec%s and balances has been established. !lthough 4+hibit E-1 shows the company divided into clearly distinct areas, information in 4+hibits E-@ and E-E indicates, for e+ample, that the !ssistant to the resident has a great many responsibilities, some of which raise the possibility of control problems.

Be+t, the auditors will have to e+amine any information that helps to ascertain the efficiency of the company's information and communication system. 3n the case presented, little data is provided to evaluate the information system e+cept that *ogers feels the systems are outdated for a company of this si0e. Therefore, the auditors should assess the design of the system and the people who operate the accounting system. /or e+ample, the auditors might want to select a number of transactions and trace them from the point of origination through the accounting system to see that the recording process is performed properly. This testing is designed to determine if the system is capable of performing the following tas%s in an effective manner. 3dentify and record all valid transactions. Describe on a timely basis the transactions in sufficient detail to permit proper classification. 2easure the value of transactions. Determine the time period in which transactions occurred. resent the transactions appropriately in the financial statements.

The final component of internal control is monitoring. 2onitoring is the process that assesses the 1uality of internal control performance over time. Aa%eside does not appear to have an e+tensive monitoring system, such as an internal audit function. #ithout an internal auditor, no independent party within the company serves to monitor and oversee the company's internal controls. The internal audit function can be e+tremely important in a company, especially where stores and sales representatives operate at a geographic distance from 41

the home office. (>) !n evaluation of the overall control environment is not possible from 4+hibits E-@ and E-E. 8owever, the auditors can see that responsibilities have been developed and divided within the company. 4ach individual or department seems to have a well-defined -ob within the two systems. Thus, some evidence e+ists to indicate that management is aware of the importance of internal control. <uch systems simply cannot be created without ade1uate support by the company's management. 3n terms of ris% assessment, Aa%eside does not appear (from Cases > through E) to have a formal method of systematically assessing ris%s (#ea%ness). The auditors should recommend a system of identifying ris%s, their significance, their li%elihood of occurrence, and how they might be managed. This is especially true with Aa%eside's growth of stores, concentration of suppliers (Cypress only), and installation of a bonus system. 3n addressing control activities, the auditors can see, as indicated in the answer to 4+ercise (>), that the company seems to use ade1uate documents and authori0ation procedures (<trength). 3n addition, although the !ssistant to the resident has many different duties (#ea%ness), the company seems to have made an attempt to segregate responsibilities in an appropriate manner. ;oth of the information systems that are presented also seem well designed especially for a small but growing company. 8owever, the company still uses some manual systems that can be slow and offer the opportunity for many human mista%es to be made (#ea%ness). The answer to 4+ercise (>) goes into more detail concerning control strengths and wea%nesses in this area. The monitoring activities seem to be somewhat la+. 8owever, with Aa%eside still being relatively small, *ogers' oversight somewhat compensates for the lac% of monitoring. #ith the growth of Aa%eside, this is becoming less true. (@) !fter a preliminary assessment of control ris%, the auditors have three possible actions. a) ;ecause of potential strengths found within internal control, the auditor may feel that control ris% can be assessed at below the ma+imum level. 3f so, the auditors must then be able to identify specific control procedures that will li%ely prevent or detect material misstatements. The auditors must perform tests of these controls to evaluate their effectiveness to determine if a reduction in the assessment of control

42

ris% is -ustified. b) ;ecause of wea%nesses found within internal control, the control ris% may have to be assessed at the ma+imum level. This evaluation will probably force the auditor to reduce detection ris% by such means as performing additional substantive testing, using more e+perienced staff personnel, carrying out procedures closer to the balance sheet data, or relying on more effective testing procedures. c) !lthough potential strengths may be identified within internal control, the auditors may still opt to assess control ris% at the ma+imum level. This decision would be made if additional substantive tests appear to be easier and cheaper to ma%e than performing the necessary tests of specific control policies and procedures. <arbanes 9+ley re1uires e+panded internal control auditing because the 2anagement !ssessment of 3nternal Control needs to be separately audited by a registered C ! firm, regardless of its effect on the audit of the financial statements. (E) The auditor will normally begin verifying control policies and procedures by ma%ing in1uiries of the employees as to the performance of their duties. The answers provided indicate to the auditor whether each individual understands the duties that have been assigned as well as their purpose. ! proper %nowledge of a -ob usually means that employees are more li%ely to comply with the system and fulfill their responsibilities. 3n addition, the auditor is often able to observe the wor% of these individuals during the audit fieldwor%. /rom these observations, an evaluation can also be made as to the 1uality of the wor% being performed. !lthough in1uiry and observation are important steps in testing control procedures, the auditor needs to obtain more substantial evidence. ! welldevised system of controls should re1uire each employee to leave physical proof whenever a tas% has been completed. a tic%mar% must be used, the person must sign a form, a code number must be entered, etc. Thus, the auditor should be able to trace this physical evidence through an entire system noting whether the policies and procedures are operating efficiently. /or important measures that might reduce the assessment of control ris%, the auditor may want to verify effectiveness by e+amining a large number of documents. /re1uently, an auditor evaluates control procedures within an entire system through a (test of transactions.( Transactions are traced through an accounting system to ma%e certain that the recording has been made properly and that each control procedure is functioning as intended. (F)

43

This new information provides an increased ris% on the motivation:incentive for fraud to occur, in terms of the fraud triangle. 3t does not mean that fraud has occurred and does not affect the opportunity or rationali0ation necessary for fraud to occur. The auditor faced with this information should document the discussion, and ma%e sure the audit team is aware of the conversation. 3t is not the -ob of the staff auditor to initiate an investigation at this early point in the audit. SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) a) The following page presents a flowchart for the revenue recognition system. Bumerous acceptable variations of this flowchart may be created. This problem is not intended to suggest a rigid format for the flowchart but rather to give the student e+perience in constructing and reading one. #hen evaluating a student's wor%, several 1uestions should be as%ed. Does the flowchart truly mirror the system" 3s the flowchart understandable" 3s the flowchart overly comple+, containing too many symbols and e+planations"

9ne techni1ue that might be used with this assignment is to divide the class into teams of three or four students each. Then select a flowchart at random from each team and as% the team members to criti1ue it. This process, which can be done inside or outside of class, will compel the students to view the flowchart as an instrument intended to communicate the design of a system.

44

"-e./ise 1a
Client. Aa%eside Company <ystem. *evenue and Cash *eceipts Cycle - Distributorship *evenue *ecognition /-1> repared *eviewed *eviewed 3nventory Department
/rom <ales

RCD RM; 4MP

5:16:65 11:11:65 1>:16:65

Botes !. *ecord telephone order on prenumbered sales invoice. ;. Merify availability of merchandise and estimate shipping date. C. Compare to current age of accounts receivable. 3f credit is available, approve sales invoice. 3f not, refer invoice to *ogers for final action. D. 2atch all copies of sales invoices. 3nitial first copy. <tampt (!pproved( on copies >-E. 3ndicate appro+imate shipping date on fifth copy. 4. ac% and ship merchandise. repare a five-part bill of lading. /. 2atch bill of lading with sales invoice as to 1uantity and description of items. !dd price to sales invoice, e+tend the prices and foot. !dd due date. Q. 2atch sales invoice to bill of lading. Merify prices, chec% e+tensions, and footings. *ecord invoice in the sales -ournal.

<ales Division
/rom Customer

!ssistant to the resident

/rom <ales

Controller's 9ffice
/rom 3nven.

<ales 3nvoice

>

<ales 3nvoice

Bote ! Bote ;
@ E F Merify Customer Credit ;ill of Aading !pproved Credit Aist @

<ales 3nvoice

>

To <ales To !sst. To 3nven.

Do.

Bote C

!:* <ubs. Aedger

*ecord 3nventory <ale

2n,entory %ales J ournal

/rom <ales <ales 3nvoice (!pproved) 1

To <ales

/rom <ales @

2n,. Do.

/rom !sst.

/rom 3nven.

<ales 3nvoice

/rom <ales

Bote 4
Credit Appro, ed5

Bo. <ales 3nvoice > F ;ill Bo.

7pdate <ubs. Aedger

!:* <ubs. Aedger

;ill of Aading @ <ales 3nvoice E (!pproved)

Bote D
<ales 3nvoice (!pproved) /rom 3nven. 1 >

F @ > ;ill of Aading 1

Bote Q

%ales J ournal

To 3nven.

Do.

To Cust.

#ith <hipmt

To Cust.

To Contr.

To Cust.

;ill of Aading E <ales 3nvoice (!pproved) > @

To Contr.

Cust Bame

;ill of Aading @ <ales 3nvoice E (!pproved)

Bote /

Current rice Aist

To !sst.

To Cust.

Cust Bame

Due Date

45

(1) b) %e0enue and Cash %e/eipts Cy/le Distributorship Cash *eceipts Chec%s arrive from customers along with the copy of the invoice slip. The chec%s are received by the Treasurer's 9ffice where each chec% is immediately stamped (/or Deposit 9nly.( The chec%s are listed on a ban% deposit slip and on a four-part cash remittance list. This listing includes the customer, the amount paid, and the invoice number. The chec%s and the ban% deposit slips are ta%en by the Treasurer's 9ffice to the ban%. The second copy of the ban% deposit slip is validated and returned to the Treasurer's 9ffice where it is placed in a permanent file by date along with the fourth copy of the cash remittance list. The ban% returns the first copy of the validated ban% deposit slip directly to the !ssistant to the resident where it is placed in a temporary file by date. The invoice slips and the first three copies of the cash remittance list are sent by the Treasurer's 9ffice to the <ales Division. The second copy of the sales invoice and the fourth copy of the bill of lading had originally been filed by that department when the goods were shipped. 4ach invoice slip is matched with the corresponding sales invoice and bill of lading. The appropriate discount is calculated and recorded on each copy of the cash remittance list. 4ach invoice slip is then attached to the appropriate sales invoice and bill of lading and placed in a permanent file by invoice number. The third copy of the cash remittance list is placed in a permanent file by date. The second copy of the cash remittance list is sent to the Controller's 9ffice where the cash receipts and the sales discounts are refooted. /rom this information, a daily -ournal entry is made in the cash receipts -ournal. <ubse1uently, the second copy of the cash remittance list is filed permanently by date. The sales division sends the first copy of the cash remittance list to the !ssistant to the resident. 8e compares the ban% deposit slip that he has received from the ban% against the total of the cash remittance list for that same date with a spot chec% of individual items. The list of collections is then used to update the !ccounts *eceivable <ubsidiary Aedger before being placed in a temporary file by date. 7pon receipt of the monthly ban% statement, the cash remittance lists and the validated ban% deposits are removed and used to prepare the monthly ban% reconciliation. The reconciliation, the ban% statement, the validated deposit slips, and the cash remittance lists are then placed in a permanent file by date.

46

(>) The student is as%ed to complete 4+hibit E-F, a preliminary analysis of the control procedures in the cash receipts system. Documents /ound in This <ystem. 3nvoice <lips (one copy per payment) - prepared internally but returned directly by outside party. 3t is the bottom portion of the number E copy of the sales invoice. Malidated ;an% Deposit <lips (two copies per day) - prepared internally but validated by outside ban% and mailed directly to the !ssistant to the resident. Cash *emittance Aist (four copies per day) - prepared internally. <ales 3nvoice (second copy) - prepared internally. ;ill of Aading (only fourth copy is a part of this system) - prepared internally, two copies sent to customer. ;an% <tatement (one copy per month) - prepared e+ternally. ;an% *econciliation (one copy per month) - prepared internally. !nswers to <pecific Luestions on the !nalysis /orm, 4+hibit E-F. 1. renumbering of forms - 4+hibits E-@ and E-E indicate that the sales invoices (including the sales invoice slip) and the bills of lading are prenumbered. Bone of the other documents shown in this system would normally be prenumbered.

>. !uthority for completing each document - 4+hibit E-E indicates that all documents within this system are clearly assigned to a specific department. @. *eview of documents - a number of the documents are reviewed prior to the beginning of this system such as the sales invoice and the bill of lading. The validated ban% deposit slips are reviewed by the !ssistant to the resident while the cash remittance list is reviewed by the Controller's 9ffice. The ban% statement is reviewed by the !ssistant to the resident. /inally, the ban% reconciliation is prepared by the !ssistant to the resident but does not appear to be reviewed. The failure to review this document would constitute an internal control wea%ness.

47

E.

rocedures for completing each document and for reviewing each document all instructions on the wor%sheet appear to be reasonably complete, although any set of written instructions could be put into more detail. 9ne problem does e+ist. none of the instructions give guidance when discrepancies are found. /or e+ample, according to the flowchart, a ma-or problem e+ists in the sales division at point ;. !ccording to the e+planation, no instructions e+ist when the collection is less than the amount of the invoice. *ather than rebilling the additional amount, the invoice information is placed in a permanent file. !lthough this rebilling process may be handled through the !ssistant to the resident or some other party, this procedure is not indicated by the flowchart.

F. <eparation of record-%eeping function and custody function--the Treasurer's 9ffice which serves the custodial function for the cash funds also records the initial receipt of cash. That type of organi0ation is typical of small companies but does offer the opportunity for theft or cash manipulation. 3n addition, the !ssistant to the resident maintains the !ccounts *eceivable <ubsidiary Aedger and reconciles the ban% statements. !lthough not specifically a control wea%ness because this individual does not have access to the cash account, these combined responsibilities do offer the opportunity for successful theft through collusion. I. Merification of mathematical computations - all computations are independently verified e+cept for the cash discounts. The flowchart is unclear as to the procedure to be applied when the sales division calculation does not agree with the customer's payment. 7. 3mmediate record-%eeping--the record-%eeping function appears to begin immediately upon the receipt of the cash. J. Transactions authori0ed -- all transactions seemed to be appropriately authori0ed. 5. 9ther control procedures that might be mentioned by the students. chec%s are immediately stamped (/or Deposit 9nly( spot chec%s made of cash remittance list totals to ban% statement deposits are made to counter potential (lapping( activities.

16. 9ther control wea%nesses that might be noted by the students - invoice slips and related documents are permanently filed by invoice number in the sales division rather than by customer name without any apparent crossreferencing. 3n case of a later dispute, locating the invoice might be difficult.

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(@) !s a small organi0ation, the controls that might actually be implemented are limited to those procedures that would be cost effective. Aisted below are several possible improvements that could be considered. 4stablish a separate credit department to investigate new clients and set credit limits based on this information. rohibit *ogers or other company personnel from giving credit e+cept under specified conditions. 7se a sales order form that is different from the sales invoice. The two documents serve different purposes and are most useful if designed to meet those specific needs. 8ave a separate shipping department to provide control over the inventory being removed from the company. 4stablish a separate accounts receivable department to monitor all changes in each customer's individual account. 4stablish a separate billing department to prepare the sales invoices and ensure their accuracy. #hen goods are shipped, a signed receipt should be received as proof of the transfer. SU!!"ST"# ANS$"%S TO SA%(AN"S 1 O'L"* &U"STIONS (1) The board of directors needs to be organi0ed so that it can fulfill its purpose. The primary improvement is to increase its independence and operation. The resident of the Corporation should need be the Chairman of the ;oard of Directors and there should be sufficient independent board members to manage create a truly independent audit committee. 7nder <arbanes-9+ley the audit committee is the primary interface with the registered C ! firm. 9ther structural changes may involve management and their duties. 7nli%e the previous non-public audits, violations of segregation of duties, or lac% of audit trail might trigger a significant deficiency or material wea%ness notification. Therefore, while in the past e+panded substantive testing was possible in the event of internal control deficiencies, <!< 11> re1uires the communication of 49

all such problems in the conte+t of the audit or the management report on the internal control system. (>) The audit or internal control is still relevant in the determination of the audit ris% model and the determination of detection ris% relative to the audit of the financial statements, however <arbanes-9+ley re1uires that public company management report separately on the internal control system over which they are responsible. /urther, the registered C ! firm must audit that management report. The result is that !bernathy and Chapman must evaluate the effectiveness, and test the effectiveness of the internal control system regardless of its impact on the financial statement audit. 3n most cases this would involve increased auditing and therefore higher fees.

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CASE 5 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) <!< @1, (4vidential 2atter,( states that. (The measure of the validity of Cevidential matterD for audit purposes lies in the -udgment of the auditor....( (par. . 6>) Thus, the 1uality of oral evidence is an evaluation made by the auditor that would be influenced by a number of factors. the perception of management's integrity, the ran% of the individual providing the information, the ability to corroborate the evidence by other sources, and the purpose for which evidence is being gathered. 8owever, in all cases, statements made by the employees of a client are only circumstantial evidence. 3n a comparison with other forms of evidence (such as observing physical e+istence and receiving confirmations directly from third parties), it provides less assurance. 3n this case, 2itchell is attempting to gather additional evidence concerning Aa%eside's systems, especially the design and operating efficiency of control procedures and policies. 9ral evidence serves an important role in such testing but still has to be complemented by other testing. a review of completed internal documents, flowcharts, organi0ational charts, -ob descriptions, systems manuals, etc. Conversely, oral information provides less evidence in the substantive testing of account balances. #hereas company employees should be able to furnish relevant information as to the functioning of control procedures within the various accounting systems, the auditor must rely almost e+clusively on other types of testing to determine the fair presentation of the client's financial statements. (>) !ccounts receivable generate a constant flow of cash into a company, offering a temptation to any employee who might be inclined to steal. 9ver the years, ingenious individuals have devised a multitude of plans for diverting this monetary inflow to themselves. <ome of the more common schemes include the following. 2oney that comes to the company from a customer is stolen by an employee with the balance then being written off the records as an uncollectible account. This diversion of funds is especially li%ely when an old account is collected, one that can be removed from the boo%s without arousing suspicion.

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Aapping can occur. 9ne or more accounts receivable are collected by the company but the money is stolen by an employee. 8owever, since the collection is not recorded, another invoice will eventually be sent to these customers who would then alert the company to the earlier payment. To prevent the processing of this second bill, subse1uent cash collections from other customers are applied to the balances of the original customers. This series of events can be repeated indefinitely. 2oney is stolen on a daily or wee%ly basis to cover each previous theft. ! customer can pay the total amount of an invoice. !n employee removes cash e1ual to the >K discount that is allowed when payment is made within ten days. 3f the company does not have a specific policy for rebilling a customer for incorrect discounts, the difference may simply be recorded as a discount that has been ta%en.

