ACCT 506 - Financial and Integrated Audits

Frederick Choo
Financial and Integrated

Audits
Table of Contents
1 Financial and Integrated Audits
2 The Auditor's Professional Environment
23
3 The Auditor's Ethical Environment
47
4 The Auditor's Legal Environment
75
5 Audit Plan - Preplan and Documentation
103
6 Audit Plan - Objectives
137
7 Audit Plan - Evidence
165
8 Audit Plan - Internal Control
191
9 Audit Plan - Materiality and Risk
229
10 Audit Plan - Program and Technology
255
11 Audit Sampling for Tests of Controls
283
12 Audit Sampling for Tests of Balances
304
13 Revenue Cycle - TOC and TOB
324
14 Expenditure Cycle - TOC and TOB
362
15 Inventory Cycle - TOC and TOB
396
16 Payroll Cycle - TOC and TOB
430
17 Capital Cycle - TOC and TOB
452
18 General Cash and Investments - TOC and TOB
476
19 Completing the Audit
504
20 Audit Report
540
21 Other Audit Engagements
588
Appendix A
630
Appendix B
631
Appendixes C D E
632
Appendix F
633
Financial and Integrated Audits - Frederick Choo
Chapter 1
Financial and Integrated Audits
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO1-1 Understanding the reason for auditing.
LO1-2 Distinguish among auditing, attestation, and assurance services.
LO1-3 Differentiate between financial audit and integrated audit.
LO1-4 Differentiate between assurance and consulting services.
LO1-5 Explain the different categories of audit and types of auditor.
LO1-6 Explain the organizational structure, category, and hierarchy of CPA firms.
Chapter 1 Financial and Integrated Audits

Definition of Auditing
Auditing may be defined as:
"A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions
and events to ascertain the degree of correspondence between those assertions and established criteria and
communicating the results to interested users."
Source: Committee on Basic Auditing Concepts, Statement of Basic Auditing Concepts AAA, 1973, p.2.
Several key phrases of this definition merit special comment in Table 1-1.
TABLE 1-1 Definition of Auditing
Key Phrase
A systematic process
Objectively evaluating and
examining of evidence
Assertions about economic actions
and events
Degree of correspondence between
assertions and established criteria
Communicating results to
interested users
Comments
Auditing is a logically structured and planned inquiry process.
Auditing involves independently obtaining and gathering evidence, such as confirmations of
balances, and objectively evaluating the sufficiency and appropriateness of this evidence.
These are assertions made explicitly and/or implicitly by the auditee with regard to the accounting
information presented to the auditor, for example, the auditee has valued inventories at the lower
of cost or market value.
Based on the evidence gathered, the auditor forms an opinion as to the closeness with which the
auditee's assertions comply with established standards and polices, for example, generally accepted
accounting principles (GAAP) and other statutory rules and regulations.
The auditor communicates the degree of correspondence between the auditee's assertions and
established criteria in the form of an audit report to interested parties that include stockholders,
lenders and creditors.
The Demand for Auditing

The definition of auditing can further be discussed in terms of a principal-agent framework that explains the demand
for auditing. See Figure 1-1 below for the relationships. First, stockholders (referred to as principals) of a
corporation appoint a board of directors who in turn hires a professional management team (referred to as agents) to
run the corporation. Second, both the stockholders and management seek to maximize their self-interest. Their
goals/activities are not necessarily congruent. Third, the stockholders appoint an outside independent party (an
external auditor) to monitor and report the goals/activities of the management. The auditor provides a form of
attestation service, an auditing service, to the stockholders. Fourth, the external auditor gathers and evaluates
evidence concerning the explicit and implicit assertions made by the management (auditees assertions) in the
financial statements and reports to the stockholders about the fairness of the financial statements presentation in the
form of an audit opinion report. If the managements financial statements are presented fairly, the auditor issues an
unqualified opinion report. On the other hand, if the managements financial statements are not presented fairly, the
auditor issues a qualified opinion report. See Table 1-2 for a brief description of the various types of audit opinion
report. A qualified audit opinion usually means that the managements financial statements contain material
misstatements. Misstatements may be in the form of errors, unintentional mistakes, or frauds, intentional
misrepresentations. Two common types of intentional misrepresentations are misappropriation of assets, also known
as employee fraud, and fraudulent financial reporting, also known as management fraud.
Table 1-2 Types of Audit Opinion Report
Types of Audit Opinion Report
Unqualified Opinion,
Standard Report
Unqualified Opinion,
Explanatory paragraph Added
Qualified Opinion
Brief Description
This report is issued when the auditor judges that the clients financial statements fairly present, in
all material respects, the financial position, results of operations, and cash flows in conformity with
GAAP.
This report is issued when the auditor judges that it is necessary to add a paragraph to explain
certain accounting related matters in a standard unqualified opinion report.
This report is issued when the auditor judges that the clients financial statements fairly present, in
Types of Audit Opinion Report
Brief Description
all material respects, the financial position, results of operations, and cash flows in conformity with
GAAP except for the material effect of certain accounting related matters to which the
qualification relates.
This report is issued when the auditor judges that the clients financial statements, taken as a whole,
do not fairly present the financial position, results of operations, and cash flows in conformity with
GAAP.
This report is issued when the auditor does not express an opinion on the clients financial
statements.
Adverse Opinion
Disclaimer of Opinion
Figure 1-1 The Demand for Auditing in a Principal-Agent Framework

XYZ Company
Stockholders
Board of Directors
XYZ Co.
Management
(Accountant)
Independent Auditor
(External)
Audit
Report
(Opinion)
Unqualified
Qualified
Attestation
Service
(Audit)
Financial Statements
containing
Managements
Implicit/Explicit
Assertions
Misstatement
Error
Fraud
Unintentional
Intentional
mistake
misrepresentation
Misappropriation
of assets
(Employee fraud)
Fraudulent
financial reporting
(Management fraud)
The Demand of Other Users

The principal-agent framework above focuses on the stockholders as a primary party demanding audited financial
statements. Besides the stockholders, there are a diversity of other users (other 3 rd parties) of the audited financial
statements. Table 1-3 describes other users of the audited financial statements.
Table 1-3 Other Users of Audited Financial Statements
User
Bondholders
Court System
Economists
Use of Audited Financial Statements

Assess the ability of a company to repay indebtedness.
Assess the financial position of a company in litigation.
Assess the effects of economic policies and the implications for public policy decisions.
User
Use of Audited Financial Statements
Financial Institutions
Labor Unions
Management
Potential investors
Regulatory Agencies
Taxing Authorities
Determine whether to make a loan to a company.

Assess the profitability of a company and the potential for future wages or profit sharing contracts.
Review performance and make decisions affecting future directions of a company.
Determine whether to invest in a company.
Determine whether regulatory action is necessary to protect the public.
Determine taxable income and tax due.
Type of Services
CPA firms provide five broad types of services as shown in Table 1-4.
Table 1-4 Five Broad Types of Services
Type of Service
Attestation services
Tax services
Management advisory
(consulting) services
Accounting services
Assurance services
Nature of Service
Attestation services are any professional services in which a CPA firm issues a written report that expresses
an opinion or conclusion about the reliability of a written assertion that is the responsibility of another party.
Attestation services include financial audit of private (non-publicly traded) companies and integrated audit
of public (publicly traded) companies; report on a client's internal control structure; review of private
companies' financial statements; examination of prospective financial statements, and application of agreedupon procedures on specific elements, accounts, or items of a financial statement. The AICPAs Auditing
Standard Board issues Statements on Auditing Standards (AUs), which provide guidance for CPAs who
perform financial audit for private companies. On the other hand, the SECs Public Company Accounting
Oversight Board (PCAOB) issues Auditing Standards (ASs), which provide guidance for CPAs who perform
integrated audit for public companies. Table 1-5 describes four broad types of attestation services.
See Appendix A for a list of the AUs and see Appendix B for a list of the ASs.
Tax services include preparation of tax returns, assistant in tax planning, and engagement in tax litigation.
The AICPA's Federal Taxation Executive Committee issues Statements on Responsibilities in Tax Practice
(SRTPs), which provide guidance for CPAs who perform tax services.
Management consulting services include design of accounting information systems, and engagement in
marketing study, and executive recruiting. The AICPA's Management Advisory Service Executive
Committee issues Statements on Standards for Management Advisory Services (SSMASs) , which provide
guidance for CPAs who perform management advisory services.
Accounting services include preparation of financial statements and compilation of financial statements. The
AICPA's Accounting and Review Services Committee issues Statements on Standards for Accounting and
Review Services (ARs), which provide guidance for CPAs who perform accounting services.
See Appendix D for a list of the ARs.
Assurance services are independent professional services that improve the quality of information, or its
context, for decision-makers. By this broad definition, assurance services include attestation services in that
they improve the quality of information for decision-makers by issuing a written report about the reliability
of certain written assertions of another party. Assurance services also encompass compilation services in
that they improve the quality of information for decision-makers by presenting (compiling) them as financial
statements in accordance with GAAP. However, assurance services do not include consulting services
although they often deliver a similar body of knowledge and skills. A key difference between assurance and
consulting services is the objective of the engagement. Assurance services are designed to optimize the
clients decision making whereas consulting services are designed to improve the clients outcomes or
conditions. The AICPA's Auditing Standards Board issues Statements on Standards for Attestation
Engagements (ATs), which provide guidance for CPAs who perform accounting services. Table 1-6
describes six common types of assurance services.
See Appendix C for a list of the ATs.
CPA firms provide four broad types of attestation services that are described in Table 1-5.
Table 1-5 Four Broad Types of Attestation services
Financial
Audit
(private company)
Integrated
Audit
(public company)
Four Broad Types of Attestation services
This type of service involves obtaining and evaluating evidence about a clients financial statements. The AICPAs
GAAP and Auditing Standard Boards Auditing Standard AU 700 require that auditors of private companies in the
United States to provide an opinion on the companys financial statements. Based on this financial audit, the auditor
issues a positive (means certain or confident) expression of opinion on whether the financial statements are presented
fairly in conformity with the GAAP and Auditing Standards. Figure 1-3 presents an overview of the financial audit.
This type of service involves obtaining and evaluating evidence about a clients internal control over financial
reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and PCAOBs Auditing
Standard AS 5 require that auditors of public companies in the United States to provide an opinion on the effectiveness
Four Broad Types of Attestation services
Examination
Review
Agreed-upon
procedures
of the companys ICFR and an opinion on the companys financial statements. Based on this integrated audit, the
auditor issues an opinion on the effectiveness of the clients ICFR and an opinion on the fair presentation of the
financial statement in accordance with the standards of the PCAOB. Figure 1-4 presents an overview of the integrated
audit.
This type of service involves obtaining and evaluating evidence about a variety of situations which contain assertions
made by another party. The auditor performing this type of service normally follows the AICPAs Statements on
Standards for Attestation Engagements (ATs). Based on the examination, the auditor issues a positive expression of
opinion on whether the other partys assertion conforms to certain applicable criteria. Examples of examination
services include (1) prospective (rather than historical) financial statements, (2) managements assertions about the
effectiveness of a clients internal control structure, and (3) a clients compliance with specified laws and regulations.
This type of service involves inquiries of an audit clients management and comparative analyses of financial
information. The scope of this service is significantly less than that of an audit or examination in that it usually does
not involve obtaining and evaluating evidence. The auditor performing this type of service normally follows the
AICPAs Statements on Standards for Accounting and Review Services (ARs). Based on the review, the auditor issues a
negative (means uncertain or unconfident) expression of opinion on whether the financial statements are presented
fairly in conformity with established criteria such as GAAP. Thus, instead of stating a positive opinion that the
financial statements are presented fairly in conformity with GAAP, a negative opinion is usually stated as that we
are not aware of any material modifications that should be made to the statements in order for them to be in conformity
with GAAP. Examples of review services include (1) review of interim financial statements of public companies and
(2) review of annual financial statement of non-public companies.
This type of service involves the auditor, the client, and the intended users to agree on certain procedures to be
performed on specified financial statement/non-financial statement matters. The auditor performing this type of service
normally follows the AICPAs Statements on Standards for Attestation Engagements (ATs) for financial matters (e.g.,
gross sales account for a lease agreement) and non-financial statement matters (e.g., compliance with federal
affirmative action laws). Based on the agreed-upon procedures, the auditor issues a summary of findings report,
which does not include an opinion.
Figure 1-3 An Overview of the Financial Audit (Private Company)
Management
Financial Audit
Implements internal controls
Conducts transactions
Attests to managements
internal controls
Accumulates transactions
into account balances
Prepares financial statements
Issues financial statements
financial statements
Issues audit report:

1. An opinion on the fair presentation
of the financial statements
Figure 1-4 An Overview of the Integrated Audit (Public Company)
Management
Integrated Audit
Reports on ICFR
report on ICFR
Management Report on ICFR contains

an explicit statement on whether managements
assessment of ICFR is effective as of the end
of the period reported on

1. An opinion on the effectiveness of the
companys ICFR
Attests managements
financial statements
Prepares financial statements

2. An opinion on the fair presentation
of the financial statements
Issues financial statements
ICFR = Internal Control Over Financial Reporting
CPA firms offer a wide variety of other assurance services. The six common other assurance service are shown
in Table 1- 6. Chapter 21, Other Audit Engagements, provides more discussion on some other assurance services
and attestation services of the assurance services.
Table 1-6 Six Common Other Assurance Services
Type
Risk Assessment
Business Performance Measurement
Information Systems Reliability

Electronic Commerce
Healthcare Performance
Function
This assurance service identifies a clients profile of business risks and assesses whether the
client has appropriate systems in place to effectively manage those risks.
This assurance service evaluates whether a clients performance measurement system contains
relevant and reliable measures for assessing the degree to which the clients goals and objectives
are achieved or how its performance compares to its competitors.
This assurance service assesses whether a clients internal information systems (financial and
non-financial) provide reliable information for operating and financial decisions.
This service assesses whether systems and tools used in electronic commerce provide data
integrity, security, privacy, and reliability. See Figure 21-15 in Chapter 21 for an example of a
WebTrust report.
This assurance service assesses and reports on the quality of care delivered by health care
Type
Function
Measurement
systems, and to provide comparative analyses on costs and delivery systems.

This assurance service provides assistance to elderly people and their family members by
offering financial advice and measuring how effectively health care providers meet the needs of
the elderly and their families.
Elder Care
A diagrammatic representation of the relationship among the professional services is shown in Figure 1-2.
Figure 1-2 Relationships among Professional Services
Assurance Services
Nonassurance Services
Attestation services
Examination
Review
Financial
Audit
Integrated
Audit
Certain
Management
Consulting
Services
E.g.,
Fraud
Investigation
Management Consulting Services
Tax Services
Agreed-Upon Procedures
Accounting Services
Compilation
Risk Assessment
Web/SysTrust
XBRL
ElderCare Plus
Health Care
Performance Measurement
Source: Adapted from the Elliott Committee Report (AICPA, 1997)
The five broad types of services shown in Table 1-4 above fall into four categories of audit (see Table 1-7) and they
are usually conducted by several types of auditor (see Table 1-8).
Table 1- 7 Four Categories of Audit
Category of Audit
Financial audit
Integrated audit
Compliance audit
Operational audit
Nature of Work
This type of service involves obtaining and evaluating evidence about a clients financial statements.
The AICPAs GAAP and Auditing Standard Boards Auditing Standard AU 700 require that auditors of
private companies in the United States to provide an opinion on the companys financial statements.
Based on this financial audit, the auditor issues a positive (means certain or confident) expression of
opinion on whether the financial statements are presented fairly in conformity with the GAAP and
Auditing Standards. See Figure 1-3 for an overview of the financial audit.
This type of service involves obtaining and evaluating evidence about a clients internal control over
financial reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and
PCAOBs Auditing Standard AS 5 require that auditors of public companies in the United States to
provide an opinion on the effectiveness of the companys ICFR and an opinion on the companys
financial statements. Based on this integrated audit, the auditor issues an opinion on the effectiveness of
the clients ICFR and an opinion on the fair presentation of the financial statement in accordance with
the standards of the PCAOB. See Figure 1-4 for an overview of the integrated audit.
A compliance audit involves reviewing internal controls, operational procedures, and regulations. This
type of audit attests whether internal procedures of management and external regulations of regulatory
authorities are complied with. The outcome of a compliance audit is a report prepared by (or
recommendation made by) the auditor to the management or the relevant authorities.
An operational audit involves analyzing organization structure, internal functions, workflow, and
managerial performance. This type of audit determines (or measures) the efficiency and effectiveness of
an organization. The outcome of an operational audit is a report prepared by (or recommendation made
by) the auditor to the management or the relevant authorities.
10
Table 1-8 Types of Auditor

Category of audit
Financial Audit
Integrated Audit
Compliance Audit
Operational Audit
IRA
IIA
DCA
CFE
CIA
CISA
CFP
CFF
Type of auditor
Affiliation
CPA
AICPA, CPA Associations
IRA, Internal Auditor, DCA

Federal and State Auditor
IRS, IIA, DCA Agency

US Government
Accountability Office (GAO), State
Auditors
Title
CPA, CFE, CFP, CISA, CFF,
etc.
CIA
= Internal Revenue Agent

= Institute of Internal Auditors
= Defense Contract Auditor
= Certified Fraud Examiner
= Certified Internal Auditor
= Certified Information Systems Auditor
= Certified Financial Planner
= Certified in Financial Forensics
The function of the various types of auditor is shown in Table 1-9.