(@) ! company's net income can always be inflated by creating fictitious credit sales. /or e+ample, an invoice is prepared for a fa%e customer with the amount being recorded as an increase in both accounts receivable and sales. 3n the Aa%eside audit, the client company wants to grow. ;an% loans or new e1uity investments may be needed for this purpose. 3ncreased income would ma%e this type of financing easier (and, perhaps, cheaper) to negotiate. /alse sales might also be created for a different reason. the regional sales representatives are paid a commission based on sales. Thus, to inflate their own income, they might attempt to falsify sales records. <tudents may also suggest that fictitious sales will inflate the profits of the individual stores and, thus, increase the bonuses paid to the manager and assistant manager. 8owever, this case indicates (as does the balance sheet in Case @) that all credit sales are made by the distributorship side of the business. The stores do not sell on credit so that fictitious sales cannot be created through the recording of e+tra accounts receivable. (E) 3n tal%ing with client personnel, an auditor must be constantly alert for any indication of potential problems. (*ed flags( are often encountered in these discussions that need to be investigated to ensure that material misstatements do not e+ist. During 2itchell's conversation with 2iller, a number of comments are made that should concern the auditors. !ccess to the accounts receivable subsidiary ledger is available to all employees within the company. Therefore, the possibility e+ists that an 52

individual could ma%e an ad-ustment to a balance without 2iller noticing. The receivable of a friend or relative, for e+ample, could be reduced. !ging of the receivables is performed only once a year. !lthough 2iller claims that he can monitor the age of individual accounts, the company needs to be aware of changes that occur over time. /or e+ample, the increase in the age of the receivables during the current period seems to have gone unnoticed. Conse1uently, the company's assets are tied up for a longer period of time and the chance of accounts becoming uncollectible increases. The company needs to be in a position to ta%e corrective action as soon as this type of problem begins to occur. 2iller controls the accounts receivable subsidiary ledger with virtually no company oversight or control. /or e+ample, no reconciliation with the general ledger is made e+cept for the auditor's testing once a year. 4rrors and evidence of irregularities could e+ist and not be discovered for months. Complaints about billings are handled by 2iller rather than by someone independent of the system. The handling of complaints is an important method of control especially in an accounts receivable system, since regular interaction with outside customers occurs. This control mechanism is neutrali0ed, however, if 2iller is assigned to loo% into and resolve the problems. Bo formal system e+ists for setting credit limits and granting credit. *ogers appears to handle this aspect of the company based almost on intuition. Thus, potentially e+cellent customers may have their credit limited while ris%y customers are given e+cessive credit. ! formali0ed system needs to be developed with some oversight included. Credit is based solely on reports that are filed by the sales representatives. These individuals have a direct interest in getting additional sales since they are paid on commission. Thus, they have reason to want each report to sound as if the customer is worthy of credit. !dditional independent information should be accumulated to help the company decide on the granting of credit. The credit files are never updated. Therefore, the company learns that a customer is no longer a good credit ris% only by incurring a loss, the writing off of a balance as a bad debt. Therefore, customers in financial difficulties can run up large debts that will never be paid. The company needs to establish a periodic review of credit information to ensure that each customer is still worthy of credit. The age of the accounts receivable is up significantly from the previous year without any good e+planation. 2iller blames the change on Christmas, but the effects of that holiday would have also been encountered in the preceding year. The possibility e+ists that bad accounts or false accounts are now included within the receivable balance. 2iller indicates that the company might have previously been holding accounts rather than writing them off as bad on a timely basis. The auditor must be concerned that this practice is still being followed. Companies will often attempt to manipulate net income by varying the point at which accounts are determined to be bad. 53

Bo -ustification seems to e+ist for using .7K of net sales as the estimation of bad accounts. The auditor cannot corroborate a number that appears to have been selected at random. ! new attempt must be made to derive an estimation that is a reasonable representation of the company's uncollectible accounts. The company waits until an account is 1F days old before a second invoice is mailed. This delay is, perhaps, one of the reasons that the age of the accounts has increased. 2any customers may be waiting for the pressure of the second bill before ma%ing payment. 2iller writes off accounts as uncollectible with no apparent company control. <ince bad accounts may indicate errors or irregularities, they should always be reviewed and approved by some independent party within the organi0ation. 2iller produces and mails the final invoice for overdue accounts. <ince 2iller has a great many responsibilities in this system, this last billing should be made by some other individual. Therefore, if the account has been paid (and stolen or incorrectly recorded), the information comes bac% to this independent person. rices and e+tensions of invoices are sometimes chec%ed after the invoice has been mailed to the customers. This system is obviously inefficient. ayments may be made incorrectly, and customers can become aggravated by later ad-ustments being made.

(F) /irst, because of wea%nesses found during the preliminary evaluation of the internal control, control ris% may be assessed at the ma+imum level. <ince ma+imum control ris% is being assumed, the auditor has no reason to test the operating efficiency of the control procedures. <econd, although potential strengths may be identified by the preliminary evaluation of internal control, the auditors may still opt to assess control ris% at the ma+imum level. This decision would be -ustified if additional substantive tests appear to be easier and cheaper to perform than the testing of the operating efficiency of specific control policies and procedures. Thus, once again, the testing of the control procedures becomes unnecessary. 3n the new <arbanes-9+ley environment, testing cannot be omitted for public companies. (I) 3nherent ris% is the susceptibility of an account balance or class of transactions to a material misstatement. ! number of factors affect this assessment. the 54

1uantity and si0e of transactions occurring over time, the past history of the company in this area, the li%elihood of theft, the necessity of performing complicated calculations in order to generate reported figures, problems inherent to a particular industry, the need for ma%ing estimations, the results of analytical procedures, and the possibility of obsolescence. /or e+ample, in the Aa%eside audit, inventory would be an account that would probably have a high inherent ris%. The company has numerous transactions in both buying and selling inventory. Computations of discounts and freight charges could be difficult, as would be the application of a cost flow assumption. The possibility of theft, brea%age, returns, and obsolescence of inventory would all be high and re1uire periodic estimations. The auditor's assessments of both inherent ris% and control ris% have a significant impact on detection ris% and, therefore, substantive testing procedures. 3f the inherent ris% and control ris% are both determined to be low, detection ris% need not be %ept low. Thus, less substantive testing (both in 1uantity and 1uality) is needed. Conversely, if the inherent ris% and the control ris% are -udged to be high, the auditor must reduce detection ris%. !s discussed above, this ris% can be brought down to an acceptable level by such means as performing additional substantive testing, using more e+perienced staff personnel, carrying out procedures closer to the balance sheet date, or relying on more effective testing procedures. (7) 3n positive confirmations, debtors are as%ed to respond in all cases whether or not they are in agreement with the information given. #hen using the negative form of re1uest, debtors are as%ed to respond only if they disagree with the information. <ince positive confirmations re1uire a response in every case, they provide better evidence than do negative confirmations. 8ence, positive confirmations are more appropriate when the internal control is wea%, accounts are large or old, or related parties are involved. 3ncreased audit evidence is needed in each of these cases. Begative confirmations are not as costly and are most often used when less evidence is re1uired. (J) The selection of a specific account for confirmation is an indication that the auditor desires additional evidence or assurance about that particular balance. ! number of situations e+ist that would suggest the need for confirmation of a specific account. a) The balance appears to be with a related partyG

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b) c) d)

The account is 1uite large in relation to other accounts receivableG The account is far overdue, indicating a possible bad debt to be written off or that payment has not been properly recordedG The activity within the account has been unusual. /or e+ample, later invoices were paid while earlier charges were ignored.

(5) The debit entries made to Aa%eside's !ccounts *eceivable control account produce an audit trail made up of the following documents or records. <ales Rournal - indicates the original -ournal entry recorded for each sales transaction. !n auditor matches the debits in the general ledger account to these -ournal entries to ascertain that no posting errors have been made. <ales 3nvoice - serves within the Aa%eside system as both an invoice indicating the amount billed to the customer and a sales order. The auditor can use the various copies of the sales invoice to verify that. credit was approved for the sale, 1uantities and types of items billed agree with the 1uantities and types of items shipped to the customer, prices included on the invoice are appropriate, that the bill is mathematically correct. ;ill of Aading - records the 1uantity and description of the items being shipped. The auditor compares it with the sales invoice to ma%e certain that the items ordered and billed are in agreement with the items that were shipped. !ccounts *eceivable <ubsidiary Aedger - indicates the receivable balance from each individual customer. !n auditor compares individual entries made to this subsidiary ledger with entries in the control account in the general ledger. 3ndicates proper functioning of system. 3nventory rice Aist - used to price sales invoices. !n auditor can use this listing to verify correct pricing of the sales invoices. 3nventory <ales Rournal - records inventory sales as a basis for perpetual inventory. !n auditor verifies that the items recorded as being sold agree with the sales invoice. !lthough this verification relates to the inventory system rather than to receivables, the -ournal is mentioned in 4+hibit @-E 56

and does indicate an appropriate interface between the two systems. !lthough the following documents are not part of the audit trail leading to the recording of the !ccounts *eceivable debits, they are certainly relevant to any testing made in connection with the fair presentation of those debits. 3nvoice <lips, Cash *emittance Aists, Malidated ;an% Deposit <lips - some or all of these documents can be used by the auditor to verify the actual amount of cash received. The 1uestion of collectibility is best answered by actual collection of the receivable. Thus, the auditor will compare the debit entries in the receivable account to the subse1uent cash collections. This 1uestion also as%s about the reliability of the evidence gathered from this audit trail. Aa%eside's audit trail is composed entirely of internally generated documents. /or e+ample, even the original customer order is ta%en by telephone and recorded by Aa%eside employees. Thus, the reliability of the documents that comprise this trail such as bills of lading or sales invoices would be closely tied to the auditor's evaluation of internal control. 3f controls are perceived as strong, the reliability of these documents is much higher than if controls are wea%. ;ecause the audit trail is composed solely of Aa%eside documents, the student should be aware that testing this trail provides the auditor with only a portion of the necessary evidence. Collection of the accounts receivable, for e+ample, and auditor confirmations would also provide evidence as to the fair presentation of the accounts receivable. (16) 2iller is uncertain how the 6.7K figure was determined. 8e says that the previous auditors determined this figure several years ago, and that the company has always used this figure. 9bviously, this is not a reasonable method for estimating bad debts. The figure should be evaluated by Aa%eside's management at least annually for its reasonableness. This evaluation should include a review of the history of uncollectible accounts, the current credit policy, and the current aging of accounts receivable. (11) 2itchell probably should not recommend that !ccounts *eceivable be confirmed as of an interim date (Bovember). The internal control for the revenues and cash receipts cycle appear to be poor and cannot be relied upon to provide reliable financial information for the month of DecemberG thus, !ccounts *eceivable should be confirmed at yearend. (1>)

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Consistent with our answer in T11 above, 2iller has not designed an effective system. 3t is not unusual for a company to grow and what wor%ed before can no longer be relied on to handle the increased volume. 2iller seems to e+hibit a la+ attitude in several of his answers and therefore, since he is responsible for the system, we must conclude that he has not made good decisions.

SU!!"ST"# ANS$"%S TO "'"%CIS"S Bote. !lthough no specific 1uestion relates to the following matter, students may detect that a contradiction e+ists between a statement made by 2iller here in Case F and the system memorandum presented in 4+hibit E-@. 2iller indicates that he verifies the prices and e+tensions reported on sales invoices. 4+hibit E-@ states that this control procedure is performed by the Controller's 9ffice. !lthough this discrepancy could mean that 2iller's assertion is incorrect, it probably signifies that the system has been altered subse1uent to the development of the memorandum. Discussion of this contradiction is a good lesson in the importance of constantly updating the firm's %nowledge of the client's systems and internal control. (1) L74<T39B (1) Comments - The subsidiary ledger is reconciled annually by the independent auditors. <ignificance - During the year virtually no control is maintained over 2iller's handling of the subsidiary ledger. The possibility that errors or irregularities will be discovered on a timely basis becomes remote if not impossible. 3n addition, 2iller has the opportunity for manipulating the records to cover thefts and other defalcations. <uggestions - 9n a periodic basis, a member of the administrative staff should verify that the subsidiary ledger for accounts receivable agrees with the general ledger control account. L74<T39B (>) Comments - The criteria for writing off accounts are nebulous and seemingly based solely on the -udgment of 2iller. <ignificance - /or the auditor, a problem e+ists as to the consistency of removing bad debts from one year to the ne+t. 9nce again, no control appears to e+ist

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over 2iller's -udgment. <uggestion - 4stablish a formal system for writing off bad accounts. This system need be no more than a list of steps to be ta%en prior to the decision to remove an account. Company needs to ensure a review of these accounts. L74<T39B(@) Comments - Bo independent party authori0es the write-off of bad accounts. <ignificance - The removal of bad accounts can be used to cover cash thefts. !lso, write-offs may be approved without sufficient attempts being made at collecting the receivables. <uggestion - 9nce a system has been established for the write-off procedure (see Luestion >), an independent employee should be re1uired to review every account prior to removal to ma%e certain that all proper steps have been followed. L74<T39B (E) Comments - /ollow-up of bad debts is not addressed in the caseG 2itchell does not as% this specific 1uestion. <ignificance - 3f no follow-up is made, the company reduces the possibility of ma%ing any future collection. !dditionally, attempting to collect an old account receivable is a control mechanism to ascertain that the balance has not actually been paid and the money stolen or the collection recorded incorrectly. /inally, if no follow-up is carried out, the opportunity e+ists for employees to steal the money if it should be received at a later date. <uggestion - The receivable can be turned over to an outside collection agency or, as an alternative, a member of Aa%eside's staff can be assigned to loo% into the bad accounts periodically. L74<T39B (F) Comments - Bo reevaluation of the method for estimating bad accounts has been made by the client company. <ignificance - Bo proof e+ists that the bad debt e+pense and the allowance for doubtful accounts is fairly presented. <uggestion - Client should schedule recent bad accounts to arrive at a new estimation of the bad debt percentage.

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L74<T39B (I) Comments - The first three invoices are mailed by the sales divisionG any further billing is made by 2iller, who is in charge of the subsidiary ledger. <ignificance - ;y having 2iller send the last invoices, the opportunity for manipulation is increased. 3n a small company such as Aa%eside, this situation is not unusual, but it should be accompanied by additional control and reconciliation features. <uggestion - Control can be established by allowing 2iller to continue the billing, but with the addition of the control procedures suggested in several of the other 1uestions. L74<T39B (7) Comments - The responsibility for loo%ing into complaints is vested in 2iller. <ignificance - !gain, all of the responsibilities are in the hands of one person with no independent control being applied. This lac% of control reduces the possibility that errors will be discovered. ;asically, an opportunity to establish control over 2iller's wor% is being missed. <uggestion - Aa%eside should have complaints sent to an employee who can then discuss the matter with both 2iller and the customer to ma%e certain that the issue is properly resolved. L74<T39B (J) Comments - !ccording to the client, no formal change in the policy of granting credit has been made. 8owever, the increases in the si0e of the receivables, the increase in the average age of the balances, and the apparent write-off of additional uncollectible accounts indicate the possibility that some, perhaps informal, modification has occurred. ;ecause the credit policy has never been formally established, the auditor may have trouble distinguishing an actual change. <ignificance - !ny shift in credit policy re1uires auditor attention as to the effect on the allowance account and bad debt e+pense. !bernethy and Chapman may want to review the new customer accounts opened during the current year for any indication of a change in credit policy. This issue may be especially significant in the Aa%eside audit since credit reports are filed by the sales representatives who are paid on commission, thus benefiting from an increase in sales. <uggestions - Aa%eside should adopt a policy to guide *ogers in his credit

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decisions. 3n addition, outside verification of credit ratings on a periodic basis would help reduce the ris% of high bad debt losses. L74<T39B (5) Comments - Bo indication is given in the case as to whether sales invoices are verified after the shipment to ascertain appropriate credit approval. The system is designed so that credit approval is necessary before the sale is made, but no control mechanism is identified to assure that the system is wor%ing properly. <ignificance - To the auditor, the possibility of a sale being made without credit approval casts further doubts on the reliability of the system of controls. !s a part of the tests of controls, the auditor will want to review a sample of sales invoices for proper credit approval. <uggestions - !t the point in the accounting system at which the e+tensions and prices are verified, the presence of credit approval should also be chec%ed. L74<T39B (16) Comments - Credit files contain only the sales representative's credit reports and do not appear to be reviewed periodically. <ignificance - !s indicated above, the credit granting policy is informal and based almost solely on *ogers' -udgment. Thus, the efficiency of the system is un%nown, and review of the system by the auditor is 1uite difficult. <uggestions - !s a part of the design of a comprehensive credit system, Aa%eside should determine the desired contents of a credit file including items such as outside credit reports, financial statements, correspondence, etc. eriodically, these files need to be reviewed by an independent Aa%eside employee to verify that all information is complete and up-to-date. 4ach customer's file is also reevaluated at regular time intervals to -udge whether credit should continue to be offered. L74<T39B (11) Comments - Merification of goods and prices is made by Aa%eside employees. 2iller implies that his chec%ing of prices and e+tensions is not made on a timely basis. 3n addition, this verification is another responsibility pertaining to accounts receivable concentrated in 2iller's hands. <ignificance - Merifying e+tensions and prices after the invoice has been sent to the customer is not a logical approach. !lso, having 2iller perform this tas% adds nothing to the efficiency of the organi0ation.

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<uggestion - !ll verifications should be made prior to mailing the invoice, ideally by a different employee. L74<T39B (1>) The answers to Luestion (11), above, appear to pertain e1ually as well to this 1uestion. L74<T39B (1@) Comments - Cash discounts are verified by the sales division. <ignificance - <ystem appears ade1uate. /inancial information should be fairly presented. <uggestions - Bone L74<T39B (1E) Comments - 7sing prenumbered sales invoices and bills of lading along with the periodic verification of all numbers is essential in assuring that all sales are recorded. 3n an earlier case, the use of prenumbered forms is mentioned. 2iller suggests that the presence of all forms is tested periodically, but the auditor should specifically as% about that procedure. <ignificance - 3f the possibility e+ists that the company can ma%e sales without recording them, the auditor's ability to gain assurance as to completeness assertion may be severely hampered. <uggestions - <ince the documents are already prenumbered, the auditor needs to ma%e certain that Aa%eside has a policy for periodically verifying the presence of all forms. (>) <T4 (1-a) !nticipated *esults - The total listed on the sales invoice should agree with the total on the sales invoice slip. 3n addition, evidence should be present to indicate that a Aa%eside employee has already made this same comparison. otential roblem - 3f the invoices do not agree, the possibility is raised that fictitious or misstated sales are being recorded. Aac% of tangible evidence (e.g., initials) that the matching procedure has been carried out would indicate that the

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employees are not complying with the re1uirements of the system. <T4 (1-b) !nticipated *esults - The 1uantity and description of the items sold should be the same as the items shipped. !gain, Aa%eside employees are supposed to have previously made this comparison and left their initials or other proof of the e+ecution of this test. otential roblem - Differences warn the auditor that sales have been both billed and recorded incorrectly, or incorrect amounts or types of inventory have been shipped. 9nce again, a lac% of compliance by Aa%eside's employees may be shown if this comparison has not been made. <T4 (1-c) !nticipated *esults - Cash received as per the remittance list should be consistent with the invoice and the invoice slip. Customers should be encouraged to include the amount of payment on the invoice slip as a further control procedure. ;ecause of the discount, the auditor may want to perform this step in connection with the discount computation in <tep 1-d. otential roblem - The cash may have been stolen, or someone in the company may be engaged in lapping. <T4 (1-d) !nticipated *esults - Calculated cash discounts should be identical with the amounts recorded by the client company. 3n most cases, this calculated discount figure will be e1ual to the difference between the sales invoice total and the cash remittance. otential roblem - Discounts may be incorrectly recorded to hide cash shortages or as a step in stealing cash funds from the company. !lso, the company may be allowing customers to ta%e discounts that have not actually been earned. !llowing these reductions would indicate lac% of efficiency in internal control. <T4 (1-e) !nticipated *esults - !ll prices on the invoices should agree with the prices being shown on the approved price list.