Table 1-9 Function of Various Types of Auditor
Type of Auditor
CPA
IRA, Internal Auditor,

DCAA
Federal and State

Auditor
Function
An independent or external auditor (CPA) performs financial audit and integrated audit. The independent
auditor is either an individual practitioner or a member of a public accounting firm. For private companies,
the CPAs work focuses on the fair presentation of financial statements and accounting records. The CPA is
responsible for reporting (in the form of an audit opinion) to the stockholders. For public companies, the
CPA performs an integrated audit which focuses on the effectiveness of internal control over financial
reporting (ICFR). The CPA is responsible for reporting on the fair presentation of the companys financial
statements as well as the effectiveness of the companys ICFR.
Internal Revenue Agent (IRA)
An internal revenue agent's work focuses on the compliance with and enforcement of federal tax law. The
IRA also audits the income tax returns of individuals and corporations. The IRA reports to the
Commissioner of Internal Revenue.
Internal Auditor (CIA)
An internal auditor's work focuses on compliance with operational procedures and regulations. The CIAs
work may supplement the work of an independent auditor in a financial audit. The CIA reports to the
management of an entity.
Defense Contract Audit Agent (DCAA)
A defense contract audit agent's work focuses on the compliance and fulfillment of defense contracts. The
DCAA reports to the Department of Defense.
The U.S. Government Accountability Office (GAO) auditor (federal auditors) and the state Auditor General
Office auditor (state auditors) perform operational audits. A federal or state auditor's work focuses on the
effectiveness and efficiency of federal or state departments and agencies. The federal auditor of GAO,
headed by the comptroller general, reports to Congress while the state auditor reports to the respective state
governments.
Table 1-10 provides brief comments on the six organizational structures of CPA firms.
Table 1-10 Organizational Structure of CPA Firms
Organizational Structure
Proprietorship
General Partnership
General Corporation
Professional
Corporation (PC)
Brief Comments
Traditionally, all one-owner CPA firms were organized as proprietorships, but in recent years, most of them
have changed to organizational structures with limited liability because of increased litigation risks.
This organizational structure is the same as a proprietorship, except that is applies to multiple owners. This
organizational structure has also become less popular as other organizational structures that offer some legal
liability protection became authorized under state laws.
The advantage of a corporation is that stockholders are liable only to the extent of their investment in the
corporation. Most CPA firms do not organize as general corporations because they are prohibited by law from
doing so in most states.
A professional corporation provides professional services and is owned by one or more stockholders. PC laws
and the resulting liability protection vary significantly from state to state. PC laws in some states offer
personal liability protection similar to that of general corporations, whereas the protection in other states is
minimal. This variation makes it difficult for a CPA firm with clients in different states to operate as a PC.
Limited Liability
Company (LLC)
Limited Liability
Partnership (LLP)
Brief Comments
A limited liability company combines the most favorable attributes of a general corporation and a general
partnership. An LLC is typically structured and taxed like a general partnership, but its owners have limited
personal liability similar to that of a general corporation. Currently, nearly all of the states have LLC laws,
and most also allow accounting firms to operate as LLCs.
A limited liability partnership is owned by one or more partners. It is structured and taxed like a general
partnership, but the personal liability protection of an LLP is less than that of a general corporation or an
LLC. Partners of an LLP are personally liable for the partnerships debts and obligations, their own acts, and
acts of others under their supervision. Partners are not personally liable for liabilities arising from negligent
acts of other partners and employees not under their supervision. It is not surprising that all the Big Four CPA
firms and many smaller CPA firms now operate as LLPs.
Table 1-11 describes the organizational category of CPA firms.

Table 1-11 Organizational Categories of CPA Firms
Category
Local CPA Firms
Regional CPA Firms
National CPA Firms
The Big 4
International CPA Firms
Other Category
Brief Comments
Local CPA firms typically have one or two offices, include only one CPA or a few CPAs as partners, and
serve clients in a single city or area. These firms usually provide income tax, management consulting, and
accounting services. Auditing service is usually only a small part of the practice and tends to involve small
business concerns that find a need for audited financial statements to support applications for bank loans.
Many local CPA firms have become regional CPA firms by opening additional offices in neighboring cities or
states and increasing the number of professional staff. Merger with other local firms is often a route to
regional status. This growth is often accompanied by an increase in the amount of auditing as compared to
other services.
CPA firms with offices in most major cities in the United Stated are called national CPA firms. They are also
referred to as second tier CPA firms (the first tier is the Big 4). The national CPA firms may operate
internationally as well, either with their own offices or through affiliations with firms in other countries.
Since the beginning of 1990s, mergers of the then Big 8 international CPA firms and the dissolution of the
then Arthur Andersen LLP have reduced them to the Big 4 international CPA firms. Since only a very large
international CPA firms has sufficient staff and resources to audit a large corporation, these Big 4 CPA
firms audit nearly all of the largest American corporations (the Fortune 500 corporations). Although these
firms offer a wide range of professional services, auditing services typically represent the largest share of their
profession services. Annual revenue of an international CPA firms is in the billions of dollars. In alphabetical
order, the Big 4 CPA firms are Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and
Pricewaterhouse-Coopers LLP.
Since the late 1990s, a number of publicly traded companies such as American Express, CBIZ, Inc., and H&R
Block began acquiring CPA firms. These companies are often referred to as consolidators because they
acquire CPA firms in various cities and consolidate them into their overall corporations. They usually only
acquire the non-attestation services division of the CPA firms and absorb the non-attestation services partners
and other personnel of the acquired CPA firms as employees of the overall corporations. Then they
outsource back these non-attestation services partners and other personnel to the remaining
attestation/auditing services partners of the acquired CPA firms to provide attestation/auditing services for the
overall corporations.
Table 1-12 describes the organizational hierarchy of CPA firms.

Table 1-12 Organizational Hierarchy of CPA Firms
Level
Staff Accountant or Associate
Senior or in-charge Accountant
Manager
Partner
Average
Experience
Typical Responsibilities
0-2 years
Performs most of the detailed audit-field-work.
2-5 years
Coordinates and is responsible for the detailed audit-field-work, including

supervising and reviewing staff work.
Helps the senior or in-charge auditor plan and manage the audit, reviews the incharges work, and manages relations with the client. A manager may be
responsible for more than one engagement at the same time.
Reviews the overall audit work and is involved in significant audit decisions. A
partner is an owner of the firm and therefore has the ultimate responsibility for
conducting the audit and serving the client.
5-10 years
10+ years
Figure 1-5 shows organization of a typical CPA firm.
11
12
Figure 1-5 Organization of a Typical CPA Firm

Executive Committee
Managing Partner
Practice Offices
Partners-in-Charge
Tax Services
Auditing, Attestation, and Assurance Services
Partner
Manger
Advisory and Accounting Services
Partner
Manager
Senior or in-charge accountant
Staff accountant or associate
A Brief History of Auditing

The last Table 1-13 in this Chapter presents a brief history of auditing.
Table 1-13 A Brief History of Auditing
Time
In the 60s and 70s

In the 60s and 70s, the detection of fraud began to assume an important role in auditing. Auditing standards used
the term irregularities to describe fraudulent financial reporting and misappropriation of assets. Auditors began
to take on a greater responsibility for the detection of fraud because (a) there was an increase in congressional
pressure to account for fraud in large corporations, (b) there were a number of successful lawsuits claiming that
fraudulent financial reporting had gone undetected by the independent auditors, and (c) there was a perception by
the public that the auditors should be expected to detect material fraud.
Consequently, the major accounting organizations (including the AICPA) sponsored the National Commission
on Fraudulent Financial Reporting (the Treadway Commission or COSO) to study the causes of fraudulent
reporting and make recommendations to reduce its incidence. The commissions final report, which was issued
in 1987, made a number of recommendations for auditors, public companies, regulators, and educators. Many of
the recommendations for auditors were enacted by the AICPA in a set of Statements on Auditing Standards
(AUs) known as the expectation gap standards. In addition, the commissions recommendations about internal
control led to the development of an internal control framework, titled Internal Control-Integrated Framework,
which was to be used to evaluate the internal control of an organization. Overall, the development of these
internal control concepts and criteria had increased the demand for auditors to attest to the effectiveness of an
Time
In the 80s and 90s
In the 2000s
organizations internal control.

In the 80s and 90s, the billions of dollars in federal funds that were required to bail out the Saving and Loan
industry caused a movement toward increased regulation of federally insured financial institutions. Congress and
regulatory agencies believed that the key to preventing such problems was to enact effective laws and regulations
and to require auditors to report on compliance with provisions of these laws and regulations.
In 1996, in response to a continuing expectation gap between user demands and auditor performance, the AICPA
issued standards that require the auditors to explicitly assess the risk of material misstatement in all financial
statement audits. Later, these standards were replaced with even more stringent standards that require the
auditors to design specific audit procedures that can detect fraudulent financial reporting.
Meanwhile, the vast improvement in information technology has resulted in the need for auditors to develop
innovative computer assisted auditing techniques (CAATs) in auditing. Consequently, a special group of
auditors, known as the Certified Information Systems Auditor (CISA), was formed to specialize in auditing
computer information systems.
In 2001, Enron Corporation filed for bankruptcy after acknowledging that fraudulent accounting had been used
to significantly inflate its earnings. Shortly thereafter, it was revealed that WorldCom had also used fraudulent
accounting to significantly overstate its reported income. At the same time, there were a record number of public
companies restating their prior-period financial statements. Consequently, investors began to question the
reliability of financial statements and the credibility of the auditing profession.
These events drew quick responses from a number of congressional committees, the SEC, and the U.S. Justice
Department. In 2002, Congress passed the Sarbanes-Oxley Act of 2002, which imposed reforms such as the
increased penalties for corporate fraud; the restriction on management consulting services that the auditors can
perform, and the creation of the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing
profession. The PCAOB has broad power to issue and enforce auditing standards, and to register CPA firms that
audit public companies. Thus, the establishment of the PCAOB has significantly reduced the auditing
professions power in self-regulation. Consequently, auditors who perform financial audit for private companies
follow the AICPAs Statements on Auditing Standards (AUs) whereas auditors who perform integrated audit for
public companies follow the PCAOBs Auditing Standards (ASs).
In 2010, the Dodd-Frank Act of 2010 amended Section 404 of the Sarbanes-Oxley Act by exempting certain
smaller companies from the requirement for an integrated audit of their internal control over financial reporting
(ICFR). However, management of these smaller companies must still provide their annual assessment of the
effectiveness of internal controls.
13
14
Multiple-Choice Questions
1-1
The primary objective of an independent audit is

a. to gather and evaluate evidence.
b. to investigate errors and irregularities.
c. to form an opinion about the fairness of a client's financial statements.
d. to match a client's assertions on financial items with established criteria.
1-2
An audit that determines the strength of a client's internal controls or its conformity with tax law is not classified as a(n)
a. internal audit.
b. tax audit.
c. financial audit.
d. compliance audit.
1-3
The independent auditor is ultimately responsible to

a. the client's management.
b. the client's management and stockholders.
c. the client's board of directors.
d. the client's stockholders and board of directors.
1-4
Attestation services performed by a CPA include

a. audit, review and tax services.
b. audit, review and compilation services.
c. audit, review and management consulting services.
d. audit, review and examination services.
1-5
Operational auditing is primarily concerned with

a. future improvement to accomplish the goals of management.
b. the accuracy of data reflected in managements financial records.
c. verification that a companys financial statements are fairly presented.
d. past protection provided by existing internal control.
1-6
Other assurance services are similar to, yet differ somewhat from, attestation services. When performing other assurance services,
the CPA
a. is not required to issue a written report, and the assurance is about the reliability and relevance of information.
b. is required to issue a written report, and the assurance is about the reliability and relevance of information.
c. is not required to issue a written report, and the assurance is about the completeness and sufficiency of information.
d. is required to issue a written report, and the assurance is about the completeness and sufficiency of information.
1-7
Which of the following audits can be regarded as solely compliance audits?

a. An independent CPA firms audit of the local school district.
b. An internal auditors review of his employers payroll authorization procedures.
c. GAO auditors evaluation of the computer operations of governmental units.
d. Internal Revenue Service Agents examinations of the returns of taxpayers.
1-8
A CPA certificate is evidence of

a. recognition of independence.
b. culmination of the educational process.
c. basic competence at the time the certificate is granted.
d. membership in the AICPA.
1-9
The use of the title CPA is regulated by

a. the federal government through the licensing department of the Commerce Department.
b. state law through the licensing department of each state.
c. the AICPA through the licensing departments of the tax and auditing committees.
d. the Securities and Exchanges Commission (SEC).
1-10
An examination of part of an organizations procedures and methods for the purpose of evaluating efficiency and
effectiveness is what type of audit?
a. Production audit.
b. Financial statement audit.
c. Compliance audit.
d. Operational audit.
1-11
CPA firms have as their primary responsibility the performance of the audit function on published financial statements of
a. all corporations.
b. all corporations listed on the New York Stock Exchange.
c. all publicly-traded companies.
d. all federally-charted corporations.
1-12
In response to the growing demand for assurance of business transacted electronically over the Internet, the AICPA
created
a. Information System Reliability assurance services.
b. CPA WebTrust assurance services.
c. AICPA WebPartner assurance services.
d. Internet Reliability assurance services.
1-13
The independent auditor is primarily accountable to

a. the management of an audit client because the auditor is hired and paid by the management.
b. the audit committee of an audit client because that committee is responsible for coordinating and reviewing the audit.
c. stockholders, creditors, and the investing public.
d. the SEC because it determines the responsibility of the auditor.
1-14
Assurance services involves all of the following except

a. improving the quality of information for decision making.
b. improving the quality of the context for decision making.
c. improving the relevance of information.
d. improving the outcome of an information system.
1-15
The work of an internal auditor is best described as

a. an audit of a companys compliance with managements policies and procedures.
b. an evaluation of a companys susceptibility to fraud.
c. an audit of companys computer systems.
d. an audit of a companys efficiency and effectiveness.
1-16
Which of the following best describes why an independent auditor reports on financial statements?
a. Independent auditors are likely to detect fraud.
b. Competing interests may exist between management and the users of the financial statements.
c. Independent auditors are likely to correct misstated account balances.
d. Ineffective internal controls are likely to be discovered by the independent auditors.
1-17
Who is primarily responsible for the assertions in financial statements?

a. Audit partner in charge of the audit engagement.
b. Senior auditor in charge of audit field work.
c. Staff auditor in charge of audit work papers.
d. Audit clients management.
1-18
In performing an attestation engagement, a CPA typically

a. supplies litigation support services.
b. assesses control risk at a low level.
c. expresses a conclusion in the form of a written communication about an assertion.
d. provides management consulting advice.
15
16
1-19
Which of the following professional services would be considered an attest engagement?

a. A consulting service engagement to provide computer advice to a client.
b. An engagement to report on compliance with statutory requirements.
c. An income tax engagement to prepare federal and state tax returns.
d. The compilation of financial statements from a clients accounting records.
1-20
The main objective of assurance services is to

a. provide more reliable information for decision makers.
b. provide confidential information for decision makers.
c. improve the quality of information for decision makers.
d. improve the quantity of information for decision makers.
1-21
Other assurance services performed by a CPA include

a. ElderCare Plus, Web Trust, and review.
b. Risk Assessment, business performance measurement, and certain management consulting.
c. Examination, electronic commerce, and compilation.
d. Audit, review, and agreed-upon procedures.
1-22
The Sarbanes-Oxley Act of 2002 and PCAOB Standard No.5 require an integrated audit for publicly traded companies in the United
States. This integrated audit is usually performed by which of the following types of auditor?
a. Internal auditor (CIA) of a public company.
b. Internal revenue agent (IRA) or defense contract audit agent (DCAA).
c. Federal, state, or local government auditor.
d. Certified public accountant (CPA).
1-23
In 2002, Congress passed the Sarbanes-Oxley Act of 2002 that did not impose which of the following reforms?
a. The creation of the Government Accountability Office (GAO).
b. The increased penalties for corporate fraud.
c. The restriction on management consulting services.
d. The creation of the Public Company Accounting Oversight Board (PCAOB).
1-24
Which of the following statements accurately describes U.S. CPA firms that are not sole proprietorships?
a. The firm will be subject to an annual peer review.
b. The most common organizational structure is the limited liability partnership structure.
c. Most derive the majority of their revenues from tax services.
d. The number of other professionals within a firm generally equals the number of partners in the firm.
1-25
Which of the following is the total number of opinion in a financial audit and an integrated audit?
Number of opinion
I.
II.
III.
IV.
Financial Audit
None
One
Two
Three
Integrated Audit
Two
Three
Two
Three
a. I
b. II
c. III
d. IV
Key to Multiple-Choice Questions

1-1c. 1-2 c. 1-3 d. 1-4 d. 1-5 a. 1-6 a. 1-7 d. 1-8 c. 1-9 b. 1-10 d. 1-11 c.
1-12 b. 1-13 c. 1-14 d. 1-15 a. 1-16 b. 1-17 d. 1-18 c. 1-19 b. 1-20 c. 1-21 b.
1-22 d. 1-23 a. 1-24 b. 1-25 b.
Simulation Question 1-1