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otential roblems - #rong amounts may be paid by customers. 3mproper pricing, either intentionally or unintentionally, also leads to incorrect sales and receivables figures on the financial statements. 3f the invoice price is too high, sales and income are overstatedG if too low, the figures will be understated, and company employees may be receiving %ic%bac%s from customers. <T4 (1-f) !nticipated *esults correct. The e+tensions and footings on the invoice should be

otential roblems - #rong amounts may be paid by customers. 3mproper footings or e+tensions, either intentionally or unintentionally, also leads to incorrect sales and receivables figures on the financial statements. <T4 (1-g) !nticipated *esults - The amount received according to the invoice slip should agree with the listing of individual items being deposited. 3n addition, the date of deposit should be the same as the date on which the payment is received. otential roblems - ! discrepancy could indicate the theft of the cash receipts. This test also may alert the auditor to the possibility of lapping. <T4 (1-h) !nticipated *esults - !ll cash remittances should be recorded promptly as credits to the specific subsidiary ledger accounts. otential roblems - <ince the subsidiary ledger is not well controlled in the Aa%eside organi0ation, this procedure may be used to determine the possibility of errors within the ledger. This test also may indicate lapping as well as other manipulations of the accounts so as to conceal cash shortages. <T4 (1-i) !nticipated *esults - 4ach invoice should be initialed by either *ogers or 2iller to indicate credit approval. otential roblems - ;ecause the credit system is not well documented, the auditor will be searching for evidence that sales can be made without credit approval. <uch evidence would have an effect on the auditor's -udgment as to the amount of evidence needed in e+amining the allowance account and bad debt e+pense.

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<T4 (>-a). !nticipated *esults - 4ach debit entry should be corroborated by an appropriate sales invoice agreeing as to amount and customer. otential roblems - This test has ma-or significance in that it can alert the auditor to any falsification of sales for the year. /ictitious sales could easily be created by Aa%eside since they prepare all sales invoices and other documents internally. <T4 (>-b). !nticipated *esults - 4ach credit should agree with the cash remittance list as to amount and possibly date of payment depending upon the method of posting. otential roblems - This tracing could denote errors in postings within the system. 4rrors could indicate lapping by company employees. <T4 (>-c) !nticipated *esults - 4ach credit to a specific account should agree with the listing of individual items on the ban% deposit slips. otential roblems - !gain, lapping or attempts by employees to cover cash shortages may be uncovered through this test. <T4 (@) !nticipated *esults - /or each of the customers, complete and updated credit reports should be on file. otential roblems - The use of credit reports is an essential step in establishing an appropriate credit-granting system. The presence of these reports would indicate that the control procedure is operating efficiently. 3f the reports are missing or incomplete, the auditor may want to see% additional evidence as to the validity and collectibility of the receivables. <T4 (E) !nticipated *esults - 4ach list should be arithmetically correct. 3ts total ought to agree in amount and date with the balance entered in the cash receipts -ournal. otential roblems - Cash shortages and cash thefts are often covered by incorrectly footing a listing of cash transactions.

65

SU!!"ST"# ANS$"%S TO SA%(AN"S)O'L"* &U"STION (1) This 1uestion is similar to the <9? 1uestion in Case E. The emphasis is on the difference between public and privately held companies. The difference involves the testing of the controls. 3n the public company setting controls are always tested because of the separate disclosure by management of their evaluation and testing of their system. 3n both public and privately held companies the evaluation and possible testing of internal controls by the independent auditors is related to the financial statement audit. The amount of substantive testing and the determination of the detection ris% is related to the internal control ris%.

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CASE 6 SU!!"ST"# ANS$"%S TO #ISCUSSSION &U"STIONS (1) 3n the brief description presented of Aa%eside's inventory procurement system, several specific control activities can be seen. (>) Canceled chec%s are the last document in this system, while receiving reports are one of the first. #henever auditors select a final document such as a canceled chec% and search for its documentation, they are see%ing to substantiate the validity of the balance being reported. !ll forms and documents must be present to prove that the amount and the company's reporting were both correct. <uch testing also see%s to discover whether false transactions have been entered into the system. /or e+ample, if a canceled chec% is found without a corresponding receiving report or purchase re1uisition, the possibility e+ists that money has been stolen from the companyG a payment was made for merchandise that was not ordered nor received. Ta%ing a beginning document such as a receiving report and tracing the impact of the transaction through an entire system is intended to provide evidence of completeness and that the system and its controls are wor%ing as designed. 67 the company maintains a perpetual inventory which provides significantly greater control than does a periodic systemG the case implies that the company uses preprinted forms so that ade1uate information is captured whenever a document is preparedG all purchase re1uisitions are reviewed and authori0ed before merchandise is orderedG incoming inventory is inspected for damage upon receiptG all invoices are matched with the appropriate purchase re1uisition and receiving report before payment is approvedG prices of every invoice are verifiedG and the mathematical accuracy of each invoice is chec%ed prior to payment.

9bviously, such testing will also provide evidence as to the validity of the account balance, but this particular procedure is more often associated with the completeness assertion and internal control evaluation. (@) 8ow might Aa%eside pay for goods that were received" The company could, as an e+ample, receive an invoice and not properly match it with the corresponding receiving report. The receiving report might state that 16 items were actually ac1uired while the invoice was for >6 or 166. The individual doing the review may not notice the discrepancy and erroneously approve the invoice. !s another possibility, this individual might authori0e an incorrect invoice in order to receive a %ic%bac% from the vendor. 8ow might Aa%eside fail to pay for goods that were not received" 3f either the receiving report or the invoice is lost, the documents will not match and payment cannot be made. Thus, the company may wait indefinitely for the other (lost) form before approving the cash disbursement. (E) !udit documentation, also called a wor%ing paper, is designed to demonstrate that the auditor has obtained sufficient, competent evidence on which to base an opinion as to the fair presentation of the client's financial statements. Qiven that overall ob-ective, the wor%ing paper indicates the testing that was performed and the evidence that was accumulated. The wor%ing paper should also specify any problems that were encountered and their resolution. The wor%ing paper must demonstrate that this portion of the e+amination was properly planned and that all assistants were ade1uately supervised. 3n addition, the audit documents as a whole must indicate that internal control was studied and evaluated. !ll audit documents are the property of the auditor and are maintained by the auditor in order to support the opinion rendered by the auditor. (F) ! C ! firm must establish policies and procedures for the supervision of wor% at all organi0ational levels to provide reasonable assurance that the e+amination conforms to generally accepted auditing standards. rocedures for supervision are necessary to ensure that appropriate -udgments and conclusions have been drawn from the wor% performed. Bot every member of an audit team will have the e+pertise necessary to evaluate the handling of each accounting and auditing problem that arises. /urthermore, some of the audit staff may lac% an in-depth %nowledge of the client or the client's industry, thus increasing the possibility of incorrect -udgments. <upervision by auditors having the necessary e+perience and e+pertise provides reasonable assurance that sufficient evidence and proper conclusions were obtained.

68

!uditing literature places emphasis on the e+istence of appropriate supervisory policies and anticipates that practices will be used by a firm in each audit engagement to verify proper supervision. 9ne such procedure is to have staff members leave their initials to indicate the completion of a test or later review. Thus, the wor%ing paper shown in 4+hibit I-1 was originally produced by !rt 8eyman (!8) and subse1uently reviewed by Carole 2itchell (C2), and #allace !ndrews (#!). /rom the location of the initials, this auditing firm must re1uire ac%nowledgment at every point of audit -udgment to indicate that the supervisors concur with the actions ta%en. This policy enables the firm to monitor the degree of supervision in each area of the audit as well as to ensure that no critical problem will escape the attention of supervising auditors. (I) ;ecause of the great volume of audit documentation accumulated during an engagement, most firms use an inde+ing system to organi0e all materials. 3nde+ing allows the auditor easier access to the various documents and e+pedites the review process. The (B->( designation on this document is apparently part of an inde+ing system, although no indication is given in the case as to the actual derivation of the symbols. !bernethy and Chapman may be using a code in which the letter B refers to the inventory account, and this particular document presents the results of the second testing procedure performed on that account. (7) 9ne of the purposes of audit documentation is to serve as an historical record of all audit testing performed by the C ! firm. This documentation provides a guideline for future audits but, more importantly, serves as evidence should the auditor's wor% ever come under 1uestion. To assure that the audit documents clearly reflect the procedures that were carried out and the evidence gathered, many auditing firms re1uire that the ob-ective, the scope, and the conclusions reached be included in the documentation of each test. /urthermore, by having to furnish this information, the staff auditor is more li%ely to understand the purpose of the procedures being applied. (J) !udit procedures are the steps that are re1uired to test a particular control, transaction, or account. <ome firms write procedures specifically designed for a particular audit client. !lso, some firms have standardi0ed audit procedures for use on all audits. /or 1uality control standards, standardi0ed procedures are

69

preferable to ensure that all audits are performed in a li%e fashion. 8owever, these standardi0ed procedures should be supplemented with procedures designed to meet the particular circumstances of each client. SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) 4+hibit I-1 may well be a student's first view of audit documentation. Therefore, discussion of its clarity and completeness should force the student into a close e+amination of the structure and function of the document. <tudents should be encouraged to discuss the strengths of this particular wor%ing paper as well as its wea%nesses. The audit procedures seem generally clear, although they do contain some problems. /or e+ample, the fifth procedure states that the auditor (e+amined canceled chec%s for amounts, dates, signatures, endorsements, and payee.( 9bviously, the auditor is not -ust physically e+amining this information but is confirming the data against some other document (the invoice). This reconciliation is not clearly stated. !lso, in the seventh procedure, no indication is given as to the purpose of verifying the account code. 4+ception (!) is poorly written. The staff auditor does not indicate whether the O>66 and the O@I6 amounts are over or under the current list price. !dditionally, the e+planation for the discrepancies is vague. <tating that (the difference represents monthly purchases from Cypress at different prices than shown in current price list( indicates nothing about the reason for the change. The ma-or problem, though, with this e+planation (and the actual testing procedure) is that Thomas' word is accepted as an ade1uate e+planation for the discrepancy. The auditor provides no information that any further testing has been carried out to verify these amounts. The assumption has apparently been made through the comment ( ass /urther #or%( that the differences are immaterial and, thus, do not re1uire additional testing. <ince all of the supervisors have added their initials, concurrence appears to e+ist with this evaluation. <tudents may want to discuss whether these two discrepancies warrant further e+amination and, if so, what testing could be performed. 4+ception (;) is also vague and poorly written. 9nce again, Thomas' e+planation is apparently accepted without further 1uestion or testing. The comment does not indicate the amount of the differences that are involved in this replacement. Therefore, -udging the materiality of the items will be 1uite difficult for the audit supervisors. 4+ception (C) seems relatively clear. !n auditor would prefer to see this policy in an official Aa%eside manual rather than accepting oral evidence, but in a small

70

company such as Aa%eside, that may not be possible. The auditor should ad-ust the flowchart and memorandum for this system to include this discovery. 9n the whole, other than comments ! and ;, this wor%ing paper appears to be clear and comprehensive. ;y reviewing the steps of the audit program listed in this case, students can see that 8eyman has performed the audit procedures designed by 2itchell. (>) !ttached is one e+ample of an audit document that could be produced by carrying out the prescribed auditing procedures. ! great amount of variety e+ists in format, and students ought to be evaluated on the clarity and understandability of their approach rather than on the development of a particular structure. 3n reviewing this audit document with students, the instructor should be aware that this 1uestion was developed with several educational ob-ectives in mind. To introduce students to the types of testing procedures performed by auditors in verifying the operating efficiency of a company's control policies and procedures. To assist students in developing the ability to discover and evaluate control problems. 3n this case, a number of problems e+istG some are meaningless, while some are 1uite significant. 3f this 1uestion is approached, at least partially, as a discussion 1uestion, student ideas as to the meaning and importance of each problem can be 1uite interesting. To aid students in developing audit document construction techni1ues. !s in a previous case, one or more of the students' efforts can be chosen and presented to the class as a whole or in small groups for a technical criti1ue.

1@3 2! Art 8eyman !ound in"onsisten"ies in this part o! the audit his primary responsi ility is to do"ument the items. 8e should do only enough )ork at this point to !ully understand the nature o! the in"onsisten"y, so that his do"umentation is ade+uate. 2n "on,ersations )ith Mit"hell !urther )ork may e de,eloped.

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Lakeside Company Tests o !e"ei#in$ !epo%ts and Cas& 'is()%sements 12*31*09 +)dit P%o"ed)%es 'ate !e"ei#in$ !epo%t N)m(e% 3918 3919 3920 3921 3922 3923 3924 3925 3926 3927 3928 3929 -n#oi"e N)m(e% 711 802 991 1261 1313 1406 1510 1616 1691 1812 2072 2149

W.P. No. N-3 1 +""o)ntant, A8 'ate, 1#E@E$< C&e"k N)m(e% 3091 3121 3164 3203 3251 3310 3345 3397 3425 3451 3471 3510

.. .. .. .. .. .. .. .. .. .. .. ..

t t t t t t t t t t t t

/ / /C 0 1 /2' / 0 + /2 /C / 0 /C

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

+)dit 3(4e"ti#e, To #e%i y t&at items %e"ei#ed 5e%e p%ope%6y o%de%ed7 %e"ei#ed7 and paid. 8"ope, Pop)6ation, +66 %e"ei#in$ %epo%ts p%epa%ed d)%in$ t&e pe%iod )nde% a)dit. 8amp6e, 9)d$menta66y se6e"ted 12 %e"ei#in$ %epo%ts %om in#ento%y depa%tment i6e. P)66ed %epo%ts se:)entia66y7 %andom6y sta%tin$ 5it& ;3918. +)dit P%o"ed)%es, !e#ie5 %e"ei#in$ %epo%ts. +66 "omp6ete and si$ned (y inspe"to%s7 e<"ept +. Compa%ed %e"ei#in$ %epo%t 5it& p)%"&ase in#oi"e o% :)antity and des"%iption. +66 a$%eed e<"ept 2. Compa%ed %e"ei#in$ %epo%t to p)%"&ase %e:)isition o% :)antity and des"%iption. +66 a$%eed e<"ept 2 and C. +66 %e:)isitions app%o#ed (y !o$e%s o% =i66e%. -n#oi"es %e#ie5ed o% "omp6ian"e to see i t&ey 5e%e "&e"ked7 e<tended7 and ooted (y Lakeside emp6oyees. +66 5e%e e<"ept '. Compa%ed in#oi"e p%i"es 5it& Cyp%ess =aste% P%i"e List. +66 a$%eed e<"ept 0.

-nspe"ted "an"e6ed "&e"ks and "ompa%ed t&em to in#oi"e amo)nts7 %e"omp)tin$ 3> dis"o)nt. +66 a$%eed e<"ept 0.

Comments, 8ee W*P N-3 pa$e 2. +)dit Con"6)sion, 1)%t&e% testin$ ne"essa%y (e"a)se o e<"eptions noted.

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Lakeside Company Tests o !e"ei#in$ !epo%ts and Cas& 'is()%sement ?"ont.@ 12*31*09 Comments

W.P. No. N-3 2 +""o)ntant, A8 'ate, 1#E@E$<

+ !e"ei#in$ %epo%t not in i6e. C6ient s&o)6d (e asked to ind it o% p%o#ide a %eason o% its a(sen"e. An6ess it is a""o)nted o%7 t&e s"ope o testin$ may need to (e e<panded. A8 2 3n t5o in#oi"es Cyp%ess (i66ed Lakeside o% items di e%ent %om t&ose %e"ei#ed. -n (ot& "ases t&e (i66 5as o% t&e items o%de%ed7 not t&ose %e"ei#ed. !.!. ;3923 s&o5s an item t&at is mo%e e<pensi#e t&an t&e one (i66ed7 5&i6e !.!. ;3927 &as an item t&at is 6ess e<pensi#e t&an t&e one (i66ed. T&e p)%"&ase %e:)isition o% !.!. ;2923 indi"ates LakesideBs a""eptan"e o a %ep6a"ement ()t no indi"ation in "onne"tion 5it& !.!. ;3927. Lakeside &as paid o% $oods o%de%ed7 not $oods %e"ei#ed. T&is %e 6e"ts a se%io)s p%o(6em 5it& (ot& t&e Lakeside and Cyp%ess systems. A8 C 8ome %e"ei#in$ %epo%ts indi"ate %e"ei#in$ a di e%ent amo)nt o $oods t&an o%de%ed. !e:)isitions indi"ate t&at $oods &a#e (een (a"ko%de%ed in (ot& "ases. Lakeside7 &o5e#e%7 paid on6y o% $oods %e"ei#ed. 8ystem is )n"tionin$ p%ope%6y. A8 ' No indi"ation on t&is in#oi"e t&at p%i"in$7 ootin$7 o% e<tensions 5e%e #e%i ied. 3t&e% in#oi"es s&o5 initia6s and ti"k ma%ks. 1ai6)%e to "omp6y 5it& t&e system in t&is one "ase. A8 0 -n a n)m(e% o "ases7 in#oi"e p%i"es 5e%e 6ess t&an t&e =aste% P%i"e List. T&e%e seems to (e a dis"o)nt on spe"ia6 items7 ()t mo%e e#iden"e is needed. A8 1 3ne in#oi"e 5as %ed)"ed (y a 4> dis"o)nt7 instead o 3>. 1)%t&e% in:)i%y %e:)i%ed to dete%mine %eason. A8 / -n #i%t)a66y a66 "ases7 "&e"ks 5e%e iss)ed 2 o% 3 days a te% t&e 20-day dead6ine o% takin$ dis"o)nts7 ()t Lakeside took t&e dis"o)nt in e#e%y "ase. 1)%t&e% in:)i%y is %e:)i%ed to dete%mine i Lakeside sti66 &as a 6ia(i6ity o% t&ese amo)nts. A8

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CASE 7 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) ! company profit-sharing arrangement is a matter of auditor concern because it provides an incentive for employees to generate artificially high income figures. These individuals can receive direct financial benefits from the manipulation of reported earnings. This potential problem is even more of a concern in the Aa%eside engagement because controls are wea% and each store is geographically isolated from the oversight provided by the administrative offices. (>) This case describes the payroll system used by the Aa%eside Company. Tests of controls are designed by the auditor to verify that specific control features identified as possible strengths are operating effectively. ! sample of such tests would include the following. a. b. c. d. e. Compare the payroll records produced by <arah <weet to time tic%ets completed by hourly employees noting agreement as to hours wor%edG Merify that time tic%ets have been appropriately authori0edG *ecalculate salaried employees' monthly pay and compare to the payroll recordsG *ecalculate salesmen's commissions and compare to payroll recordsG *ecalculate payroll deductions based on government payroll tables and the data listed on the #-E form filed by each employee. Compare these deductions to the company's payroll recordsG *ecompute Aa%eside's payroll ta+es and compare to total reported balanceG Merify mathematical accuracy of net wage figures (salary less deductions)G /oot the payroll recordG Merify that each payroll record has been properly authori0ed by 2ar% 8ayesG 74

f. g. h. i.

-. %. l.

Compare the payroll transfer made from the general fund each period to the total payment computed on the payroll recordG *eview canceled chec%s for proper signature, amount, payee, date, and endorsementG *eview payments made for withholdings and payroll ta+es. Compare these amounts to payroll records %ept for each of these items.