Simulation Question 1-1 is an adaptation with permission from a case by Walker, P. L., W.G. Shenkir, and C.S. Hunn in the Issues in Accounting
Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
The information contained in the simulation question was obtained from publicly available sources.
Introduction
The Nicholsons Story
What Went Wrong?
Prudential Insurance Company of America (hereafter, PI), whose symbol is the Rock of Gibraltar, assures its customers that for
financial security and peace of mind they could depend on the Rock. For years its advertisements built its Rock-Solid image. PI was created
around its people, who were committed to a set of core values lauded by management: client focus, winning, trust, and respect for each other. The
company was dedicated to selling the right product, to the right client, in the right way. Yet for Prudential customers, selling the right product
in the right way proved to result in something less than peace of mind.
Keith and Carol Nicholson trusted their financial security to the PI when they purchased a rather sizable life insurance policy from
their PI agent. At one point, the policys cash value was $103,000. Since Keith suffered from leukemia, this policy was comfort for the unstable
times that lay ahead of them. Carol needed to know that this money was going to be there.
Carol had been known to say that she trusted her PI agent as she trusted her pastor. He was going to play a vital role in smoothing a
very uncertain future. Therefore, when her agent suggested that she and her husband take out a new life insurance policy on Keith at no
additional cost, the couple agreed, no questions asked. They just signed the forms, believing that they had bought even more certainty to the
unpredictable future.
Eventually, Keith succumbed to leukemia. Much to Carols surprise, the six figure nest egg that she thought would be awaiting her
was now a mere $22,000. Carols agent had not been honest when he had Carol and her husband changed his life insurance policy. The
Nicholsons agent had taken advantage of the couples trust by having them borrow against their old policy to purchase a new and more
expensive policy.1 Without even realizing it, Carol and Keith had signed a blank withdrawal form that allowed their agent to raid the cash value
of the old policy to begin to pay for the new policy. Carols reaction was a tearful plea of How could they?
PI is a massive entity whose asset base is equivalent to the economy of Sweden. You should access Data File 1-1 in iLearn for
Table 1, which presents the top ten life/health insurers ranked by assets, and Table 2, which presents them ranked by premium income.
PIs primary businesses were life insurance, health care, investments, and property and casualty insurance. Of all the different types of insurance
being offered by PI and its competitors, life insurance was the most lucrative for both the company and its agents. From 1983 through to 1987, PI
saw record-breaking increases in its sales of life insurance policies, even though the industry saw a decline in sales. You should access Data File
1-1 in iLearn for Table 3, which presents PIs total life insurance sales 1982-1987, and Table 4, which presents industry life insurance
purchases in the United States.
Carol and Keith Nicholson were not the only victims of PIs churning scam. Before the end of 1995, over 10.7 million life insurance
policyholders had allegedly fallen prey to the scam and a class action lawsuit was soon filed. Additionally, investigations of the nations largest
life insurer spanned the country, from New Jersey to Florida to Arizona, in an effort to answer the question, How could they?
In 1996, as part of the Florida Department of Insurances investigation of PI, a former PI Vice-President of Regional Marketing
testified regarding sales practices. In part of his testimony, the witness discussed the process of how customers buy life insurance.
WITNESS: They said that their agent sits there, and he says sign there, sign here, sign here, sign here, and I have to trust in the agent.
I sign; he turns it over and says sign here, sign here, and sign here. I sign.
Most people, even after they signed them, didnt take them home and read them. That is what its like applying for life insurance.
The Nicholsons were among the many insurance customers who just signed forms as instructed by their agent. According to this e-PI
employee, the most prevalent financing scam at PI was selling a new policy as free life insurance by essentially using the accumulated cash
value of an older policy to pay the new, increased premiums. In many cases, the old whole life or universal policy was replaced with a term
policy. The former policies build up cash value, whereas term policies do not. In some cases, insured persons would increase their total life
insurance coverage because they had more overall coverage from the term policy. In his two days of testimony, the confidential witness
commented as follows:
WITNESS: I would say financing was minuscule in 82, 83, 84 and then started growing rapidly in 85, 86,87,88, and then
started to level off probably in 90,91.92, and then may have gone down a little bit in 93, 94.
PI contended that such practices were never condoned. Under oath, the ex-employee stated otherwise:
WITNESS: That has always been Prudentials public statement, financing and replacement is bad; not generally in the best interests of
the policy holder At the peak, it was used in at least 30 percent of the cases and probably higher.
According to a Coopers & Lybrands (now PricewaterhouseCooper LLP) assessment of PIs controls:
Training of field management with respect to supervising sales practices and identifying and dealing with compliance-related issues
has been inconsistent at best. As such, managers are not always sure as to what constitutes good vs. bad sales practices, are reactive toward
compliance issues, and are not held accountable for their own actions or those of their representatives.
PI, like many life insurers during this period (1982-1993), offered a very complex product. Without adequate instruction, many agents
felt as if they had been misled about what they were selling. Even so, it should be noted that many PI employees were fully aware of the
consequences of their actions. The deposed former employee noted that there existed an informal system of training on refinancing policies. The
witness told how this manipulative practice was able to spread:
WITNESS: What happens is because there is no formal training of this kind of thing; it passes by word of mouth or by transfer of
people. So it doesnt surprise me that you will find it pop up here or pop up there. Then after these people got to be very successful, they would
go to conferences and say, this is how we do it. An then it spread countrywide, and my belief is it really got heavy in 84 and 85 because
illustration sold nicely, too.
Such a tactic is referred to as a churning, financing, or refinancing.
17
18
The ex-employee remarked that many agents set up booths at the Regional Business Conference in an effort to illustrate the art of
selling financed insurance. The employee also claimed that, in support of these practices, many agents developed and used their own sales
materials, as revealed by testimony on these self-developed materials:
QUESTION: Typically, would he [management] say anything about it? Would he care?
WITNESS: I dont know. Im not sure. But keep in mind that the managers are paid overrides. If there is a piece that appears to be
working, theyre not going to stop using it, because it affects their pocketbook.
The former PI worker also discussed the monetary consequences of churning:
QUESTION: So this document [a memo] would indicate that the company knew way back in 76 that financed insurance was
regularly producing unacceptable results?
WITNESS: Correct. And the next question is why it was producing unacceptable results. Did you [Prudential] look into it? Did you
[Prudential] ascertain what occurred in the sale that produced unacceptable results? The answer is nothing. The reason that Prudential didnt care
was they were sales driven. Everything was measured off new sales There was a benefit to the agents, to management, to individuals working
for the company, because their bonuses grew dramatically If you look at the pay scale of management in 1976, a senior vice president in 1976
probably made $$100,000 a year, a lot of money. A senior vice president in the company today probably in the same position might make a
million dollars a year. Now inflation has been eating away a lot since 1976, but I dont think it ate ten times so there was a financial incentive
for he employees, all employees, not just senior people.
The incentive for the salesperson was simply commissions. Characteristically, a large percentage of the premium paid by the
consumer in the first year went directly to the agent. That commission shrunk in later years. The ex-employee further elaborated upon this subject
in the second day of his testimony:
WITNESS: Another file you would want to look at is Phoenix West. That was an investigation done last year [1995] As a result of
that investigation, there were recommendations with regard to the discipline of many, many people; but if you look at that whole investigation,
you will see the attitude of the company toward people who were engaged in wrongful financial insurance transactions over a long period of time,
with the knowledge of many people They merely state that we did it because we made money and we didnt care And Phoenix West is just
a microcosm of what was really going on in the country.
John Vetter, an insurance representative in the beleaguered Phoenix West Agency, admitted to some questionable sales. In an
investigation of the Phoenix West Agency, the Florida Department of Insurance documented that:
He [John Vetter] said your judgment gets clouded out in the field when you are pressured to sell, sell, sell. In response to questions on
how he could explain a case where he had rewritten a policy instead of reinstating it when the rewrite resulted in a higher premium for the
insured, he responded that it was pure greed.
With everyone in PI benefiting financially from refinanced life insurance policies, there seemed to be no need to stop, regardless of
managements official stance on the issue:
WITNESS: You will probably see that in Prudential all the documents that you see or the bulk of the documents you see will be very
good on their face, theyll say you shall not do this. The problem was that there was nothing behind you shall not do this. There was no
mechanism to punish. In fact, I dont believe youll find a single termination of an agent or member of management for financing insurance
outside of Cedar Rapids and a couple of other districts in the 80s.
The ex-employee felt not only that management condoned churning, but also that management explicitly allowed it. Many PI
customers complained about their new life insurance policies before this scandal fully surfaced in 1994, and, according to this ex-employee, PI
addressed such complaints in the following manner:
WITNESS: whenever they [the customer] had a complaint, the first thing they had to do if they had an oral complaint, they had to
put it in writing. That knocked down a number of the complaints right away because most of our customers, because most of their educational
level and because of their financial circumstances, hesitated to put things in writing. The second thing we did is we would get the complaint and
then would ask the agent what the agent did. If the agent said he did it right, we would deny the complaint and we would hold to that denial
through three or four subsequent complaints. And basically we didnt actually do an investigation except to get the statement of the person who
was complained about, and that was the position in Prudential probably until late 1994.
Some PI executives did seek changes, given the growing number of customer complaints (although it was later alleged that not all
complaints were logged into the companys database). One such measure was having the customer sign a release verifying that he or she fully
understood the terms and conditions of his or her new policy. Testimony recounts the reaction to such a measure:
WITNESS: The next one is a memo [dated August 29, 1995] from Bill Hunt [Head of Ordinary Agencies]: I do not believe we
should have the applicant sign off on anything. Not only does this imply a lack of trust toward agents, it also has the potential to build skepticism
from the prospective insured regarding what they are being sold. Basically what he is saying is he is not going to ask him to sign anything
because it could disrupt the sale.
The selling of life insurance has become a complex process. Clearly, customers frequently do not understand the product they are
buying, but instead appear to place a high level of trust in their agent. That trust places additional burdens and responsibilities on agents and PI
itself. It also appears evident that sales practices such as churning and refinancing were not only widespread but may have been occurring for an
extended period of time. The witness implied that financial incentives may have encouraged this activity and that managements attitude toward
controls and problems was questionable.
A New CEO
The New CEOs Reaction and Changes
As early as 1982, the companys internal auditors reported to the Board of Directors fraudulent practices on the part of sales agents. In
addition, internal audits of individual divisions and regional offices in the early 1990s detailed a failure by management to enforce consumerprotection laws and regulations. In a June 1994 report commissioned by PI in the wake of regulatory inquiries about insurance sales practices,
Coopers & Lybrand stated that PI officials failed to act adequately upon such warnings. The Board admitted that it had been made aware of
major irregularities, but they continually asserted that they trusted managements claims that the problems were being properly monitored.
In November 1994, PIs Board of Directors turned to Arthur Ryan (the president of Chase Manhattan Corp.) This was the first time in
over 120 years that PI had looked outside the company to fill the position of CEO. Lacking any formal background in the field of insurance, his
reputation was built upon his ability to streamline operations and introduce new technology. He is renowned to rolling up his sleeves at his own
computer. He enjoys working one-on-one and is perfectly comfortable at center stage of the company auditorium. Simply put, Ryan is direct,
open, focused, and engaged.
Ryan had made a conscious choice to change PIs business approach. Under Ryans command, PI would no longer be a series of
independent silos, freewheeling subsidiaries working at cross-purpose with fragmented game plans. The buzzword at Ryans PI would be about
facilitating teamwork and cooperation.
To break from the past, Ryan began recreating PIs management team. Much of the old guard was released. Ryan hired twelve of the
14 executives who reported directly to the CEO. Of the top 150 executives, two-thirds were new, and half of these replacements were newcomers
to PI.
Ryan also decided on cutbacks like those that had won him much praise at Chase Manhattan. Within two years of Ryans arrival, a
workforce of 100,000 had been reduced to 83,000. Ryan also eliminated about $790 million in overhead by shutting down five regional
headquarters (that had once been proud outposts for the companys management). He also sold the home-mortgage operation, thereby reducing
the companys exposure in the homeowners insurance side of the business. By the end of 1995, Ryans restructuring had resulted in seven major
operating groups: individual insurance, money management, securities, healthcare, private asset management, international insurance, and a
diversified group.
Although Ryans actions would appear to be a step in the right direction, not all of his streamlining was met with open arms. The
companys insurance sales force, which numbered 20,000 when Ryan came to PI, was cut in half within four years. The company fired or
counseled out agents who could barely sell enough insurance to cover the costs of their employee benefits. During the first months of 1997, more
than 1,600 junior and senior insurance-sale managers were still going through very severe reviews. As a result, about 100 of these employees
left PI.
Ryans labor troubles did not end with complaints from the sales force over tighter controls. In an effort to mitigate some of the
damage to PIs bottom line resulting from the churning scandal, PI attempted to increase agent production quotas. The proposed labor contract
would have increased quotas by 25 percent, but the union representing PIs insurance agents rejected the deal.
In 1998, PI officials estimated that the class-action suit could cost PI as much as $2 billion. Many questions still remain for Ryan, but
for the customers of PI, the most significant question remaining is, Has enough been done to ensure that they will no be the next Carol
Nicholson?
Required
1. a. Research the risk framework suggested by the Special Committee on Assurance Services (also known as Elliott Committee) at the AICPAs
website: http://www.aicpa.org
b. Assume you were engaged by PI to provide Risk Assessment assurance services. Identify and discuss the following risks associated with
PI for the period from the 1980s and the early 1990s:
i.
Marketing and sales risks
ii.
Corporate culture risks
iii.
Strategic risks
A document that may help you in answering 1.b. is the AICPAs statement of Position 98-6, Reporting on Managements Assessment Pursuant to
the Life Insurance Ethical Market Conduct Program of the Insurance Marketplace Standards Association.
2. Assume you were engaged by PI to provide Risk Assessment assurance services. Suggest controls that should be established to manage the
risks identified in 1.b.
Note: These controls are not the traditional internal controls. Rather, they are controls that are needed to help PI manage its risk and ultimately
achieve its objectives.
A document that may help you in answering SQ1-1 is the Committee of Sponsoring Organizations (COSO) report,
Internal Control-Integrated Framework (also known as the Treadway Commission Report).