(@) 4+istence or 9ccurrence - /or payroll e+pense, the auditor would want to determine that all employees do, indeed, wor% for the company. 3f EJ employees are paid each period, the auditor needs to ensure that EJ individuals are wor%ing for Aa%eside. The auditor should be concerned that one or more employees are stealing money by receiving more than one chec%. ! review of the payroll records completed by the employees before they begin wor% provides some evidence that the individuals do e+ist. 3n addition, the auditor can accompany the paymaster (or whoever serves in this capacity) when paychec%s are distributed. This procedure allows the auditor to identify the person receiving each chec% to ensure that the employee is the same as is listed on the chec% itself. Completeness - Completeness is not usually a ma-or problem in the area of payroll e+pense where misstatements most often result from having e+tra e+pense recorded (because of theft) rather than from having transactions omitted. 8owever, the auditor still wants to ascertain that the O1.1 million figure to be reported contains all applicable payroll e+penses. Thus, for e+ample, verifying that a year-end e+pense accrual has been made helps to prove that all e+penses were recorded. /urthermore, if payroll ta+es and other costs are to be reported within the payroll e+pense figure, the auditors should determine that all such costs (<ocial <ecurity, unemployment ta+es, medical insurance premiums, etc.) have been properly included in the final balance to be presented. *ights and 9bligations - /or payroll e+pense, the auditor would want to ascertain that wor% did occur during the period for which the company does have a legal obligation to pay. The auditor would review the time tic%ets to ma%e sure that they seem proper and then recompute the amounts to be paid based on the hours wor%ed. These calculations provide evidence that the payments were, indeed, the actual obligations of the client company. Maluation or !llocation - <ince an e+pense rather than an asset is involved, the auditor is more interested in allocation than valuation. Merification should be made that the proper e+pense is being allocated to the current year. 8ence, the auditor should recompute the cut-off made of the payroll calculation at both the

75

beginning and ending of the fiscal year. Determination needs to be made that the figure being reported is for >66I only. resentation and Disclosure - The auditor wants to ma%e certain that the financial statements fairly present the payroll e+pense figure. !s shown in 4+hibit @-1, a balance for (<alaries, Commissions, ;onuses( is reported for both the stores and the distributorship. The auditor needs to determine that the separation into these two classifications is properly performed. 3n addition, the specific accounts included within this single category should be consistent from year to year so that comparability is enhanced. <ince the company does not manufacture its inventory, no portion of the payroll e+pense should be assigned to Cost of Qoods <old. (E) Types of evidence-gathering procedures that are used by an auditor during an e+amination would include the following. (9ne method for approaching this 1uestion is to as% the students to identify the accounts that could be tested through each procedure.) a) 9bservation of activities and conditions - usually a test of controls to provide evidence of operating efficiency. b) hysical e+amination and count - used to prove that an item physically e+ists and agrees with the ledger balance.

c) Confirmation - proves e+istence of a balance by communication directly with an outside party. d) 3nspection of documents - demonstrates that control procedures have been performed or provides support for reported balances. e) *ecomputation (including footings, cross-footings, e+tensions, recalculations, etc.) - demonstrates that control procedures have been performed or provides support for reported balances. f) *etracing transactions from origination to final reporting - ensures that accounting system is functioning properly so that balances will be correctly reported.

g) <canning accounting records - an analytical procedure designed to highlight significant or unusual differences. h) 3n1uiry (including discussion, 1uestioning, etc.) - helps auditors to learn design of accounting systems and internal control and to evaluate efficiency

76

of operations. i) -) %) l) 4+amination and corroboration of subsidiary records - serves as support for reported balances. Correlation with related information (including ratio and trend analysis) another analytical procedure to identify possible problem areas. *eview of subse1uent events - provides support for year-end balances and identifies happenings that re1uire disclosure. *eliance on outside e+perts - used for evidence-gathering purposes that go beyond purely auditing and accounting s%ills such as inventory valuations and engineering estimates.

m) 4+amination of legal letters and confirmations - helps to identify, assess, and value significant events and contingencies. n) 9btaining a representation letter from the client's senior management management ac%nowledges responsibility for statements and provides evidence in areas where other evidence may not be available.

This 1uestion also as%s about the competence (significance and reliability) of these procedures. 4ach test is potentially 1uite important and produces reliable evidence but only if used in the appropriate circumstances. /or e+ample, confirmation is one of the most important steps in auditing cash ban% balances but is rarely used in connection with an account such as land. hysical e+amination is essential in auditing mar%etable securities where ownership and value can often be ascertained visually. This same procedure is much less of a factor in e+amining e1uipment. !n audit procedure must match an account and the type of evidence needed. (F) 2aintaining a separate payroll ban% account is a common control procedure encountered by auditors. 8aving a separate payroll account. !llows for easier application of control procedures such as limit tests, item counts, and validity chec%sG 9perates as a safety measure. ;y setting aside sufficient cash for payroll, the company guards against spending money re1uired for that purposeG !llows for additional control over unclaimed chec%s, uncashed chec%s, etc.G

77

/acilitates the audit function in that the payroll balances are easier to verifyG Aimits the amount of money that would be sub-ect to theft in a payroll systemG /acilitates reconciliation of the ban% account. <ome organi0ations even use 1> ban% accounts - one for each month - to limit the problems associated with the ban% reconciliation process.

(I) <ome of the more critical potential problems involving payroll include. !. Chec%s are issued to fictitious employees or to former employees who have left Aa%eside, with the chec%s being diverted and fraudulently cashed. <ubstantive tests that may disclose this problem. 9bserve distribution of payroll chec%s. *eview personnel files for a sample of employees to verify current status is maintained. Compare names in files to time tic%ets and verify authori0ation of time tic%ets. *eview company's system for removing names of employees who no longer wor% for the company. Compare current number of employees to previous years for unusual differences. ;. ayroll deductions are recorded or computed incorrectly, through error or as part of a defalcation scheme. <ubstantive tests that may disclose this problem. *eview #-E forms, voluntary deduction forms, and employee contracts for completeness. Compare payroll register to #-E forms recomputing appropriate deductions. 2athematically verify payroll deductions (foot and cross-foot) and compare payroll balance to canceled payroll chec%s. 78

 *eview payroll ta+ forms for agreement with computed balances and with payroll register. C. )ear-end accrual may be ignored or incorrectly computed. <ubstantive tests that may disclose this problem. *eview last payroll for the year to verify that recording was made in proper period. *ecalculate accrual and verify against the first payroll of the subse1uent period.

SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) This problem e+tends the students' introduction to wor%ing paper construction by placing them in the role of supervisor. ! number of errors e+ist in the e+ample presented in 4+hibit 7-1 and the students should be able to identify most of them. The wor%ing paper is not properly dated so that a reviewing auditor cannot be certain that this testing applies to >665. The columns are not labeled. Bo method e+ists for identifying the information that has been gathered. 3n the first three columns, abbreviations such as (<2,( (2->,( and (<alar.( are used without e+planation, which ma%es possible the erroneous usage of the information. 3n the column that starts with O@JJ, the seventh item and two items in the ne+t column do not have tic%mar%s, which may indicate that they have not been tested. Bo indication is given as to the significance of these three omissions. !ccording to the wor%ing paper, none of the items in the column that begins with O@5 has undergone any testing. That possibility seems unli%ely, since an e+ception has been found at point !. Comment ! is vague and does not indicate any reason for the e+ception nor does it discuss the significance of the problem. 3n addition, the note 79

ma%es no mention of potential testing that may be re1uired because of the e+ception. Two canceled chec%s could not be found at point ;, but no reason is given nor is any suggestion included for further testing. 9ne tic%mar% (a caret) was used for two different tests. The reviewer has no method of distinguishing the actual procedure performed. <everal of the auditing procedures listed at the bottom (on the left) use vague terms such as (company records,( (government records,( and (calculations( without any specific identification. Thus, determining the procedures actually performed and the specific documents analy0ed would be virtually impossible. The wor%ing paper does not contain ob-ectives, scope, or conclusion (see 4+hibit I-1). Therefore, it does not clearly spell out what was done or what was found. Bo indication is presented as to the method of selecting the employee names that have been used.

(>) a ! completed 4+hibit 7 wor%sheet is shown on the following page. b 3t appears that the >66J bonus e+pense account is overstated (actual balance S OI,666 v. estimated balance S O@,5E6)G however, the amount of overstatement (O1,6I6) does not seem material. The >665 e+pense appears to be overstated by OJ,1JE (S O15,F66 recorded - O11,@1I estimated). This overstatement represents appro+imately IK to 7K of net income and, thus, is fairly significantG however, since it overstates an e+pense, it understates net income. The auditor could either accept the balance or suggest that the client ma%e an ad-ustment.

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Exhibit 7 Lakeside Company +""o)nt 5857 0stimated 2on)s 0<pense7 o% Nine =ont&s ended 8eptem(e% 307 2008 and 2009 2008 Bonus Plan 8T3!0 No.1 C2737000 77900 1627600 457200 97600 487200 2> 964 8T3!0 No.2 C3977800 257190 2397300 597200 287400 457710 2> 914 8T3!0 No.3 C2367100 117950 1387200 397300 127000 347650 2> 693 8T3!0 No.4 C2427300 147050 1377200 387600 137200 397250 2> 785 8T3!0 No.5 C3737000 307010 2297000 547800 307000 297190 2> 584 8T3!0 No.6 C1107800 117300 687100 327300 127000 ?127900@ 2> 0 T3T+L 8T3!08 C176337500 1007400 9747400 2697400 1057200 1847100 2> 37940

8a6es -8a6es !et)%ns -Cost o 8a6es -'i%. 8a6. 0<p. -!ent D2on)s 2asis < 2on)s > D2on)s 2009 Bonus Plan

8a6es -8a6es !et)%ns -Cost o 8a6es -'i%. 8a6. 0<p. -!ent D2on)s 2asis < 2on)s > D2on)s

8T3!0 No.1 C3197900 127200 1857300 517200 107500 607700 4> 27428

8T3!0 No.2 C3987900 297900 2287400 597300 337000 487300 4> 17932

8T3!0 No.3 C4587800 497500 2317100 407400 137200 1247700 4> 47988

8T3!0 No.4 C2657400 197850 1527400 417200 147000 377950 4> 17518

8T3!0 No.5 C3647600 487250 2187000 557100 327000 117250 4> 450

8T3!0 No.6 C1217200 137700 737800 327300 127200 ?107500@ 4> 0

T3T+L 8T3!08 C179287800 1737400 170887900 2797400 1147700 2727400 4> 117316

Notes, Lakeside makes an Eimp)ted %entE "&a%$e to 8to%e No. 6 o% t&e p)%pose o dete%minin$ t&is (on)s. 8a6es ?+*C 500@F 8a6es !et)%ns ?P%epa%ed (y C6ient@F Cost o 8a6es ?+*C 550@F 'i%e"t 8a6a%y 0<pense ?+*C 580@F !ent ?P%epa%ed (y C6ient@.

SU!!"ST"# ANS$"%S TO SA%(AN"S)O'L"* &U"STIONS During the audit of the internal control system (<ect E6E), the C !s can conclude that the management report on their evaluation and audit of the system is fairly stated and that the system wor%s as it was designed and the design is effective. That is the best case situation. roblems create other reporting options based on whether the management report identifies the problem, or the C !s have found a problem that is unreported by the management. 3t is possible to conclude that the management report is fair and the system is ineffective and the significant deficiencies have been identified both in the management report and the C ! internal control audit. U 2anagement=s report. 2anagement will state its responsibility for maintaining

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ade1uate internal control over financial reporting and give its assessment of whether or not internal control over financial reporting is effective. !ccording to the rules, management cannot state that internal control over financial reporting is effective if even one material wea%ness e+ists at year-end. U !uditor=s report. The independent auditor will evaluate and report on the fairness of management=s assessment. The auditor also will perform an independent audit of internal control over financial reporting and will issue an opinion on whether internal control is operating effectively as of the assessment date (i.e., the company=s fiscal year-end). 3f one or more material wea%nesses e+ist at the company=s fiscal year-end, the auditor cannot conclude that internal control over financial reporting is effective. <ource. 3nternal Control over /inancial *eporting. !n 3nvestor *esource, December >66E by. Deloitte V Touche AA G 4rnst V )oung AA G P 2Q AA G ricewaterhouseCoopers AA . Documenting a significant deficiency could appear as in this e+ample. ! material wea%ness is a control deficiency, or combination of control deficiencies, that results in more than a remote li%elihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material wea%ness has been identified and included in management=s assessment. The company has no effective human resource function and personnel files are inade1uate to assure approval of salaries and wages. 3n addition, salaries are not approved by the board of directors. This material wea%ness was considered in determining the nature, timing, and e+tent of audit tests applied in our audit of the >66? financial statements, and this report does not affect our report dated Csame date as belowD on those financial statements. <ource. erspectives on 3nternal Control *eporting ! *esource for /inancial 2ar%et articipants, December >66E by. Deloitte V Touche AA G 4rnst V )oung AA G P 2Q AA G ricewaterhouseCoopers AA . CBote. ayroll e+ample was not in the original 1uoted materialD.

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CASE 8 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) ! number of reasons could e+plain a difference between the physical inventory count and a company's perpetual inventory records. #hen faced with any discrepancy such as this, the auditor should consider all possible causes. The perpetual records may be in error. ! large volume of transactions are processed during the course of a year, and some amount of human error is to be e+pected in the recording. The cost flow assumption (/3/9, in this case) may have been improperly applied in the perpetual records. The inventory may have been counted incorrectly by the company. 2erchandise on hand, for e+ample, could have been overloo%ed. 3nventory might be out on consignment. 3nventory might have been stolen. Damaged or obsolete inventory may have been disposed of by the company without recording a reduction in the subsidiary ledger. Qoods in transit could have been incorrectly handled in either the perpetual records or the physical inventory. The rollbac% procedure used to arrive at the December @1 year-end figure may have been incorrectly applied. The specific cost assigned to each inventory item might have been incorrect in certain cases. The final inventory listing (4+hibit J-E) may have been e+tended or footed erroneously.

The 1uestion as to whether the OI,666 difference warrants further attention is sub-ect to the auditor's -udgment. <ince the financial records are ad-usted to agree with the physical inventory, the auditor is primarily interested in potential errors contained in the counted figure. 3f 2itchell has appropriately observed the 83

ta%ing of the physical count, the possibility of errors in the 1uantity of inventory should be at a minimum. !dditional testing, such as verifying the costing, the e+tensions, and the footings will further reduce the ris% of a material error in the figure to be reported. The presence of perpetual records adds another dimension to the inventory verification. ;y comparing the ending figures from the physical count with the perpetual records, the auditors can determine whether differences are connected with the 1uantity or the unit cost for the individual inventory items. 3f the OI,666 is primarily created by 1uantity differences, the auditors should consider the need for selected recounts. Conversely, if the difference is based on costing variances, the auditors will concentrate on establishing the validity of those particular figures. ! 1uestion may be raised by the students as to the reasonableness of a OI,666 difference between the physical count and the perpetual inventory records. /or a company having O@.F million in cost of goods sold and a warehouse with over OIF6,666 in inventory, this difference is not significant in si0e even with the use of a perpetual system. ! more important issue would be the composition of the difference. 3f a great number of items are not in agreement with the records and simply net to a OI,666 variance, the auditors have reason to be concerned. Conversely, if only a few items display differences, verification is much easier. (>) !n over-count of inventory leads to a decrease in cost of goods sold and, thus, an increase in reported net income. 3n any situation in which the company desires a high reported income (for e+ample, to maintain high stoc% prices, in anticipation of a loan or a bond issuance, to reach the level anticipated by a financial forecast, etc.), over-counting of inventory must be of concern to the auditors. This possibility is especially relevant to the Aa%eside stores because of the profit-sharing plan. The inventory is being counted by the manager and assistant manager of each store, the same people who receive a bonus based on that store's net income. Therefore, these employees can increase their bonus for the current year simply by over-counting the inventory. (@) !n undercount of ending inventory leads to an increase in cost of goods sold and a decrease in reported net income for the current year. The most obvious reason for a company to undercount ending inventory is to defer payment of income ta+es. ! manipulation of this %ind would be especially tempting to a company e+periencing cash flow problems. 9ther reasons for undercounting inventory may be encountered but are less compelling than the motive to overcount. 9ne

84

possible incentive is to push earnings from a very high performance year into the ne+t to smooth out a growth curve and avoid having to achieve that record again in the following year. 3n a different vein, if the company must undergo union contract negotiations in the near future, reporting less net income might prove to be advantageous. 8owever, little evidence e+ists in this case to indicate that Aa%eside's management would be tempted to reduce reported earnings e+cept possibly for the accompanying reduction in current ta+es. (E) 3n the engagement letter prepared by !bernethy and Chapman (see 4+hibit @-1), the firm stated that it e+pected (to obtain reasonable but not absolute assurance that ma-or misstatements do not e+ist.( #hen a material misstatement goes undetected and is reported in the client's financial statements, the 1uestion to be raised concerns the difference between reasonable and absolute assurance. 3n assessing responsibility in such cases, the public accounting firm is -udged against the wor% of the average prudent auditor. The firm must provide proof that the e+amination was performed at least as well as would have been done by the average prudent auditor. 3f a misstatement is missed that would have been detected by the average prudent auditor, the firm is normally considered to be guilty of negligence in the performance of the audit e+amination. 3n that case, any losses incurred by the client company resulting from this mista%e can be recaptured from the firm. 8owever, because Aa%eside is privately owned, the C ! firm will probably be liable to third parties for losses only if gross negligence can be proven. 7nfortunately, the distinction between negligence and gross negligence is not clearly delineated by the courts. (F) ! decision to observe less than 166K of the ending inventory always e+poses the auditor to some degree of ris%. This ris% is based on the possibility that a material misstatement e+ists in the inventory not being observed. Three factors would reduce that ris% level in the audit of the Aa%eside Company. /irst, according to the <eptember @6, >665, trial balance, the inventory at the warehouse ma%es up nearly J6K of the total inventory owned by Aa%eside. Thus, the possibility of a material problem in the inventory held at the stores is limited. <econd, the perpetual records enable the auditors to isolate variances at all stores which can then be sub-ected to recounts or further testing if necessary. Third, Aa%eside appears to have an efficient system of ta%ing the physical inventory. 7nless 2itchell and her staff spot wea%nesses in the actual procedures in use, the efficiency of this system offers assurance that the count in each store has been accurate.

85

(I) 9ne method of manipulating net income is to record sales in one year with recognition of any subse1uent returns being delayed until the following period. Bormally, this problem is overcome by a year-end ad-ustment to establish an estimation of all subse1uent returns. !s evidence of the validity of this estimation, the auditor will review any sales returns received at the beginning of the new year. The auditor should be aware that companies can alter reported earnings significantly by shipping out large 1uantities of inventory at the end of a year %nowing that most of the items will be returned. 3f the shipments are recorded immediately as sales, while the returns are estimated based on historical data, the company can overstate current income. (7) !s indicated in Luestion (>), above, over-counting of inventory is a potential concern in any audit but especially so in the Aa%eside engagement. 2itchell records the last tag number as a preventive measure against the preparation of falsified tags subse1uent to her observation. (J) This 1uestion can generate debate among students who often e+pect the auditors to perform e+tensive auditing procedures in regard to damaged and obsolete merchandise. 3n reality, 2itchell's role is that of an observerG damaged or obsolete inventory is the client's responsibility. The Aa%eside memorandum clearly indicates that company employees should separate these items prior to the inventory count. 2itchell will want to verify that all damaged or obsolete inventory items have been segregated and correctly valued. 3f she is convinced that such inventory has been isolated, she needs only to ascertain that the value has been appropriately established by the company. 3f 2itchell is not satisfied by the method used to value these items, especially if the total is material, she has the option of calling upon an independent appraiser to assist her in substantiating the valuation process. ! different problem arises if 2itchell discovers any damaged or obsolete inventory that has not been separated from the rest of the merchandise. 7nless the client can provide a reasonable e+planation, this discovery casts doubts on the reliability of the counting process. 2itchell may then need to e+tend her testing procedures to search for further evidence of such inventory.