Simulation Question 1-2 is an adaptation with permission from a case by Phillips, F. and D. Kalesnikoff in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The
information contained in the simulation question was obtained from publicly available sources.
Introduction
Professor Irene Ballinger is founder and chief executive officer of Q-Dots Incorporated (hereafter, QDI) a small, private company
that operates adjacent to Cornell University in Ithaca, NY. QDI has pioneered ways to mass produce and manipulate nanoscopic fragments of
silicon, which are called quantum dots. In addition to being extremely small, consisting of only a few hundred atoms, quantum dots have the
unique capability of being tuned to light-up in any color by simply changing their size.
Dr. Ballinger first reported the properties of quantum dots or q-dots, as she calls them, at an academic conference in June 1999. A
discussant at the conference commented that the discovery might be useful in a broad array of applications, ranging from microscopic lighting to
television display. Intrigued by these possibilities, Ballinger set out to determine whether the theory could be applied in practice. After nearly two
years of further research, she discovered that Q-dots could be used in multiphoton microscopy. Simply put, with q-dots, Ballinger could make
tiny blood vessels beneath a mouse skin appear so bright and vivid in high-resolution images that she could see the vessel walls ripple with each
hearbeat-100 times a second. Ballinger referred to this application as a Q-light a finding that published in a leading academic journal in May
2001.
Within a few months, Ballinger began receiving enquiries from scientists around the world about the availability of Q-lights for use in
their laboratories. In late 2001, Ballinger decided to create QDI (a private company), employing a team of nanotechnology engineers to fully
develop the Q-lights and make the marketable to a broader base of customers. In addition, Ballinger hired a management team to take care of the
business side of things. The management team purchased a 25 percent interest in QDI when it was incorporated at the beginning of January
2002.
19
20
The first line of Q-lights was completed and available for commercial distribution in March 2002. Q-lights were an immediate
success, and have become one of QDIs primary sources of revenue. The other major source of revenue for QDI is the manufacture and
distribution of raw Q-dots that other researchers are using to develop their own new product applications.
Things had been going well for Ballinger and QDI until August 14, 2004, when Ballinger received a letter from attorneys at the
University of California, Berkeley claiming that Ballingers Q-lights discover took place several months later than a similar discovery by a
team of researchers from Berkeley. Patent applications had been filed by both Ballingers management team and the Berkeley team around the
same time, and it is not clear which researchers, if any, will be granted the patent for multiphoton microscopy. The Berkeley attorneys threaten
legal action if QDI does not immediately stop production and sale of Q-lights. These threats have shaken Ballenger, who now wants out of the
commercial side of her scientific work. She has said, The last thing I want is to have my research lab shut down. She has advised her
management team to ship Q-lights only to existing customers and to store any excess Q-dots production at a colleagues research lab in
Pittsburgh. Fortunately for Ballinger, the QDI management team does not view the legal action as a credible threat, and has agreed to purchase
Ballingers shares under the terms set out in Table 1. You should access Data File 1-2 in iLearn for Table 1, which presents details of the
purchase-and-sale agreement.
Request for Business Performance Measurement Assurance Services
Your CPA firm has been providing tax services to QDI since it was incorporated as a private company on January 1, 2002. In 2004,
QDI also engaged your firm to provide business performance measurement assurance services. Specifically, Ballinger would like your firm to
look at the numbers that will be used to determine the purchase-and-sale price and to analyze the purchase-and-sale agreement to make absolutely
certain that she is rewarded fairly for what she contributed to QDI.
Required
Tom Cohen, the assurance services partner in your CPA firms office has asked you to review the proposed terms of the agreement
(see Table 1) and the notes he made during his meeting with Ballinger (see Table 2). You should access Data File 1-2 in iLearn for Table 1,
which presents details of the purchase-and-sale agreement, and Table 2, which presents Tom Cohens notes on information gathered
from Dr. Ballinger. After reviewing these two documents, Tom Cohen also would like you to write him a report that identifies and analyses
significant engagement issues pertaining to this business performance measurement assurance services. Your report should consist of three
parts that fully address the questions provided in each part as follows:
Part 1: Regarding the proposed buy-out agreement.
a. What are the strong and weak points of the proposed buy-out agreement?
b. What is it that has to be measured for the buy-out to occur?
c. What skills are required in performing this measurement?
d. What level of assurance can be reached?
e. Will this level of assurance meet the needs of Dr. Ballinger?
f. Will this level of assurance meet the needs of QDIs management?
g. What are the 3.0 and 1.5 multipliers intended to represent?
h. What are the implications of the non-compete clause?
i. What suggestions/advice should Tom Cohen make with regards to the proposed agreement?
Part 2: Regarding litigation
a. Who is bearing the risk of the litigation?
b. What are the ramifications if Berkeleys threat of litigation becomes a reality?
c. What would be the implications of losing a law suit to Berkeley?
Part 3: Regarding financial reporting
a. What are your general thoughts on managements accounting decisions?
b. Is managements write-off of Q-lights and Q-screen product development costs consistent with their earlier communicated thoughts on the
litigation?
c. Is the payment to lobbyists unethical or just smart business?
d. Does the payment to lobbyists constitute an asset or expense?
e. If the payment to lobbyists is an expense, is it an operating or non-operating expense?
f. How does the FBI contract fit with principles governing revenue recognition? What about conservatism? What makes sense given the
situation?
g. Is managements decision to expense the Q-prints development and production costs consistent with fundamental accounting concepts and
principles?
Note: Your report must not be a list of answers to the above questions. It must be written in a report format with Parts 1, 2 and 3 as three
sub-headings.