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(5) Aa%eside's procedures for ta%ing its physical inventory seem well designed especially since perpetual records are available for comparison purposes. ;y following the process outlined in 4+hibit J-1, the company should be able to arrive at an accurate ending inventory figure. SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) !n audit program designed to verify the inventory listing and the reconciling items would include steps such as the following. a. Trace the tags recorded by the auditor (4+hibit J-@) to the physical inventory listing (4+hibit J-E), noting agreement as to description and 1uantity. Merify that no tags were added to the inventory listing beyond the last tag recorded by the auditor. /or each of the inventory items recorded by the auditor, compare the unit cost indicated on the inventory listing with the cost per the master price list (4+hibit I-I). Bote agreement as to description as well as unit cost. (Bote. <tudents may choose to select a new sample for this and the remaining tests. The advantages to using the same sample throughout are that recording on the wor%ing paper may be simplified and efficiency gained.) /or each of the inventory items recorded by the auditor, mathematically verify the e+tensions on the physical inventory list. *efoot the inventory listing. 7sing the master price list, compute a cost for the Ranuary 1->, >616, receiving reports. Compare this total to the inventory listing for agreement. 7sing the master price list, compute a cost for the Ranuary 1->, >616, bills of lading. Compare this total to the inventory listing for agreement. *eview the inventory listing to ascertain that all tag numbers are included with no duplications. ;y review of Cypress discount announcements, establish validity of monthly discounts included in inventory listing. (#ith the information included in this

b. c.

d. e. f. g. h. i.

87

case, this step will not be possible for the students to perform.) -. % *ecompute the @K discount ta%en by Aa%eside and compare this amount with the inventory listing noting agreement. !gree the (total ad-usted cost of inventory - 1>:@1:65( to the general ledger at December @1, >665.

(>) 9ne techni1ue for approaching this case is to assign Luestion (1) for one class period with the wor%ing paper to be prepared only after review of the students' audit programs. This procedure helps to stress the connection between preparing an audit program, evidence gathering, and developing a wor%ing paper. 3t demonstrates a continuum from. establishing the audit procedures to be performed, to indicating the steps actually ta%en by the auditor, to documenting the evidence collected.

3n reviewing the audit documents prepared by the students, the instructor should insist that each specific audit procedure be spelled out along with the results of that testing. !s always, the wor%ing paper should be clear and complete, but it must also indicate the fulfillment of each audit program step. The attached wor%ing paper has been created as an e+ample. 3t was produced to correspond with the audit procedures outlined in 4+ercise (1). 3n completing this assignment, procedure (i) has not been performed because the information was not made available in the case. 3n addition, the wor%ing paper has been prepared under the assumption that all goods are sold f.o.b. shipping point and all purchases are ac1uired f.o.b. destination. These assumptions have been made to simplify the audit testing, but the students may want to discuss the additional procedures that would be re1uired if other f.o.b. points had been appropriate.

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Lakeside Company Tests o -n#ento%y Listin$--Wa%e&o)se 12*31*09

Inventory Item +mp6i ie%s Component 8ystems 2eepe%s 8te%eo 8ystems +mp6i ie%s 8peake%s 8te%eo 8ystems C' P6aye%s !e"ei#e%s 8te%eo 8ystems LC!s 8peake%s Kead P&ones C' P6aye%s a! "o# 116 124 102 138 130 150 127 142 113 126 104 137 147 132 $erial "umber 2C76-W 9245-= C221-8 1A87-! GH54-T I/28-I !+69-= !W21-J N273-J 9K88-+ CH55-K 2123-/ P388-M C'00-N %uantity 22 69 80 60 88 71 99 49 112 77 46 84 49 121

WP ; 1-3 p. 1 P%epa%ed (y, /1E1#E1$ !e#ie5ed (y,

&udit Pro'edures

+)dit 3(4e"ti#es, To #e%i y t&at t&e p&ysi"a6 "o)nt s&e o(se%#ed a$%ees 5it& t&e in#ento%y 6istin$. To #e%i y t&at t&e in#ento%y 6istin$ p%o#ides a ai%6y p%esented in#ento%y "ost (a6an"e. 8"ope, -tems t&at 5e%e se6e"ted d)%in$ t&e in#ento%y o(se%#ation. 8ee WP 1-1 and 1-2. +)dit P%o"ed)%es, T%a"ed items to in#ento%y 6istin$ notin$ a$%eement as to des"%iption and :)antity. No e<"eptions noted. T%a"ed items %om in#ento%y 6istin$ to maste% p%i"e 6ist notin$ a$%eement as to des"%iption and )nit "ost. No e<"eptions noted. !e"omp)ted e<tensions on in#ento%y 6istin$. No e<"eptions noted. 3t&e% P%o"ed)%es, +$%eed 6ast ta$ ?;152@ on in#ento%y 6istin$ to WP 1-1. 1ooted in#ento%y 6istin$. No e<"eptions noted. +""o)nted o% se:)en"e o ta$ n)m(e%s on in#ento%y 6istin$. No e<"eptions o% d)p6i"ates noted. +)dit Con"6)sion, T&e in#ento%y 6istin$ is ai%6y stated.

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Lakeside Company Tests o -n#ento%y Co)nts--Wa%e&o)se 12*31*09 !e"ei#in$ !epo%ts ?9an)a%y 1-27 2010@
(ate and Item 9an. 17 10 Te6e#isions 9an. 27 10 Keadp&ones 9an. 27 10 Po%ta(6e C' P6aye%s Tota6 9245-K G932-G !J04-L )e'# )ep# 3988 3989 3989 %ty# 20 40 10

WP ; 1-3 p. 1 P%epa%ed (y, /1E1#E$< !e#ie5ed (y,

*nit Cost 481.87 32.00 285.99 otal Cost 97637.40 17280.00 27859.90 137777.30 &udit Pro'# N

2i66s o Ladin$ ?9an)a%y 1-27 2010@

9an. 17 10 9an. 17 10 9an. 27 10 9an. 27 10 9an. 27 10 9an. 27 10 9an. 27 10 Tota6 +mp6i ie% Te6e#isions 8te%eo 8ystems 8te%eo 8ystems !e"ei#e%s Te6e#isions 8peake%s JI76-! 2=09-K +215-= 9K88-+ C833-P +!65-C 2123-/ Bill + 6015 6015 6016 6016 6016 6016 6017 %ty 20 10 20 12 10 6 8 *nit Cost 219.95 812.35 256.98 324.00 698.98 17319.00 469.00 otal Cost 47399.00 87123.50 57139.60 37888.00 67989.80 77914.00 37752.00 427205.90 &udit Pro'# N

+)dit 3(4e"ti#e, To #e%i y t&at t&e %e"on"i6in$ items to t&e in#ento%y 6istin$ a%e #a6id and %easona(6e. 8"ope, +66 %e"on"i6in$ items to t&e in#ento%y 6istin$. +)dit P%o"ed)%es, +$%eed :)antity and des"%iption to WP 1-1. No e<"eptions noted. +$%eed to maste% p%i"e 6ist notin$ a$%eement as to des"%iption and )nit "ost. No e<"eptions noted. N +$%eed to in#ento%y %e"on"i6iation. 3t&e% P%o"ed)%es, !e"omp)ted dis"o)nts on in#ento%y %e"on"i6iation 5it&o)t e<"eption. 1ooted in#ento%y %e"on"i6iation 5it&o)t e<"eption. -n#ento%y ad4)stment o C67156.78 is immate%ia6. Pass )%t&e% 5o%k. +)dit Con"6)sion, -n#ento%y %e"on"i6in$ items a%e #a6id and %easona(6e.

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WP ; 1-1 P%epa%ed (y, P! 'ate, 1*12*09 Lakeside Company !0C3NC-L-+T-3N 31 PKI8-C+L -NL0NT3!I - W+!0K3A80 9an)a%y 37 2010 T3T+L C38T 31 -NL0NT3!I - 9+NA+!I 37 2010 - W+!0K3A80 C6647950.33 N Less, -n#ento%y !e"ei#ed on 9an)a%y 1 and 9an)a%y 2 ? %om !e"ei#in$ !epo%ts@ ?137777.30@ 1-3 p. 1 +dd, -n#ento%y 8&ipped 3)t on 9an)a%y 1 and 9an)a%y 2 ? %om 2i66s o Ladin$@ 407205.90 1-3 p. 1 T3T+L C38T 31 -NL0NT3!I - '0C0=20! 317 2009 - W+!0K3A80 C6917378.93 1 Less, +d4)stments o% =ont&6y 'is"o)nts /i#en (y Cyp%ess Ta$ 113 - 'is"o)nt C30.00 < 85 -tems P)%"&ased ? 27550.00@ ! Ta$ 121 - 'is"o)nt C 8.25 < 40 -tems P)%"&ased ? 330.00@ ! Ta$ 132 - 'is"o)nt C12.60 < 60 -tems P)%"&ased ? 756.00@ ! Ta$ 146 - 'is"o)nt C11.50 < 80 -tems P)%"&ased ? 920.00@ ! Ta$ 149 - 'is"o)nt C 6.50 < 35 -tems P)%"&ased ? 227.50@ ! 8A2-T3T+L C6867595.43 1 Less, +d4)stment o% 3> Cas& 'is"o)nt Taken on +66 -n#ento%y P)%"&ases ? 207597.86@ T3T+L +'9A8T0' C38T 31 -NL0NT3!I - '0C0=20! 317 2009 - W+!0K3A80 C6657997.57 1 L -NL0NT3!I -N W+!0K3A80 P0! P0!P0TA+L -NL0NT3!I !0C3!'8 ?6727154.35@ -NL0NT3!I +'9A8T=0NT ?!0'ACT-3N@ C? 67156.78@ 1 + -6.1 +)dit 3(4e"ti#e, To #e%i y t&at t&e in#ento%y (a6an"e is #a6id and %easona(6e. 8"ope, T&e 6istin$ to t&e in#ento%y (a6an"e %e"on"i6iation. P%o"ed)%es, N +$%eed to -n#ento%y Listin$ F 1ooted - !e"a6")6ated A +$%ees to T*2 +)dit Con"6)sion, T&e in#ento%y (a6an"e is ai%6y stated.

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CASE 9 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) !ny company which does not maintain an e+tensive accounting staff will often rely on the independent auditors for information concerning the application of authoritative pronouncements. 2ost C ! firms assume some responsibility for %eeping client companies aware of important accounting standards and the potential effects on financial reporting. Thus, *ogers' lac% of %nowledge about Statement 12 is not unusualG a bigger surprise might be that the company's auditors had not previously discussed the re1uirement with this client. (>) #here possible, e+pense accounting follows the matching principle which states that e+penses should be recogni0ed in the period in which they assist in generating revenues. !n asset produces no revenues prior to being placed into service. Therefore, any e+pense recognition (such as depreciation or interest) would be inappropriate during construction. 9nly after the asset is in use generating revenues, should any related e+pense be recorded. (@) Theoretically, the management of the client company prepares all financial figures which are then corroborated by the independent auditors. 8owever, Aa%eside apparently has no one on its staff with the e+pertise to ma%e this particular calculation. 3n such cases, the auditor is fre1uently forced to generate the data, and provide figures which are presented to the client as proposed ad-ustments. Aa%eside should be warned though that this tas% is outside the realm of a normal audit and, if e+tensive, may re1uire an additional fee. (E) This 1uestion offers another opportunity for interesting class discussion. <tudents often view accounting as a discipline in which all 1uestions can be ultimately resolved by an ade1uate %nowledge of accounting standards. 3n this instance, they face a case of financial statement manipulation that is being carried out by the client within the framewor% of accounting's own official guidelines. ! review of /!<; Statement 31 can be assigned to assist the

92

students in analy0ing this case.

aragraph >5 of this pronouncement states.

(3nsofar as the separate financial statements of the related parties are concerned, the classification and accounting shall be the same as for similar leases between unrelated !arties e+cept in cases where it is clear that the terms of the transaction have been significantly affected by the fact that the lessee and lessor are related. 3n such cases the classification and:or accounting shall be modified as necessary to recogni0e economic substance rather than legal form. The nature and e+tent of leasing transactions with related parties shall be disclosed.( !fter reading /!<; Statement 31, students may argue that the lease is actually for a number of years (probably the life of the building) and that the proposed series of one-year contracts is only a sham to create the appearance of an operating lease. 3n reality, the lease (or so this argument would go) is for over 7FK of the economic life of the property. 8owever, if new lease payments are to be negotiated each period (or if Aa%eside intends to stay for only a short time in that location), a legitimate economic reason may e+ist for this arrangement. 7nless Aa%eside can show such a rationale for the one-year leases, the auditor will probably use the (actual( life of the lease as -ustification for re1uiring capitali0ation. The auditors also need to verify that the O>1,666 payment for the building has not been (significantly affected( by the relationship between Aa%eside and *ogers. !bernethy and Chapman will want to learn how this figure was determined and, perhaps, see% information about rental rates for similar property in the vicinity of that store. *ogers states that (the price is 1uite reasonable for that store at that location,( but his opinion does not provide the auditors with much assurance. *egardless of the accounting, as a related party transaction, the auditors must ensure that the nature and e+tent of the lease has been fully disclosed within the financial statements. *ogers has indicated that such reporting will be made. 4ven if the lease were deemed to be an operating lease, the information included within these notes could be used by readers to come to an understanding of the nature of this transaction. This case indicates the importance of a complete %nowledge of accounting. ! decision-ma%er need not be limited to wor%ing with -ust the numbers presented in financial statements but should become capable of using and understanding all of the information that is provided. CBote. !nother interesting issue is whether or not the *ogers Development Company is a variable interest entity (M34) that should be consolidated, as defined in /!<; nter!retation No. 24. <ee the (!pply )our *esearch( section for this caseD.

93

(F) The recording of accounting information is normally based on ob-ective evidence gathered by analy0ing the impact of transactions that occur between the reporting entity and outside parties. 8owever, related party transactions do not provide evidence with the same degree of ob-ectivity. <ales prices or contracts, for e+ample, might not be negotiated as they would otherwise be with outsiders. /igures may simply be fi+ed by management. Conse1uently, to inform the financial statement readers of the impact of these dealings, the relationship must be described along with the details of the transactions. (I) The potential impairment of value of <tore <i+ has been an underlying problem throughout the Aa%eside audit. 3n discussing this issue, students fre1uently concentrate on the wrong issues. client retention versus safety from litigation. !udit opinions, however, should be based on the actual evidence accumulated and the related reporting employed by the client, not on the avoidance of problems. <uch a limited approach fails to recogni0e the auditor's function. to gather corroborative evidence on which to base an opinion as to the fair presentation of the financial statements. Mirtually no corroborative evidence is presented in these cases in connection with <tore <i+ and its potential impairment of valueG therefore, students have no basis for any specific course of action. 3n practice, auditors first gather as much evidence as possible and only then do they ma%e a final determination when faced with this type problem. <tudents can be as%ed to list the %inds of evidence !bernethy and Chapman might see% in evaluating the possibility of a material impairment of value in connection with <tore <i+. This e+ercise is a good techni1ue for demonstrating the necessity of creativity in the auditor's wor%. The auditor needs to consider all possible ways to gain assurance about the future of this store. ! few of the evidence-gathering procedures that might be carried out would include. Discussion with the owners and managers of the shopping center as to their strategies for renting more space and improving customer traffic. /urther in1uiry of *ogers as to a -ustification for his favorable forecast regarding this store. 3f these pro-ections are based on tangible data or on specific plans, the auditors will have much more assurance than if *ogers is simply acting on intuition. Tal% to owners and managers of the stores located in the shopping center to see whether their pro-ections are similar to those of *ogers. <earch for any studies that have been prepared on the consumer 94

electronics business which might a) pro-ect a brea%-even point for a store or b) assess the ris%s involved in the failure of a single outlet. 8ire a real estate appraiser to estimate the sales value of the building if it should have to be sold. This valuation will enable the auditor to anticipate the potential loss being faced by Aa%eside.

9ne final point should be made in connection with this potential impairment of value. The implication is made throughout these cases that the primary responsibility for resolving this issue lies with the auditors. That is not correct. The financial statements are representations of the management of the client company. !s such, management is responsible for -ustifying the financial reporting. 7nless *ogers ma%es a significant attempt to prove his present position in this controversy, the auditors will have trouble rendering an un1ualified opinion. (7) Aittle doubt e+ists that *ogers has issued a subtle threat to the new audit firm. 9ne of the primary reasons for investigating the integrity of management prior to accepting an engagement is to avoid the possibility of this type of blac%mail. This warning was issued in such a way by *ogers that !bernethy and Chapman will probably not need to consider the possibility of resigning but, if a similar threat is ever made in an overt manner, immediate resignation by the C ! firm should be considered. SU!!"ST"# ANS$"%S TO "'"%CIS" (1) This assignment re1uires the students to analy0e the client's #arehouse account. 3n this case, for the first time, no audit program is available. The students must determine which procedures to perform and then record the actions ta%en as well as the evidence accumulated. The instructor may want to discuss this re1uirement by simply as%ing the class what evidence-gathering techni1ues should have been carried out by the auditor. !n e+ample of a completed wor%ing paper for this assignment is attached.

95

L+G08-'0 C3=P+NI 2)i6din$-Wa%e&o)se*3 i"e +*C 111-1 12*31*09

W.P. --3 2 +""o)ntant, A8 'ate, 1E1:E1$

2a6an"e pe% (ooks7 1*1*09 +dditions in 2009 ?Ne5 Wa%e&o)se Const%)"tion@ 3145 3189 3214 3228 /%ade 6and and po)% o)ndation 3"to(e%-Wa%e&o)se Const%)"tion No#em(e%-Wa%e&o)se Const%)"tion !oo in$ %epai% and 5a%e&o)se "onst%)"tion + P%oposed +d4)stments o% 5a%e&o)se "onst%)"tion, + 2 C ' 0 P%oposed +d4)stment+90;1 P%oposed +d4)stment+90;2 P%oposed +d4)stment+90;3 8)(tota6 ?5a%e&o)se "onst%)"tion e<"6)din$ inte%est@ P%oposed +d4)stment-inte%est +90;4 8)(tota6 ?5a%e&o)se "onst%)"tion in"6)din$ inte%est@ P%oposed %e"6assi i"ation+90;5 +d4)sted Tota6

1637500-

217800167900257300147600-

O 37500- P 1771001760093780027345967145O 967145- P 1637500-

+)dit 3(4e"ti#e, To #e%i y t&e ai% p%esentation o t&e E2)i6din$--Wa%e&o)se*3 i"eE a""o)nt. 8"ope, +66 "&a%$es and potentia6 "&a%$es to t&e a""o)nt.

+)dit P%o"ed)%es, T%a"ed to 12*31*08 a)dited (a6an"e pe% p%ede"esso% a)dito%Bs a)dit do")ments notin$ a$%eement. ?Note, +6t&o)$& ne"essa%y7 t&is p%o"ed)%e "annot (e pe% o%med 5it& t&e in o%mation $i#en in t&is te<t.@ T%a"ed to $ene%a6 6ed$e% notin$ a$%eement. +6so7 t%a"ed to p)%"&ase in#oi"e notin$ a$%eement as to amo)nt7 and app%o#a6. 3t&e% +)dit P%o"ed)%es, 0<amined 9*1*09 min)tes o 2oa%d o 'i%e"to%sB meetin$ notin$ app%o#a6 o% e<pansion. 0<amined (ank "on i%mation %om Li%$inia Capita6 8e")%ity 2ank indi"atin$ 6ien on 5a%e&o)se in "onne"tion 5it& C1007000 6oan. P%oposed +d4)stments, 8ee ne<t pa$e.

96

L+G08-'0 C3=P+NI 2)i6din$ - Wa%e&o)se*3 i"e +*C 111-1 12*31*09 P!3P380' +'9A8T=0NT8 + 640-1 111-1 2 111-1 210-2 C37400 %oo %epai% in"o%%e"t6y "6assi ied in asset a""o)nt. +90 1 !epai%s and =aintenan"e 35002)i6din$-Wa%e&o)se*3 i"e

W.P. --3 1 +""o)ntant, A8 'ate, 1E1:E1$

3500-

-n#oi"e o% 'e"em(e% 5o%k (y Kei6man Const%)"tion %e"ei#ed a te% yea%-end. +90 2 2)i6din$-Wa%e&o)se*3 i"e 17100+""o)nts Paya(6e 17100-

C -n#oi"e o% 5o%k done 12*28*09-1*8*10 (y /aine% 06e"t%i"a6 Company %e"ei#ed a te% yea%-end. +""%)e o)% days ?4*12 < C47800D C17600@. +90 3 111-1 2)i6din$-Wa%e&o)se*3 i"e 1600210-2 +""o)nts Paya(6e 1600' Capita6iQe inte%est on ()i6din$ 6oans. T&is i$)%e is %o)$&6y estimated (ased on t&e e<pendit)%es on "onst%)"tion ? %om Es)(tota6E on p%e#io)s pa$e@ o C9378007 t&e inte%est %ate "&a%$ed on t&e di%e"t 6oan7 10>7 and t&e time o "onst%)"tion d)%in$ 2009 ?3 mont&s %om 3"to(e% to 'e"em(e%7 pe% t&e in#oi"es in 0<&i(it 9-6@. T&)s7 C937800 < .10 < 3*12 D C27345. 111-1 220-1 0 Ne5 a""t. 111-1 +90 4 2)i6din$-Wa%e&o)se*3 i"e +""%)ed -nte%est Paya(6e 23452345-

Wa%e&o)se e<pansion not in se%#i"e at 12*31*09. !e"6assi y to ne5 a""o)nt. +90 5 Const%)"tion in P%o$%ess-Wa%e&o)se 2)i6din$-Wa%e&o)se*3 i"e 9614596145-

+)dit Con"6)sion, +""o)nt is ai%6y stated7 a te% ad4)stments7 in a""o%dan"e 5it& /++P.

97

SU!!"ST"# ANS$"%S TO SA%(AN"S)O'L"* &U"STIONS

?1@ M)otin$ %om t&e +"t, 8e"tion 301, P)(6i" Company +)dit Committees. 0a"& mem(e% o t&e a)dit "ommittee s&a66 (e a mem(e% o t&e (oa%d o di%e"to%s o t&e iss)e%7 and s&a66 ot&e%5ise (e independent. E-ndependentE is de ined as not %e"ei#in$7 ot&e% t&an o% se%#i"e on t&e (oa%d7 any "ons)6tin$7 ad#iso%y7 o% ot&e% "ompensato%y ee %om t&e iss)e%7 and as not (ein$ an a i6iated pe%son o t&e iss)e%7 o% any s)(sidia%y t&e%eo . T&e 80C may make e<emptions o% "e%tain indi#id)a6s on a "ase-(y-"ase (asis. T&e a)dit "ommittee o an iss)e% s&a66 (e di%e"t6y %esponsi(6e o% t&e appointment7 "ompensation7 and o#e%si$&t o t&e 5o%k o any %e$iste%ed p)(6i" a""o)ntin$ i%m emp6oyed (y t&at iss)e%. T&e a)dit "ommittee s&a66 esta(6is& p%o"ed)%es o% t&e E%e"eipt7 %etention7 and t%eatment o "omp6aintsE %e"ei#ed (y t&e iss)e% %e$a%din$ a""o)ntin$7 inte%na6 "ont%o6s7 and a)ditin$. 0a"& a)dit "ommittee s&a66 &a#e t&e a)t&o%ity to en$a$e independent "o)nse6 o% ot&e% ad#iso%s7 as it dete%mines ne"essa%y to "a%%y o)t its d)ties. 0a"& iss)e% s&a66 p%o#ide app%op%iate )ndin$ to t&e a)dit "ommittee. ?2@ M)otin$ %om t&e a"t, 8e"tion 302, Co%po%ate !esponsi(i6ity 1o% 1inan"ia6 !epo%ts. T&e C03 and C13 o ea"& iss)e% s&a66 p%epa%e a statement to a""ompany t&e a)dit %epo%t to "e%ti y t&e Eapp%op%iateness o t&e inan"ia6 statements and dis"6os)%es "ontained in t&e pe%iodi" %epo%t7 and t&at t&ose inan"ia6 statements and dis"6os)%es ai%6y p%esent7 in a66 mate%ia6 %espe"ts7 t&e ope%ations and inan"ia6 "ondition o t&e iss)e%.E + #io6ation o t&is se"tion m)st (e kno5in$ and intentiona6 to $i#e %ise to 6ia(i6ity.

98

CASE 10 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) The sheer 1uantity of transactions that are processed by most modern corporations prohibits the auditor from attempting to evaluate more than a portion of the total. 2any large companies record millions of transactions per year, a number that could not possibly be verified by an audit team at an acceptable cost. 4ven if complete testing were possible, nonsampling ris% would still e+ist because of potentially unrecorded transactions, fraudulent transactions, and auditor errors and oversights. Rust as importantly, independent auditors are employed to provide reasonable rather than absolute assurance as to the fair presentation of a company's financial statements. The desired degree of assurance can be achieved without e+amining every item. Thus, some amount of ris% is tolerated in the testing procedures being applied. <tatistical sampling allows certain aspects of that ris% to be measured mathematically. !uditors use statistics to determine the number of items that should be e+amined to reduce sampling ris% to a level that is considered -ustified. (>) <tatistical sampling does not create additional wor%G rather, it guides the auditor in performing the proper amount of wor%. 3n addition, although statistical sampling may initially appear to be comple+, the various procedures become significantly easier with practice. 3n any sampling plan (statistical or -udgmental), a degree of uncertainty about the final results must be accepted. <tatistical sampling allows the auditor to set in advance the amount of ris% that is acceptable for a particular test. 2athematical formulas and charts then enable the auditor to compute the si0e of the sample that is necessary to reduce the ris% involved to this tolerable level. Computer programs ma%e these calculations 1uic% and easy. !n auditor who appropriately calculates a sample si0e of J5, for e+ample, %nows that the e+amination of this number of items will provide results within predetermined parameters. <tatistical sampling also forces the auditor to consciously consider several important aspects of the specific testing procedure. 3n this case, 2itchell has to analy0e the type of wor% being performed by the client and then set an acceptable ris% of assessing control ris% too low (!*!C*). <he must also evaluate the ability of the client personnel and estimate an e+pected population e+ception rate. /inally, she has to arrive at a tolerable e+ception rate, the 99

highest rate at which reliance can be -ustified. !ll of these considerations are important in applying this audit procedure. The statistical sampling plan being used by !bernethy and Chapman re1uires the auditor to consider each of these limits before testing can begin. (@) <ampling for attributes is utili0ed whenever an auditor wants to estimate the occurrence rate of a specified characteristic. This procedure is fre1uently applied in tests of controls where the auditor is see%ing to measure the prevalence of errors made by employees in following the control procedures built into a particular accounting system. Thus, the auditor is attempting to determine a rate the percentage of errors committed. !lthough sampling for attributes has other uses within an e+amination, it does enable the auditor to derive this specific information being sought in a test of controls. (E) 2itchell is see%ing to verify that a proper cut-off has been performed by the client in recording its year-end accounts payable and accrued e+penses. 3n this process, a number of invoices are to be reviewed to ensure that Auc% has appropriately determined the amount owed by Aa%eside on December @1, >66I. !t the same time, the auditor can also ascertain that a purchase re1uisition has been prepared for each of these invoices. 2itchell may also elect to e+amine the invoices to determine if physical evidence e+ists to indicate that each document has been mathematically proven and properly authori0ed by company personnel. Thus, several testing procedures can be carried out simultaneously by the audit team. (F) 9nce again, as in 1uestion (1), the auditor is see%ing only reasonable, not absolute, assurance about the fair presentation of the client's financial statements. Thus, the presence of some errors, especially if they are not material, does not necessarily nullify the value of the information. 3n addition, the auditor rarely relies e+clusively on the wor% of one particular individual in ma%ing an assessment. Auc%'s analysis will provide evidence about this e+pense accrual, but other testing should be carried out before the audit team is satisfied that the account balances are fairly presented. Auc% might commit mista%es for a number of reasons, most of which involve human errors caused by carelessness, fatigue, misunderstanding, etc. <he may, for e+ample, misread an invoice or miscalculate the amounts involved. <he

100

could also omit an invoice entirely or include one a second time by accident. The possibility also e+ists that Auc% might have purposely misrepresented the yearend accrual as a way of manipulating the income figures to be reported by the company. (I) 3n most e+aminations, previous e+perience with the client and its personnel will assist the auditor in arriving at an estimation of an actual e+ception rate. 8owever, the firm of !bernethy and Chapman has not audited Aa%eside in the pastG thus, 2itchell must rely more heavily on other techni1ues. To begin, she should ascertain the difficulty of the tas% being performed. <he will also have had the opportunity to observe Auc%'s wor% throughout the engagement and should hold some opinion as to the reliability of this employee. <he may do a pilot test, choosing a relatively small random sample to see what the sample e+ception rate is. /inally, from e+perience with other clients, the auditor can usually anticipate an e+ception rate for a particular tas%. (7) The IK figure established by 2itchell in this case is a good e+ample of the importance of an auditor's being able to use -udgment developed through e+perience. The selection of this rate was undoubtedly influenced by a number of factors such as the si0e of Aa%eside's accrual, the ade1uacy of other testing procedures, 2itchell's evaluation of Auc%'s ability, the ris% involved in accepting an incorrect accrual, e+perience with other audit clients, etc. 8owever, after assessing these and other possible variables, the ultimate decision as to the line between reliance and non-reliance must always lie with the auditor. (J) !ccording to 4+hibit 16->, a sample si0e of E6 (left column) with > errors (top row) indicates a ma+imum error rate of 1>.JK with a 16K !*!C*. <ince 2itchell has specified a tolerable e+ception rate of only IK, she cannot accept the client's wor% as a fair representation of the amount of the year-end accrual. The client's total accrual figure may, indeed, still be accurate, but the sample indicates the possibility of too many errors for the accrual to be -udged as reliable. The error rate indicates that the ris% level is too high for auditor acceptance without additional testing.

101

(5) 3n most cases, the auditor would now see% to apply other procedures to verify the reported balance. The client might, for e+ample, be re1uested to reconstruct the accrual with the newly derived balance then being tested, again using sampling for attributes. 8owever, because of the small population si0e in this case, 2itchell may simply resort to reviewing all >J@ invoices to achieve ade1uate assurance about the accrual. !fter analy0ing the entire population, the auditor can either accept the client's accrual or propose an ad-ustment. SU!!"ST"# ANS$"%S TO "'"%CIS"S (1-a) !;4*B4T8) !BD C8! 2!B <ampling for !ttributes Client. The Aa%eside Company )ear 4nding. December @1, >665 !udit !rea. !ccrued 4+penses Date of Testing. /ebruary E, >616 (1) <tate the ob-ectives of the audit testing. To verify the year-end accrual of e+penses developed by the client. (>) Define the attribute or attributes to be estimated. The e+ception rate made by the client in determining the year-end liability owed in connection with invoices received during December >665, and Ranuary >616. (@) Define the population. !ll invoices received by the company during December >665, and Ranuary >616. (E) Define the sampling unit.

102

4ach individual invoice and the accrual established for it as of December @1, >665. (F) <pecify the acceptable ris% of assessing control ris% too low and discuss any factors affecting this decision. 16K (Bo information is presented in this case to indicate how this ris% level was derived. This is typically either FK or 16K). (I) 4stimate the e+ception rate of the population, and discuss any factors affecting this estimation. @K (Discussion Luestion I above e+amines the factors that should have influenced this estimation.) (7) <pecify the tolerable e+ception rate and discuss any factors affecting this decision. IK (Discussion Luestion 7 above e+amines the factors that should have influenced this parameter.) (J) 3ndicate the sample si0e and show the use of the finite correction factor if applicable. 56 4+hibit 16-1 is appropriate for a 16K !*!C*. The e+pected population deviation rate of @K is found in the left column with the tolerable deviation rate of IK found across the top. These two figures intersect at a sample si0e of 1@>. The finite correction factor presented in the case can be applied as follows. !ppropriate <ample <i0e S
132 = 90 132 1+ 283

(5) 3ndicate the method used to draw a random sample. *andom number generator on the C ! firm's computer. (16) 3ndicate the number of deviations discovered, the rate of deviations in the sample, and the upper deviation rate in the population.

103

Two errors were discoveredG the sample e+ception rate is >.>K rounded (>:56)G and from 4+hibit 16->, two deviations found in a sample of 56 items indicates a ma+imum rate of F.JK (C74*) with a 16K !*!C*. (11) /rom a 1uantitative perspective, is the population reliable" (3nclude the rationale for your answer). #ith a 16K !*!C*, the sample indicates that Auc%'s accrual of yearend e+penses has a C74* of F.JK. (1>) Describe the types of deviations that were found. The two errors are of relatively small amounts and appear to be caused by mathematical mista%es. (1@) *ecommendations. Auc%'s analysis should be considered a fair representation of the yearend accrual derived from these >J@ invoices. 8owever, the possibility still e+ists that other invoices have been omitted either accidentally or to manipulate net income. Thus, a search should be made for liabilities which are unrecorded. (1-b) 3f three errors were found, then the results for 1uestions (16) through (1@) of 4+hibit 16-@ would be different. #ith three errors, the sample e+ception is @.@K rounded (@:56)G and from 4+hibit 16->, three deviations found in a sample of 56 items indicates a C74* of 7.@K with a 16K !*!C*. <ince the tolerable rate was IK, her wor% should not be considered reliable based on the number of errors it contains.

104

CASE 11 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) <tatistical sampling re1uires the auditor to establish ris% parameters prior to the start of a testing procedure. Thus, a desired level of assurance (and, conversely, an acceptable level of ris%) is always defined whenever statistical concepts and mathematical formulas are to be utili0ed. The auditor is aware in advance of the possibility of a mista%en conclusion. <uch information is especially important if the audit firm ever has to -ustify its e+amination and the opinion rendered. 8owever, application of statistical sampling does demand a speciali0ed degree of %nowledge. The auditor must have an ade1uate understanding of statistical methodology. 3n addition, developing a statistical sampling plan may re1uire a significant amount of audit time. Rudgmental sampling is many times easier and 1uic%er to apply and is, thus, especially appealing in audit areas where e+act precision is not re1uired. /or the auditor with sufficient e+perience, this type of sampling can fre1uently provide satisfactory conclusions about much of the client's data. 7nfortunately, since no guidelines e+ist for %ey decisions such as acceptable ris% levels, re1uired sample si0e, or the evaluation of final results, the auditor has no way of measuring the potential for an incorrect assessment. 3n any test, not enough items may have been e+amined to support a conclusion, or too much testing could occur creating an inefficient audit. /urthermore, if the auditor must ever demonstrate in a peer review or court case the basis for a particular decision, ob-ective evidence to substantiate the -udgment is usually not available. There is no correlation between sample si0e and choice of statistical versus -udgmental sampling methods. (>) !s the partner-in-charge of the Aa%eside e+amination, Cline must ensure that sufficient, competent evidence has been obtained to satisfy himself that the client's figures are fairly presented. ;ased on his years of audit e+perience, if Cline is uncomfortable with the evidence accumulated to date, he is obligated to see% additional assurance. Bo other individual has the responsibilityG no one else can specify the appropriate amount of evidence re1uired in a particular situation. ;ecause the decision is a -udgment, some auditors might agree with 2itchell that the testing presented in 4+hibit 11-> is sufficient. 8owever, Cline is

105

in charge of this audit, and he should never accept a client figure until personally satisfied of its fair presentation. (@) !lthough based on mathematical concepts, statistical sampling relies heavily on the auditor's professional -udgment. <uch -udgments can be seen throughout the sampling plans discussed by the !bernethy and Chapman audit team in Case 11. The auditors had to decide whether to test the >J@ invoices by sampling or by e+amining the entire population. The auditors had to choose between applying sampling for attributes to evaluate the client's e+pense accrual or some type of sampling for variables plan. The auditors had to establish an acceptable ris% of incorrect acceptance. The auditors had to establish an acceptable ris% of incorrect re-ection. The auditors had to set a tolerable misstatement, the amount of error the firm was willing to accept in the reported balance. The auditors had to decide which type of sampling for variables plan would be usedG both mean-per-unit and difference estimation were discussed in this case. 2onetary unit sampling and stratified mean-per-unit sampling are -ust two of the other techni1ues used by auditors. The auditors had to select a point estimation of the population error. The auditors had to choose a method for randomly selecting the items to be sampled.

Conse1uently, even in statistical sampling, a great number of decisions must be made by the auditor. The legitimacy of the results that are eventually achieved is related directly to the auditor's ability to ma%e appropriate decisions in each of these areas. 3n designing a sample, it is not unusual to obtain assistance from a specialist, normally from within the firm. (E) 3n the competitive times that now preside over the public accounting profession, the auditor cannot afford to rely on unnecessarily slow and time-consuming techni1ues. 2ore importantly, though, the auditor can never afford to do an e+amination in less than a 1uality manner. 7sing -udgmental sampling simply because it may be faster is a shortsighted approach. 4ach audit must be performed appropriately regardless of the amount of time involved. ;ecause of the time pressures present in modern auditing, each auditor needs to possess a ready %nowledge of statistical sampling techni1ues so that the efficiency of their use can be increased substantially. Certainly, any procedure is 106

time-consuming if the auditor's understanding is limited. Through education and the utili0ation of devices such as preprinted forms and computers, statistical sampling plans can be carried out in a minimum of time. 8owever, the auditor should continue to be alert to situations where -udgmental sampling can be applied. Bot every test warrants the use of statistical sampling, and the auditor needs to be capable of drawing this distinction. (F) 3f the auditor is see%ing to measure a rate of occurrence, sampling for attributes is utili0ed. Conse1uently, this type of statistical sampling is often associated with tests of controls where an error rate is being estimated. 3f, however, the auditor is attempting to determine an amount, sampling for variables is appropriate. This sampling techni1ue is fre1uently used in substantive testing to evaluate the reasonableness of a reported balance. !s is shown by Cases 16 and 11, the distinction between sampling for attributes and sampling for variables is not always as clear-cut as the previous paragraph implies. 3n Case 16, sampling for attributes was used to verify Auc%'s e+pense accrual, whereas sampling for variables was utili0ed in Case 11 for this same purpose. The auditor must always determine the ob-ective of a specific test and evaluate which type of testing will achieve that goal in the most efficient manner. (I) Qiven the ris% parameters that have been established by the auditor, the actual total of the differences in the client's population is estimated to lie between an understatement of OJ,5I6 (O@,7I6 W OF,>66) and an overstatement of O1,EE6 (O@,7I6 -OF,>66). <ince the auditor wants assurance that the client figure is within OJ,666 of the real total, the firm cannot accept the OEI,@11 as fairly presented. The OJ,5I6 estimation derived from the sample lies outside of the acceptable boundary. The client total may still be appropriate, but this sample indicates that too much ris% e+ists to accept the balance without further testing.