Simulation Question 1-3 is an adaptation with permission from a case by R. N. Schmidt and F. Phillips in the Issues in Accounting Education, a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The
information contained in the simulation question was obtained from publicly available sources.
Introduction
Company Background
The Meeting
Assume that you are an audit manager at KST LLP, a mid-sized public accounting firm located in northern Colorado. Recently, you
attended a local Oktoberfest celebration and had the opportunity to be seated at a table with Sammy Blitzthe CEO of a local private
manufacturing firm. Always looking for the opportunity to extend your network of contacts and potential clientele, you engage in an insightful
conversation with Sammy and learn a great deal about him and his business, both of which have interesting backgrounds.
Blitz Bow Corporation (BBC) is a manufacturer of archery equipment with a predominant focus on manufacturing high-quality bows
for competitive archers and bow hunting enthusiasts. BBC was incorporated in 1977 when former repeat summer Olympic competitor Samuel
(Sammy) Blitz, with the financial support of his sister, Lauren Blitz, began to manufacture bows for archery competitors. Since 1983, BBC has
exclusively sold its bows through its single retail store located immediately beside its manufacturing facility. The proximity of the manufacturing
facility and retail store has allowed Sammy to maintain strict quality control over BBC products while also permitting patrons the opportunity to
tour the manufacturing facilities. Despite the demands of owning and managing a family business, Sammy took time and great pride in watching
his son, Brandon, share in his passion for the sport of archery. After enjoying success as a junior amateur, Brandon later pursued a mechanical
engineering degree. Now, Brandon is the VP of Operations at BBC, and for nearly a decade Sammy and Brandon have worked closely together at
BBC leading a team on product innovations.
Although relatively small compared to its competitors in terms of gross sales, BBC has established itself as a North American leader
in product innovation and as such has reaped the benefits of the strong consumer brand loyalty that typically plagues the sports market.
Specifically, BBC has changed its product line from initially focusing on traditional recurve bows, which are the only bows permitted at the
Olympic Games, to compound bows. Innovation in the archery industry, market preferences, and resurgence in bow hunting have established
compound bows as the fastest growing market niche in the bow manufacturing industry.
Consumers in the compound bow market demand specific features to maximize their probability of success in the field. In particular,
the bow's ability to propel arrows with high levels of kinetic energy is critical to bow hunting enthusiasts (widely referred to as knock down
power), in addition to flat arrow trajectory, accuracy, and quiet operation. In regard to the first two features, bow manufacturers have focused on
modifying the design of the bow to mechanically maximize arrow speed, which is a key driver for kinetic energy and flat trajectory. As such, bow
manufacturers use their estimates of arrow speed in their advertising campaigns to differentiate their bows from competitors. Moreover, consumer
research conducted by the archery industry has documented that this single measure of foot-per-second arrow speed is an important determinant
in the consumer's choice to purchase a particular bow, despite the fact that bows that offer blazing arrow speeds often do so at the cost of reduced
accuracy and increased noise of operation. Given that every incremental foot per second is important, consumers demand that manufacturers
furnish a highly accurate estimate of arrow speed for every bow model.
Looking out your office window, you are reminded by the thick layer of snow that December has arrived. As your mind slips to your
upcoming weekend snowboarding plans, your phone rings. It is your receptionist announcing that you have a drop-in client that has asked
specifically to meet with you. Glancing at the clock, you realize that it is already 4:00 p.m. on Friday, but are always happy to meet with potential
new clients. You open the boardroom door and are surprised to see a familiar faceSammy Blitz. After a brief catch up over coffee, the
conversation turns to business.
Sammy: Thank you for seeing me on such short notice. I was happy to have the opportunity to meet you several months ago, and I
noted your interest then in our business at BBC.
You: It was my pleasure. How can I be of service?
Sammy: With the new line-up of bows set to be unveiled next month, I was recently informed about the advertising campaigns of
my competitors. I'm tired of seeing my competitors make up stories about how great their bows are. This really has gotten out of
control. Given the structural complexities in compound bows, manufacturers have seen the opportunity to make ridiculous statements
with limited to no support for their claims.
You: What are some examples?
Sammy: Our closest competitor, Wicked Axis Archery, came out with a new line of bows this year which it claims are quiet as a
mouse. In truth, Wicked bows vibrate violently when you release the arrow, to the extent that the sound would wake the dead!
Another competitor, ProCam, is misleading consumers in its claims that its cam designs deliver superior let-off' for the archer at full
draw. Perhaps what is bothering me the most is the marketing campaign of the newest entrant to the bow manufacturing market, Bow
Fever. This company is advertising that its bows are able to deliver arrow speeds of 365 feet per second, when in truth these speeds are
being determined in conditions that take advantage of the more flexible IBO standards rather than the more stringent ATA standards.
As we had discussed in October, arrow speed is arguably the most critical element that manufacturers focus on, given its importance
to consumers. It is no secret that we take great pride at BBC to make our bows capable of sending arrows at the fastest speeds in the
industry. We view Bow Fever's claims as a serious threat to our future profitability.
You: Sounds like you either need a lawyer or a new engineer. How can I help you today?
Sammy: I just got back from a bow manufacturer association conference last week. Consumers are seriously complaining about the
arrow speed claims of the bow manufacturers. I'm concerned because customers who have been loyal to BBC for years have begun to
question whether they can trust our arrow speeds. They suspect that all manufacturers are overstating their arrow speed ratings. Heck,
it is documented in virtually every online archery forum. Take a look, for example, at archerytalk.com. We're all being painted with
the same broad brush. I share in the customers' concerns, and I want to make sure our customers can trust that our bows deliver what
we say they deliveran honest to goodness 360-feet-per-second arrow speed. We have carefully constructed our quality control
processes to ensure that every bow is manufactured to the specified ratings. I want to cut to the point. My son, Brandon, recalls from
one of his elective university courses that there is some sort of service that public accountants can provide that increases the credibility
of numbers. Basically, what I want is for you to back up my claim that our bow shoots arrows at 360 feet per second. Actually, now
21
22
that I think of it, maybe we should be more aggressive and assert that our bows shoot arrows faster than any of our competitors. What
do you think? Is there some sort of service you folks can do?
You: Let me look into this for you, Sammy. May I ask why you are interested in our firm?
Sammy: Well, you folks are accountants. Accountants know how to deal with numbers, and this arrow speed number in feet per
second is an important number to me and my customers. I figured you would know how to help me out. Also, I'm confident that your
firm has the necessary expertise. In fact, I know several of your colleagues from the local archery club. I believe Erich is a partner, and
Sarah and John have recently started with your firm, maybe a year or two ago. Unfortunately, Erich must have left early for the
weekend, because he wasn't available earlier. Let him know that I hope he is better at accounting than shooting!
You: I'll be sure to pass on the joke.
You promised to check into the situation and get back to Sammy on Monday. After Sammy left the office, you slouched back in your chair. You
believed that you would be considered for promotion to senior manager if you could secure BBC as a client to the firma client that Erich, the
office audit partner, would be eager to have. You accessed your online auditing and attestation standards, and also did some quick research on
compound bow dynamics and industry guidelines on bow speed ratings. You should access Data File 1-3 in iLearn for Exhibit 1, which
presents a picture of a compound bow; Exhibit 2, which presents notes on the dynamics of a compound bow, and Exhibit 3, which
presents notes on ATA and IBO criteria for Bow Speed Rating. You then started writing a memo to Erich striving to explain what specific
types of engagements the firm could provide BBC to meet its needs. Furthermore, you tried with your current limited knowledge of BBC's
business to outline anticipated complexities involved with the proposed engagement.
Required
Write a memo to Erich, the office audit partner, with regard to the following:
1. Explains what types of engagement your CPA firm should provide to BBC. Should it be auditing, attestation, assurance, or other types of
service?
2. What specific auditing, attestation, assurance, or other standards should you consider as a guide for this engagement?
3. Based on Exhibits 1, 2, and 3, and your current limited knowledge of BBCs compound bow, explain how would you test Sammys assertion
that his compound bow shoots at 360 feet per second?
Note: A document that may help you in answering SQ1-3 is PCAOB AT Section 101, Attest Engagement.
Chapter 2
The Auditors Professional Environment
LO2-1 Understand the AICPAs influence on the auditors professional environment.
LO2-2 Describe four fundamental principles underlying an audit (AICPA).
LO2-3 Describe the AICPAs six elements of quality control.
LO2-4 Understand the Securities and Exchange Commissions (SECs) influence on the
auditors professional environment.
LO2-5 Summarize the duties of the Public Company Accounting Oversight Board
(PCAOB).
LO2-6 Understand multiple sets of standards for the audit of public, private, and foreign
companies
LO2-7 Explain the influence of the Corporate and Criminal Fraud Accountability Act of
2002.
LO2-8 Discuss the influence of the International Federation of Accountants (IFAC) and
the International Standards on Auditing (ISAs).
LO2-9 Identify some key changes required by the SEC that affect the audit committee.
23
24
Chapter 2 The Auditors Professional Environment

The American Institute of Certified Public Accountants (AICPA) and Securities Exchange Commission (SEC) are
the two major forces that influence the auditors professional environment. The AICPAs influence is depicted in
Figure 2-1.
Figure 2-1 AICPAs Influence on the Auditors Professional Environment
AICPA
Influences CPA firms and individual CPAs through
Auditing Standard
Board
(ASB)
Previously
promulgated
10 Generally
Accepted Auditing
Standards (GAAS)
CPA Firms Division

Professional Ethics
Peer Review Board
Executive Committee
(PEEC)
Directs
Peer
Review
Program
Quality Control
Standards Committee
Enforces
Code of
Professional
Conduct (CPC)
Establishes
6 Elements of
Quality Control
Audit Practice and

Quality Centers
(CAQ)
Improves
Audit Practice
Quality
Currently
replaced by
4 Fundamental
Principles
Detailed
guideline in
More than 100 Statements on Auditing Standards, labeled as AUs # in Topical Order
Organized into
6 topical contents
AU 200
AU 300-499
AU 500
AU 600
AU 700
AU 800-999
General Principles and Responsibilities

Risk Assessment and Response to Assessed Risks
Audit Evidence
Using the Work of Others
Audit Conclusions and Reporting
Special Considerations
AICPAs Influence on the Auditors Professional Environment