107

SU!!"ST"# ANS$"%S TO "'"%CIS"S (1)-(!) !;4*B4T8) !BD C8! 2!B D4T4*23B!T39B 9/ <!2 A4 <3X4 <!2 A3BQ /9* M!*3!;A4< Client. The Aa%eside Company /orm Completed ;y. Carole 2itchell !udit !rea. !ccrued 4+penses Date of Testing. >:E:16 )ear 4nding. 1>:@1:65 (1) - 4stimate the standard deviation of the population. <how the formula being used and identify each element within this formula.

4stimated <tandard Deviation S

( e)

n( e )

n 1

e is the value of each unit sampled F is the average of each unit sampled n is the number of units sampled The initial @6 items selected in 4+hibit 11-> show >I differences with a 0ero balance and four with either positive or negative balances.

e >6F E5 (116) 1FI @66

(e)> E>,6>F >,E61 1>,166 >E,@@I J6,JI>

F S @66:@6 or 16

108

4stimated <tandard Deviation S

807862 30 (10 ) 30 1

= 52 ( rounded

(>) - <pecify the acceptable level of ris% for incorrect acceptance. 3dentify the confidence coefficient (X value) for this percentage. 3nclude any considerations that were used in arriving at this parameter. The ris% of incorrect acceptance was set at 16K but no information was provided in this case to indicate the rationale for this decision. The X Malue for a 16K ris% of incorrect acceptance is 1.>J according to 4+hibit 11-1. (@) - <pecify the acceptable level of ris% for incorrect re-ection. 3dentify the confidence coefficient (X value) for this percentage. 3nclude any considerations that were used in arriving at this parameter. The ris% of incorrect re-ection was set at @6K but no information was provided in this case giving the rationale for this decision. The X value for a @6K ris% of incorrect re-ection is 1.6E according to 4+hibit 11-1. (E) - <pecify a tolerable misstatement for this population. considerations that were used in arriving at this parameter. 3nclude any

Tolerable error is OJ,666, a figure apparently set -udgmentally by Dan Cline. (F) - <pecify a point estimate of the population error. Describe the method by which this determination was made. The initial sample of @6 items had an average error of O16 as computed in (l) above. <ince >J@ items ma%e up the entire population, the point estimate of the population error is O>,J@6. (I) - Calculate the appropriate sample si0e. <how the formula being used and identify each element within this formula. <ample si0e S
SD ( Z a + Z r ) N TM E
2

#here. B is the population si0e Xa is the confidence coefficient for the acceptable ris% of incorrect acceptance Xr is the confidence coefficient for the acceptable ris% incorrect re-ection 109

<D is the estimate of the standard deviation of the difference T2 is the tolerable misstatement of the population 4 is the point estimate of the population misstatement <ample si0e S
52 (1.28 + 1.04 ) 283 = 44 ( rounded 87000 27830
2

(1)-(;) !;4*B4T8) !BD C8! 2!B <!2 A3BQ /9* M!*3!;A4< D3//4*4BC4 4<T32!T39B Client. The Aa%eside Company /orm Completed ;y. Carole 2itchell !udit !rea. !ccrued 4+penses Date of Testing. >:E:16 )ear 4nding. 1>:@1:65 (1) - <tate the ob-ectives of the audit testing. To determine the reasonableness of the client's year-end cut-off to arrive at accrued e+penses. (>) - Define the population. !ll differences between the year-end accrual (as determined by the client) and the audited balance. !ccruals were computed using all invoices received by the client in December >665 and Ranuary >616. (@) - Define the sampling unit. The difference between each year-end accrual determined by the client and the proper balance as calculated by the independent auditors. (E) - <pecify the acceptable level of ris% for incorrect acceptance and identify the confidence coefficient (X value) for this percentage. *is% of incorrect acceptance is 16K with a confidence coefficient of 1.>J. (F) - <pecify the acceptable level of ris% for incorrect re-ection and identify the confidence coefficient (X value) for this percentage.

110

*is% of incorrect acceptance is @6K with a confidence coefficient of 1.6E. (I) - <pecify a tolerable misstatement for this population. OJ,666 (7) - <pecify a point estimate of the population error. O>,J@6 (J) - Calculate appropriate sample si0e (all computations should be attached). F6 (given in the problem) (5) - 3ndicate the method used to draw a random sample. *andom number generator using computer (16) - *ecompute the standard deviation using the entire sample selected. 4stimated <tandard Deviation S #here. e is the value of each unit sampled F is the average of each unit sampled n is the number of units sampled !ll F6 items sampled in 4+hibit 11-> and 11-@ show E@ differences with a 0ero balance and seven with either positive or negative balances. e >6F E5 (116) 1FI (57) (1F6) E7 166 (e)> E>,6>F >,E61 1>,166 >E,@@I 5,E65 >>,F66 >,>65 11E,5J6

( e)

n( e )

n 1

F S 166:F6 or >

111

4stimated <tandard Deviation S

114 7980 2( 50 ) 50 1

= 48( rounded

(11) - Calculate the average difference within the sample and e+tend this figure to the entire population. !verage Difference of <ample S O166:F6 S O> difference per unit (audited numbers are higher than client's balances) 4stimated Total Difference S >J@ items + O> S OFII (client figure is understated) (1>) - Determine the precision interval. <how the formula being used and identify each element within this formula (all computations should be attached). recision 3nterval S
N Za SD n N n N

B is the population si0e n is the total sample si0e <D is the recomputed estimation of the standard deduction Xa is the confidence coefficient for the acceptable ris% of incorrect acceptance recision 3nterval S
283 1.28 48 50 283 50 = C27238 283

(1@) - 3dentify the upper and lower confidence limits of the population based on the precision interval and the average difference of the sample. !ctual population of difference is estimated to be between an understatement of O>,J6E (OFII W O>,>@J) and an overstatement of O1,I7> (OFII - O>,>@J).

(1E) - Conclusions:*ecommendations. Bo portion of the computed range of total errors falls outside of the OJ,666 112

tolerable error limit. The client's accrual should be accepted as a fair representation of the year-end liability.

113

CASE 12 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) The e+amination of a ban% cut-off statement is a common audit procedure that serves to generate several types of corroborative evidence. 3n reviewing this document, the auditor is see%ing to verify the client's reported balance for cash and related accounts. 3n addition, the auditor must always be aware of the possibility of theft in connection with cash held by the client. Thus, the auditor is especially attentive to any information from the cut-off statement (such as a chec% that did not clear the ban% in a reasonable time) suggesting the e+istence of a defalcation problem. !udit procedures that could be performed using the information obtained in a ban% cut-off statement would include. N *eview of the chec%s clearing the ban% during the first few days of the new year. Clearance of these chec%s serves as evidence of the validity of the (outstanding chec%s( total included in the client's year-end ban% reconciliation. !ny chec% which is not returned by this time may have been falsified to cover a cash shortage. *eview of the specific date on which each returned chec% cleared the ban%. This procedure serves as a means of ascertaining the appropriateness of the year-end cut-off made of cash disbursements. Merification of any unusually large chec% or any chec% of an odd nature (such as to a related party) that cleared the ban% during this subse1uent period. <uch chec%s might have been issued at year-end to manipulate cash or other account balances. 3dentification of all inter-ban% transfers made near the end of the year so that they can be scheduled in assessing the possibility of chec% %iting. *eview of all deposits clearing the ban% during this cut-off period as proof of the (deposits-in-transit( figure on the year-end reconciliation. 3dentification of deposited (customer) chec%s returned by the ban% because of insufficient funds as well as any other ban% charges reducing the cash balance. This listing enables the auditor to determine the necessity of a year-end ad-ustment.

N N N

114

N (>)

Merification of the ban% balance included in the year-end cash reconciliation.

2any thefts and other illegal acts are perpetrated through the use of ban% accounts that supposedly have been closed. /or e+ample, a dishonest employee can utili0e such an account to cash chec%s made out in the name of the company. The chec% is first deposited in this account followed by a subse1uent withdrawal by the employee. 3n a different vein, the company itself could use a (closed( account to hide illegal payments or other transactions from the auditors. To gain evidence of the possibility of such actions, a confirmation should be used to obtain final information about any ban% account that has been closed by the client during the current year. (@) a. #arehouse - The construction-in-progress on the warehouse addition must be reported apart from the other land, buildings, and e1uipment on the balance sheet since it is not yet used in the company's operations. ;ecause of the material nature of the e+pansion as well as the potential effects on the company, Aa%eside also needs to include an e+planatory note about the construction. This information would disclose the degree of completion, the anticipated completion date, and an estimation of the final e+penditure total. /ire Damage - !lthough the fire occurred subse1uent to the fiscal year , Statement on Auditin" Standards 3 specifies that some events happening after the end of the period (may be of such a nature that disclosure of them is re1uired to %eep the financial statements from being misleading.( <!< 1 goes on to list a number of e+amples, including inventory destroyed by fire. Thus, Aa%eside's >667 fire loss will probably re1uire disclosure in the >66I financial statements. <tudents may raise a 1uestion as to the materiality of the estimated loss especially since it did not occur during >665 and only disclosure is at issue. Certainly, if the loss is not -udged to be material, disclosure will not be re1uired. /re1uently, though, unless the amount is e+tremely small, the auditors will propose reporting a loss simply to avoid any later recrimination, an e+ample of data being included for protection rather than for information. 8owever, if Aa%eside ob-ects to the inclusion, the auditor once again faces the materiality issue that has been discussed at several points within these cases. Bow that the students are familiar with the information involved in this audit, the 1uestion may be as%ed of them as to whether the nondisclosure of this >616 loss would re1uire a 1ualification by the auditors in

b.

115

>665. c. Declaration of Cash Dividend - 7nless the auditor views the declaration of this cash dividend as an abnormal occurrence or an unusually large amount, disclosure would not seem warranted. Aittle evidence e+ists to indicate that this distribution will cause the >665 financial statements to be misleading if not disclosed.

(E) /or many companies, a number of transactions occur within two or three days of the end of the fiscal year. 3n see%ing evidence of the fair presentation of the financial information, the auditor needs to ensure that the impact of these transactions is recorded in the proper time period. Cut-off testing is designed to accomplish this goal. *eporting problems are especially li%ely if the client's accounting system is not able to ade1uately classify the sheer volume of transactions that can occur at year's end. 3n addition, the auditor must be aware that company management can manipulate reported net income by having the cut-off made either a few days before or a few days after the end of the period. Cut-off testing is especially important in connection with inventory and sales. /irst, the daily 1uantity of transactions involving these accounts is usually 1uite large. <econd, if shipment of merchandise is re1uired (either for goods being bought or sold), the auditor must ascertain the point at which title legally transfers as well as the physical location of inventory at the end of the year. (F) Determining the fair presentation of the liability accounts is a concern to the auditor because of the possibility that obligations may have gone unrecorded by the client company. !t least two reasons e+ist for this potential problem. N /ailure to record liabilities improves a company's debt:e1uity ratio and, where e+penses are involved, would also produce an increased net income for the current period. Therefore, a more favorable financial reporting is possible simply by leaving some liabilities unrecorded until the beginning of the following year. 9ften the incurrence of a liability will not generate a client-produced document. /or e+ample, an obligation for utilities e+penses might be ac%nowledged by the client only at the receipt of an invoice. Thus, the discovery of such liabilities is fre1uently dependent on the arrival of an invoice which may not be for some wee%s after the end of the year. /or the auditor, establishing complete assurance that all invoices have been received and liabilities recorded in the proper time period can be difficult to achieve.

116

(I) Contingent losses such as those arising from law suits or the possible closing of a store are fre1uently 1uite material in si0e. Thus, the auditor is usually faced with a potential outcome that can have an enormous impact on reported financial figures. /urthermore, the ability of the auditor (or anyone else) to foresee the future resolution of such contingencies is largely speculation. 3n the audit of Aa%eside, for e+ample, the loss from <tore <i+ may never occur or it may amount to as much as O1JI,666. The auditor is being forced to evaluate the reporting of possible future outcomes, data that is not easily sub-ected to attestation. /inally, contingent losses are not always easy to uncover. 7nasserted claims, for e+ample, may generate little or no documentation by the client until a formal claim is made. Therefore, the auditor must perform a thorough investigation in hopes of revealing any contingencies that might otherwise go unreported. 3n see%ing evidence of these losses, the auditor will tal% with the client management, read the minutes of stoc%holders' meetings as well as the meetings of the board of directors, chec% contracts and disputed transactions, read correspondence with lawyers, and review all ban% confirmations. (7) !s with any confirmation, the letter of in1uiry to the legal counsel must be prepared and signed by the client but mailed by the audit firm. The confirmation should direct the recipient to send all responses to the auditor who is attempting to gain assurance about the e+istence, evaluation, and reporting of both asserted and unasserted claims against the client company. The in1uiry letter lists all pending or threatened litigation identified by the client along with management's evaluation of the current status of these actions. The list should be limited to claims for which the law firm has devoted substantial attention so that a proper evaluation can be made. The counsel is re1uested to furnish information as to the nature of each matter, progress to date, li%elihood of an unfavorable outcome, and the range of potential losses. The legal firm is also as%ed to identify any other asserted claims against the client that are %nown to e+ist. This letter also includes a list and evaluation prepared by management of unasserted claims against the company that are considered probable of assertion with a reasonable possibility of unfavorable outcome. The law firm is as%ed to indicate any disagreements with this client data. The in1uiry letter also see%s a confirmation that the client (not the auditor) will be advised of any other unasserted claims that should be disclosed. /inally, the letter re1uests the law firm to identify the nature and reason for any limitations in the response to these in1uiries.

117

(J) The discovery and assessment of pending and threatened litigation has long been an area of contention between the auditing and legal professions. Traditionally, the independent auditor has loo%ed to the client's attorney for information to help evaluate these contingent losses. The legal profession has often protested such in1uiries for a number of reasons. 9ne ob-ection is that any communication between the attorney and the auditor may be construed as a breach of the confidentiality that e+ists between the attorney and the client. 8aving bro%en the confidential nature of the relationship, attorneys ris% not being able to avail themselves of this privilege in the future. 3n addition, the 1uestion has been raised as to whether the attorney could incur any liability if the assessments provided to the auditor proved to be incorrect. /inally, attorneys are cogni0ant of the effect upon client retention if they should reveal information to the auditor which the client did not want disclosed. !uditors search for all possible contingent losses which would then be evaluated by the client. The client would describe these contingencies in a letter to the company's legal counsel. The losses were to be split between (pending or threatened litigation( and (unasserted claims and assessments.( 3n response to the first category, the attorney was to inform the auditor of any omissions or any disagreements with the client's evaluations. /or unasserted claims and assessments, the attorney was as%ed to inform the auditor only of disagreements with the evaluations. 3f unasserted claims were omitted, the attorney would advise the client of the necessity of ma%ing appropriate disclosure. 3f the client then refused to report this information, the attorney was instructed to consider withdrawal by resignation. (5) *elated party transactions will always concern independent auditors because of the difficulty in distinguishing the economic substance of the transaction from its legal form. To obtain evidence that all related party transactions have been disclosed, auditors send out in1uiry letters to all related parties. The letter 1uestions the e+istence and e+tent of the dealings with the reporting entity, the nature of the transactions, and the relationship between the parties. 9nce the identity and terms of these transactions have been established, the auditor has to use other means to verify their validity. Statement on Auditin" Standards 25 suggests that the auditor may want to follow such steps as e+amining contracts, verifying approval by the board of directors, evaluating any collateral, and confirming information with intermediaries such as ban%s, attorneys, or agents to determine the true economic substance of each transaction. (! complete listing of (related parties( can be found in the glossary to /!<; <tatement Bo. F7, +elated Party 6isclosures.)

118

(16) and (11) 3n order to arrive at an estimation of the product warranty e+pense for >66I, the auditors must certainly loo% at the past history of the company as mentioned in this case. ! schedule can be determined from the information given of the e+pense incurred during the previous months. 8owever, the auditors cannot be satisfied with that evidence alone. !bernethy and Chapman should loo% for factors that would cause the future repairs of the company to differ from the past. /or e+ample, in scheduling the past repairs, the auditors need to watch for any trends that are evident. *epair costs (such as labor or parts) might have begun to climb recently or the incidence of product failure could be falling. <uch trends affect the calculation of the client's present liability. The auditors should also loo% for other changes that are occurring that might have an impact on this estimation. <ome products, as an e+ample, might be more li%ely to brea%. 3f so, the auditors should determine if sales of those items were growing or decreasing. ! call to Cypress roducts could provide valuable data as to the repair rate for various items. This company, most li%ely, will monitor closely the need for repairs. 3n addition, publications such as Consumer +e!orts often provide statistics on the li%elihood that products will fail. /or e+ample, radios may brea% more often than stereo systems and, thus, re1uire a different percentage for estimation purposes. Changes at Cypress roducts can also impact on the product warranty. 3f Cypress has recently begun to stress 1uality in its production, repairs may be reducedG whereas, if 1uality control is not emphasi0ed, Aa%eside's repairs can potentially s%yroc%et. !bernethy and Chapman may want to tal% with the management of the local shops that do Aa%eside's repairs to see if they have noted changes in the 1uality of the items produced by Cypress. These individuals can also provide the auditors with information on any changes in repair costs that have occurred recently. /inally, the auditors will want to review the repair costs incurred during the appro+imately seven wee%s following the end of the fiscal year. 3f repair costs -ump during the subse1uent period, !bernethy and Chapman may need to raise their estimation. 8owever, if costs are being held at a minimum, the accrual should be decreased.

119

SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) ! good introduction to this 1uestion is to as% the students to give their estimations of the accrued repair e+penses as of December @1, >665. ! number of different responses will probably be volunteered. The instructor can then as% a few individuals to e+plain the logic used to derive their figures. This e+ercise serves as a lesson as to the nebulous nature of some accounting problems. The students, who often believe that one absolutely correct answer can be derived for every situation, should be 1uite interested in the number of legitimate answers that are generated. 9bviously, as long as the logic is sound, different estimated amounts can be reasonable. !n additional factor in this case concerns the structuring of the data. Luite often, the client will have accumulated information in a manner that is not relevant to the needs of the auditor. Aa%eside has classified its repair e+pense by the month in which the item is returned while the auditors want to match the e+pense with the month in which the item is sold. Therefore, a necessary step in establishing the appropriate accrual is the restructuring of the data as is demonstrated in the attached wor%ing paper. This wor%sheet presents one method of computing the estimated repair accrual as of the end of >665. The computation indicates that Aa%eside's accrued e+penses are actually O>E,I7F too highG the ad-ustment will, therefore, increase the company's net income by this amount. ! final point which may deserve some class discussion is the necessity of verifying the client's data. To avoid ma%ing the case overly comple+, the client's figures have been used for this estimation without any testing. ;y now, the students should reali0e that such immediate acceptance is inappropriate. The auditor will have to ascertain the validity of this information before relying on it for this computation.

120

L+G08-'0 C3=P+NI 0stimated +""%)ed P%od)"t Wa%%anty 0<pense 'e"em(e% 317 2009

W.P. No. =-4 1 +""o)ntant, 'ate, #E#E1$

A8
+)dit 3(4e"ti#e, To estimate t&e a""%)ed p%od)"t 5a%%anty e<pense as o 'e". 317 2009. +)dit P%o"ed)%es, +$%eed 8a6es pe% =ont& to t&e $ene%a6 6ed$e%. No e<"eptions noted. +$%eed !epai%s pe% =ont& to t&e $ene%a6 6ed$e%. No e<"eptions noted.

Comments, + Kisto%i"a6 data o% t&e mont&s %om 9an)a%y 2008 to 9)ne 2009 ?18 mont&s@ a%e (ein$ )sed to de#e6op an estimate o mont&6y %epai%s e<pense. T&is estimate 5i66 (e app6ied to t&e 6ast si< mont&s sa6es o 2009 to dete%mine t&e yea% end a""%)a6. ')%in$ t&e 18-mont& test pe%iod7 %epai% e<penses s&o5ed a $%ad)a6 in"%ease %om .72> to .90> o sa6es. 2e"a)se o t&is )p5a%d t%end7 it is %e"ommended t&at Lakeside )se . 95> o sa6es o% estimatin$ %epai% e<penses o% t&e 6ast si< mont&s o 2009. 2 8a6es d)%in$ t&e 6ast si< mont&s o 2009 a%e sti66 )nde% 5a%%anty. T&ese sa6es tota6 C376017500 o% an estimated %epai% e<pense o C347214 (ased on .95> ?see + a(o#e@. ')%in$ t&e 6ast si< mont&s o 20097 C137424 in %epai%s 5e%e made in "onne"tion 5it& t&ese sa6es. +s o 'e"em(e% 317 20097 an estimated 6ia(i6ity o C207790 ?DC347214-C137424@ %emains. LakesideBs a""%)a6 o C457465 s&o)6d (e ad4)sted ?C457465 %e"o%ded (a6an"e - 207790 desi%ed (a6an"e DC247675 o#e%statement@. +90 ;13- P%oposed +d4)stment 220-1 680-1 +""%)ed 0<penses Paya(6e 3t&e% =is"e66aneo)s 0<penses 2467524675-

+)dit Con"6)sion, +""%)ed p%od)"t 5a%%anty e<pense is ai%6y stated7 a te% ad4)stment7 in a""o%dan"e 5it& /++P.

121

L+G08-'0 C3=P+NI 0stimated +""%)ed P%od)"t Wa%%anty 0<pense 12*31*09 &, $ales not under -arranty Kisto%i"a6 'ata 1*08 8a6es o% mont& 582000 !epai%s, =ont& o 8a6es 193 1 mont& a te% 533 2 mont&s a te% 837 3 mont&s a te% 875 4 mont&s a te% 343 5 mont&s a te% 571 6 mont&s a te% 457 Tota6 %epai% e<pense 3809 !epai% e<pense as a .72> pe%"enta$e o sa6es 2*08 316000 137 388 319 662 320 205 251 2282 .72> 3*08 359000 177 329 481 658 456 228 202 2531 .71> 4*08 479000 222 369 480 591 702 812 517 3693 .77> 5*08 486000 147 514 625 441 1029 698 220 3674 .76> 6*08 414000 61 276 429 797 735 490 272 3060 .74> 7*08 371000 256 313 569 541 512 456 199 2846 .77>

W.P. No. =-4 2 +""o)ntant, A8 'ate, #E#E1$ 8*08 460000 284 497 462 639 604 675 391 3552 .77> 9*08 442000 210 559 629 664 594 699 140 3495 .79> 10*08 533000 292 583 666 917 625 500 583 4166 .78> 11*08 586000 469 563 657 845 798 657 704 4693 .80> 12*08 800000 505 948 885 1074 1203 1030 695 6318 .79>

B, $ales still under -arranty Kisto%i"a6 'ata Cont. 8a6es o% mont& !epai%s, =ont& o 8a6es 1 mont& a te% 2 mont&s a te% 3 mont&s a te% 4 mont&s a te% 5 mont&s a te% 6 mont&s a te% Tota6 %epai% e<pense !epai% e<pense as a pe%"enta$e o sa6es 1*09 610500 323 969 861 915 1028 808 485 5884 .88> 2*09 381000 336 366 397 580 549 519 305 3052 .80> 3*09 346000 234 351 410 527 292 468 644 2926 .85> 4*09 557000 335 670 766 1054 718 575 670 4788 .86> 5*09 590000 421 736 684 947 1894 999 579 5260 .89> 6*09 409000 368 442 516 664 627 553 516 3686 .90> 7*09 422000 599 337 375 749 824 524 3408 8*09 550000 251 752 1203 852 602 3660 9*09 511000 277 738 830 876 10*09 602500 220 769 934 11*09 642000 423 785 12*09 874000 504

2721

1923

1208

504

137424 %et)%ns to date o% p%od)"ts sti66 5it& 5a%%anty.

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(>) This 1uestion has been included to emphasi0e the audit report as the end product of the auditor's wor%. !s this te+t has been an e+ploration of the attest function rather than a full-scale audit, determination of an appropriate opinion for >665 is not feasible. resented below are two possible conclusions for this case. The first is based on an un1ualified opinion on the >665 statements because !bernethy and Chapman either believes the potential impairment of value on <tore <i+ is not material, or that its li%elihood is only remote. The second possible conclusion is that disclosure is needed in connection with the problems encountered with <tore <i+, and that *ogers is unwilling to ma%e this disclosure. 3n both cases, the assumption is made that Ping and Company, the predecessor auditor, continues to believe that a 1ualified opinion is still appropriate for the >66J statements. <ince comparative statements are being published, !bernethy and Chapman also have to provide information about this previous opinion.

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UN&UALI2I"# O+INION 3BD4 4BD4BT !7D3T9*'< *4 9*T #e have audited the accompanying balance sheet of the Aa%eside Company as of December @1, >665, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. 9ur responsibility is to e+press an opinion on these financial statements based on our audit. The financial statements of Aa%eside Company as of December @1, >66J were audited by other auditors whose report dated 2arch 1F, >665, on those statements included a 1ualified opinion due to inade1uate disclosure of a potential impairment of value for one of Aa%eside's stores. #e conducted our audit in accordance with auditing standards generally accepted in the 7nited <tates of !merica. Those standards re1uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. !n audit includes e+amining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. !n audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. #e believe that our audit provides a reasonable basis for our opinion. 3n our opinion, the >665 financial statements referred to above present fairly, in all material respects, the financial position of the Aa%eside Company as of December @1, >665, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the 7nited <tates of !merica. !bernethy and Chapman Certified ublic !ccountants *ichmond, Mirginia /ebruary 1F, >616

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&UALI2I"# O+INION 3BD4 4BD4BT !7D3T9*'< *4 9*T #e have audited the accompanying balance sheet of the Aa%eside Company as of December @1, >665, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. 9ur responsibility is to e+press an opinion on these financial statements based on our audit. The financial statements of Aa%eside Company as of December @1, >66J, were audited by other auditors whose report dated 2arch 1F, >665, on those statements included a 1ualified opinion due to inade1uate disclosure of a potential impairment of value for one of Aa%eside's stores. #e conducted our audit in accordance with auditing standards generally accepted in the 7nited <tates of !merica.. Those standards re1uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. !n audit includes e+amining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. !n audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. #e believe that our audit provides a reasonable basis for our opinion. During >667, the company made a O1JI,666 investment in a retail store located in the eastern sector of *ichmond, Mirginia. This store has failed to reach a brea%-even sales point to date, and total recovery of the Company's investment is highly uncertain. 3n our opinion, the chances are reasonably possible that the asset's value has been permanently impaired and should be reduced to the net reali0able value in conformity with generally accepted accounting principles. 3n our opinion, e+cept for the effects of not recording or disclosing the impairment of value of the asset, as discussed in the preceding paragraph, the aforementioned financial statements present fairly, in all material respects, the financial position of the Aa%eside Company at December @1, >665, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the 7nited <tates of !merica. !bernethy and Chapman Certified ublic !ccountants *ichmond, Mirginia /ebruary 1F, >616

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CASE 13 SU!!"ST"# ANS$"%S TO #ISCUSSION &U"STIONS (1) The authoritative auditing literature describes a material internal control wea%ness as a condition where a company's systems fail to reduce to a relatively low level the ris% that a material error or irregularity will both occur and avoid being detected within a timely period by employees in the normal course of performing their assigned duties. 3f any such wea%ness does e+ist, the company is e+posed to the danger that an error or irregularity will occur, go undetected, and then directly affect reported financial figures. The auditor's role is to accumulate sufficient, competent evidence on which to form an opinion as to the fair presentation of the client's financial statements. 8owever, during this investigation, one or more material control wea%nesses may be discovered. ! description of these problems should be immediately communicated to the client. 3n this way, management has the opportunity to reduce the possibility that subse1uent errors and irregularities will go undetected. This report can also protect the auditor from legal responsibility if losses are incurred by the client at a future point in time because of the wea%ness. Conse1uently, if !bernethy and Chapman discovers a material wea%ness in Aa%eside's internal control, this information must be conveyed to the client as soon as possible so that corrective actions can be ta%en. The description is to be communicated either orally or in writing and should go to the senior management of the company as well as the board of directors (or its audit committee). (>) 2any individuals in business are s%illed in one particular industry. audio e1uipment, car dealerships, fashion design, etc. 9thers are trained in one general aspect of business such as mar%eting, personnel, shipping, etc. !lthough these people may be e+tremely efficient and productive, they are not necessarily %nowledgeable about computers and computer applications. 3n the past, they may have focused their attention on a particular function and limited their thin%ing to the methods that have historically proven successful. !ny time that a new approach is put forth, especially one with the comple+ity of modern technology, human nature seems to resist the change. *ogers has built a large company without a large computer componentG he may be s%eptical about ma%ing significant alterations in a successful operation, especially changes that he admittedly cannot visuali0e or fully comprehend.

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!bernethy and Chapman has employed an appropriate system for educating the client. Plont0 is developing and will present a series of potential, clearly-defined, functions that could be computeri0ed. Thus, *ogers will be able to analy0e the possibilities that are offered by an automated system and -udge for himself as to which are worth the costs that are involved. (@) ublic accounting firms come into contact with numerous business organi0ations, their operations, and their accounting systems. <ince the client's systems and controls must be understood as a part of the attest function, the auditor has always been in a position to note and propose improvements. 8ence, the opportunity and the e+pertise are both naturally in place to provide advisory wor%. 3n recent years, such advice has become more formali0ed as firms have begun to offer a wide range of services to clients as well as to other organi0ations. During the last two decades, C !s have come to recogni0e such wor% as a lucrative offshoot of the public accounting profession. (E) ! fully computeri0ed accounting system has two ma-or impacts on the wor% of the independent auditor. /irst, the traditional audit trail is changed significantly. The series of paper documents that could be followed from the inception of a transaction to its final recording is often unnecessary in an automated system. The information is entered into the computer so that no tangible record of changes and events necessarily e+ists. <econd, computer processing does not utili0e the same control procedures commonly found in a manual system. /or e+ample, in manual systems, one individual is fre1uently assigned to review and authori0e the wor% of another employee, a verification tas% not necessarily re1uired by a computer. Conse1uently, when an automated system is in use, the internal control must ta%e on new, sometimes creative, forms. ;ecause of the lac% of an audit trail and the presence of different control procedures, the audit firm must adapt its e+amination to new circumstances. 3ncreased emphasis is placed on developing tests of the computer controls to ensure that all of the data being processed is reliable. The auditor would e+pect the computer installation, for e+ample, to have restricted access to limit the possibility of unauthori0ed changes. #here direct input into the computer is allowed, pass codes should be used for this same purpose. ! control group also needs to be created to monitor all computer processing and its output. 3n addition, the client should re1uire the use of control totals (batch totals, item

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counts, or hash totals) to provide evidence of the accuracy of information produced by the computer system. eriodically, the programs in use should be rechec%ed for unauthori0ed alterations. Control of a computeri0ed system can also be enhanced by re1uiring a limited amount of documentation for transactions. ! physical receiving report, for e+ample, might be produced to bac% up the information that has been entered directly into the computer. This document could be used for daily reconciliation of transactions while also allowing for a periodic verification of the computer records. (F) and (I) ublic accounting firms have long held that a distinction is maintained between consulting and audit services, a separation that protects them from any possibility of a conflict of interest. 3n many organi0ations, the two services are offered through relatively autonomous divisions. /urthermore, the client is free to discuss possible improvements with any other business enterprise providing these services. 2any large companies, for e+ample, use one firm for auditing and a different organi0ation for advisory services to avoid becoming too dependent on any one group. The 4nron ;an%ruptcy will have ramifications on auditor independence issues for many years to come. /or e+ample, the Qovernment !ccounting 9ffice (Q!9) issued new independence rules dealing with non-audit services performed by the auditor in governmental audits. !lso, the <arbannes-9+ley !ct re1uired that many of the consulting activities be eliminated for a firm's publicly-traded audit clients. SU!!"ST"# ANS$"%S TO "'"%CIS"S (1) The cases in this boo% have described several of the accounting systems in use by the Aa%eside Company. ;ecause of the lac% of complete computeri0ation, these various functions are mechanical in design, relying on the s%ills of the company's employees. Therefore, !bernethy and Chapman can recommend to *ogers a number of specific functions to be moderni0ed through the installation of a new accounting information system. Aisted below are a few e+amples of the types of suggestions that students may provide. ayroll The names and pay rates for all employees are programmed into the

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computer. !t the end of each pay period, the number of hours wor%ed by every hourly employee is also entered along with sales figures for individuals being paid on commission. The computer automatically calculates the gross pay for each employee. The amount to be paid to salaried wor%ers is based on individual contract rates while the salary for each hourly and commission wor%er is determined from the information entered for the period. /ederal and state income ta+ withholding figures are also computed as well as <ocial <ecurity payments and any other payroll deductions. ! net wage for each individual is then derived with the computer printing out the actual paychec%s. Credit /ile 3nformation is accumulated about all of the customers to whom credit sales are made. ! review board is established by Aa%eside to approve or re-ect the continuation of credit to these customers as well as the e+tension of credit to new customers. !n approved customer list is then entered into the computer and updated as needed. #henever a sales order is received by the company and processed, the computer scans this file to ensure that credit should be given. The computer also reviews the amount and age of any balances already owed by this same customer. 3f an e+cessive amount is presently outstanding or if a balance is past due, credit approval can be rescinded even if the customer is listed in this file. erpetual 3nventory !ll inventory balances are monitored by a computer program. !t the time merchandise is transferred to a customer, the identity of the specific items is entered into the computer along with the 1uantity, perhaps using point-ofsale technology. The computer is programmed to reduce the appropriate account balances and automatically warns of any merchandise that is at an unacceptably low level. #henever goods are delivered to Aa%eside, a description of the newly ac1uired inventory is similarly entered. !gain, the computer updates the information stored in the perpetual records for each of these particular items, thus providing ongoing data about the inventory on hand. !ccounts *eceivable <ubsidiary Aedger ! listing of all customers is maintained within the database as well as the current amounts owed by each and the age of the receivable. !t the time that a new sales order is approved and the merchandise shipped, the dollar amount is entered into the computer so that the specific customer's balance will be updated. #hen a collection is subse1uently received, the payment is also recorded by the computer as a reduction in the appropriate account receivable balance. ! daily list of overdue accounts is printed so that new

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invoices can be mailed or other follow-up procedures instigated. (>) 3n studying and evaluating the controls surrounding computeri0ed systems, the independent auditor anticipates finding certain procedures in use. Computer controls are divided into (general( and (applications( controls. Qeneral controls relate to all 4D activities and include. ! plan of organi0ation and operation of the 4D function. rocedures for documenting, reviewing, testing, and approving systems or programs and changes in them. 8ardware and programmed controls built into the operating systems. !ccess controls. 9ther data and procedural controls (e.g., record reconstruction, bac%up facilities, emergency procedures, etc.). !pplications controls relate to specific tas%s performed by the 4D department, such as preparing payroll. These controls are intended to provide assurance that the recording, processing, and reporting of data are properly performed. !pplications controls can be further divided into (input,( (processing,( and (output( controls. 3nput controls ensure that input data is authori0ed, converted into machinesensible form, verified, and not lost, duplicated, or altered. rocessing controls provide assurance that transactions are processed, as authori0ed, and that none were added or omitted. 9utput controls ensure that output data are accurate and received only by authori0ed personnel. 3n Aa%eside's situation, specific controls would include the following. !ll programs should be purchased from reputable software firms or written by employees with an appropriate bac%ground in software development. The company's entire accounting system often depends on the reliability of these programsG thus, control must begin with their very creation. rogrammers should be segregated from computer operators and not permitted unrestricted access to the hardware so that the programmers cannot manipulate any of the programs. roper documentation should be furnished with all programs to indicate the controls that have been established within the various functions. This documentation allows the client to verify that each program was developed in an appropriate manner and has not been improperly modified since it was put into operation. !ll program alterations and updates are to be documented and reviewed by appropriate supervisory personnel prior to any 130

changes being made. Testing of all programs should be performed before the client relies on them. /or a time, as an e+ample, the company may want to run parallel processing where all functions are carried out both manually as well as through the new information system to ensure that the output is accurate. 3n addition, Aa%eside should process test (or erroneous) data using the various computer systems to further verify the reliability of the output. !ll programs should be tested periodically to verify that no unauthori0ed changes have been made by company employees or any other parties. The computer system should be physically protected to prevent unauthori0ed access as well as any physical damage that might occur because of fire, smo%e, heat, water damage, or other problems. 3n addition, bac% up files need to be maintained in case current files are destroyed. /or e+ample, the company should assure that its perpetual inventory records and its accounts receivable subsidiary ledger can be reconstructed if damaged. ;ecause an on-line, real-time system is being designed by Plont0 in 4+hibit 1@-1, many of the employees of Aa%eside will have direct access into the memory of the computer. !ccess (or pass) codes should be used to limit any one employee's ability to enter and change files that are not directly related to an assigned function. These codes should be changed periodically. The computer may be programmed so as to prevent access into files e+cept during assigned times. 4ntry into a system after wor%ing hours, for e+ample, might be prohibited. Thus, employees would be prevented from returning to wor% during the night to manipulate data. #here possible, validity chec%s could be installed within the various systems so that data must be verified independently before being processed. ! customer name, as an e+ample, has to be on an approved customer list before a sale is authori0ed and merchandise shipped. Ai%ewise, an individual's identification number must be listed on a master employee file, or a paychec% will not be produced. Aimit tests can be initiated so that transactions above or below specified parameters will not be processed by the computer unless additional authori0ation is entered. !n order for merchandise of over OF,666 might, for e+ample, re1uire further approval before the goods are shipped. 3nventory ac1uisitions for more than O>6,666 might also necessitate a similar authori0ation. 4mployees entering data might be re1uired to complete documents for verification purposes. 9bviously, a computeri0ed system can virtually reduce

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to 0ero the need for any type of written information. 8owever, control may be enhanced by having employees record a limited amount of data at the point of a transaction solely for reconciliation purposes. !s an illustration, a bill of lading may be produced (manually or by the computer) and sent to the customer as a verification of a shipment. ! copy of this document can subse1uently be used by the company to chec% the data entered into the computer.

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