The AICPA is a national professional organization. Its membership is voluntary; however, a majority of CPAs are
members of AICPA. The AICPAs influence on the auditors professional environment is briefly discussed in Table
2-1.
Table 2-1 AICPAs Influence on the Auditors Professional Environment
Division/Committee
Auditing Standards Division

(ASB)
CPA Firms Division
Professional Ethics
Executive Committee (PEEC)
Quality Control Standards

Committee
Audit Practice and Quality

Center (CAQ)
Influence
An important arm of the Auditing Standards Division is the Auditing Standards Board (ASB), which
promulgates the 10 generally accepted auditing standards (GAAS) that guide the quality of audit
services. Compliance with the 10 GAAS is mandatory for members of AICPA who perform auditing
and other related professional services. See Table 2-2 for details.
Detailed guideline to the 10 GAAS are provided by more than 100 Statements of Auditing Standards
(AUs) issued by the ASB. The AUs are labeled by their AU numbers #, which are based on the topical
content with which they are issued. For example, the Statement on Auditing Standards, Consideration of
Fraud in a Financial Statement Audit, is labeled as AU 240.
As part of improving clarity and converging with international auditing standards, the ASB replaced the
previously promulgated 10 GAAS with a more comprehensive and coherent description of the
Principles Underlying an Audit in Accordance with Generally Accepted Auditing Standards. These
fundamental principles are grouped into four categories: (1) the purpose and premise of an audit, (2)
personal responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting.
They are referred to as the Four Fundamental Principles underlying an audit. See Table 2-3 for details.
In addition, as part of improving clarity and converging with international auditing standards, the more
than 100 AUs are reorganized into six groups in a new AU codification scheme: (1) AU 200 General
Principles and Responsibilities, (2) AU 300-499 Risk Assessment and Response to Assessed Risks, (3)
AU 500 Audit Evidence, (4) AU 600 Using the Work of Others, (5) AU 700 Audit Conclusions and
Reporting, and (6) AU 800-999 Special Considerations. For example, the Statement on Auditing
Standards, Consideration of Fraud in a Financial Statement Audit, is grouped under General Principles
and Responsibilities as AU 240 (previously AU 316). See Appendix A for details.
With the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of
public companies (integrated audits) are to be established and promulgated by the Public Company
Accounting Oversight Board (PCAOB). Consequently, the AICPA reconstituted the ASB as a body with
the authority to establish the auditing standard to be used in the audits of private companies (financial
audits). This means that a CPA practicing in the United States normally performs an integrated audit of
a public company in accordance with the auditing standards (ASs) established by the PCAOB, and
normally performs a financial audit of a private company in accordance with the auditing standards
(AUs) established by the ASB.
In addition, the PCAOB adopted and retained the ASBs previously promulgated 10 GAAS as part of its
interim auditing standards; thus, auditors performing an integrated audit for a public company must
continue to follow the 10 GAAS until they have been superseded by a PCAOB standard.
In the CPA Firms Division, membership is granted to CPA firms, not to individual CPAs. This division
consists of two sections: the Securities and Exchange Commission Practice Section (SECPS) and the
Private Companies Practice Section (PCPS). CPA firms voluntarily join either, or both, sections based
on the type of clients that they serve.
Each section promotes a high quality of services offered by the CPA firms. For example, the SECPS
requires audit partners on SEC audit clients to be rotated at least every seven years, mandatory peer (or
quality) review (every three years) and mandatory continuing education for firm personnel (120 hours
every three years).
The executive committees of the two sections have the power to sanction member firms for poor quality
services. These sanctions may include additional education requirements, special peer reviews, fines,
and suspension or expulsion from the CPA Firms Division.
The Professional Ethics Executive Committee (PEEC) enforces the Code of Professional Conduct
(CPC) and interprets Rules of Conduct (more discussion in Chapter 3). The CPC is essential because a
distinguishing mark of a profession is its acceptance of responsibility to the public.
The Quality Control Standards Committee monitors a peer (or quality) review program among the CPA
firms. Every three years, members of the CPA Firms Division must subject their practice to a Peer (or
Quality) Review Program.
A peer (or quality) review involves a study of the adequacy of the reviewed firm's established quality
control policies and procedures (see Table 2-5), and tests the extent of the reviewed firm's compliance
with these policies. Typically, these tests consist of a review of selected working paper files and audit
reports.
A peer (or quality) review may be performed by another CPA firm (a firm review), by a state CPA
society or association, the Quality Review Executive Committee (a committee-appointed review team),
or by a regional association of CPA firms (an association review). The reviewer issues a report stating
their conclusions and recommendations.
The AICPA has established audit practice and quality centers as resource centers to improve audit
practice quality. In addition to these resource centers for CPA firms, the AICPA has established audit
quality centers for governmental audits and employee benefit plan audits.
25
26
TABLE 2-2 10 Generally Accepted Auditing Standards (PCAOB)

10 Generally Accepted Auditing Standards
General Standards
1. The audit must be performed by a person or persons having adequate technical training and proficiency as an auditor.
2. In all matters relating to the assignment, an independent mental attitude is to be maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the audit and the preparation of the report.
Standards of Field Work
1. The auditor must adequately plan the work and must properly supervise any assistants.
2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of
material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit
procedures.
3. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion
regarding the financial statements under audit.
Standards of Reporting
1. The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation
to the preceding period.
3. Information disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding financial statements, taken as a whole, or an assertion to the effect that an
opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons thereof should be stated. In all cases where an
auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's work,
if any, and the degree of responsibility the auditor is taking.
Table 2-3 Four Fundamental Principles Underlying an Audit (AICPA)

Four Fundamental Principles
Purpose of an Audit and Premise upon which an Audit is Conducted
1. The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented
fairly, in all material respects, in accordance with the applicable financial reporting framework. An auditors opinion enhances the degree of
confidence that intended users can place in the financial statements.
2. An audit in accordance with generally accepted auditing standards is conducted on the premise that management and, where appropriate, those
charged with governance, have responsibility
a. for the preparation and fair presentation for the financial statements in accordance with the applicable financial reporting framework; this
includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial
statements that are free from material misstatement, whether due to fraud or error; and
b. to provide the auditor with
i. all information, such as records, documentation, and other matters that are relevant to the preparation and fair presentation of the financial
statements;
ii. any additional information that the auditor may request from management and, where appropriate, those charged with governance; and
iii. unrestricted access to those within the entity from whom the auditor determines it necessary to obtain audit evidence.
Responsibilities
3. Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical
requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the
audit.
Performance
4. To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error.
5. To obtain reasonable assurance, which is a high, but not absolute, level of assurance, the auditor
a. plans the work and properly supervises any assistants.
b. determines and applies appropriate materiality level or levels throughout the audit.
c. identifies and assesses risks of material misstatement, whether due to due to fraud or error, based on an understanding of the entity and the
environment, including the entitys internal control.
d. obtains sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate
responses to the assessed risks.
6. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatement because of inherent
limitations, which arise from
a. the nature of financial reporting;
b. the nature of audit procedures; and
c. the need for the audit to be conducted within a reasonable period of time and so as to achieve a balance between benefit and cost.
Reporting
7. Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in accordance with the
auditors findings, or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all
material respects, in accordance with the applicable financial reporting framework.
11 Attestation Standards (AICPA and PCAOB)

Other attestation services such as agreed-upon procedures services get little or no specific guideline from the 10
GAAS because those standards relate primarily to historical financial statements prepared in accordance with GAAP
for the auditing service. This problem has been addressed by the Auditing Standards Board through the issuance of
11 Attestation Standards that parallel the previously 10 GAAS. Following the same framework used for auditing
standards, detailed interpretations of the 11 Attestation Standards are provided in more than 10 Statements on
Standards for Attestation Engagements (ATs). For example, AT 501 An Examination of an Entitys Internal Control
Over Financial Reporting That Is Integrated With an Audit of Its Financial statements . Table 2-4 describes the 11
Attestation Standards. See Appendix C for a list of the ATs. In addition, the AICPAs Accounting and Review
Services Committee Auditing issued a number of Statements on Standards for Accounting and Review Services
(ARs) that provide guideline for other attestation services such as review services. For example, AR 50 Standards for
Accounting and Review Services. See Appendix D for a list of ARs. The PCAOB adopted and retained both the ATs
and ARs as part of its interim auditing standards.
Table 2-4 11 Attestation Standards (AICPA and PCAOB)
11 Attestation Standards
General Standards
1. The engagement shall be performed by a practitioner having adequate technical training and proficiency in the attest function.
2. The engagement shall be performed by a practitioner having adequate knowledge in the subject matter.
3. The practitioner shall perform an engagement only if he or she has reason to believe that the subject matter is capable of evaluation against
criteria that are suitable and available to users.
4. In all matters relating to the engagement, independence in mental attitude shall be maintained by the practitioner.
5. Due professional care shall be exercised in the planning and performance of the engagement.
Standards of Field Work
1. The work shall be adequately planned and assistants, if any, shall be properly supervised.
2. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report.
Standards of Reporting
1. The report shall identify the subject matter or assertion being reported on and state the character of the engagement.
2. The report shall state the practitioners conclusion about the subject matter or the assertion in relation to the criteria against which the
subject matter was evaluated.
3. The report shall state all of the practitioners significant reservations about the engagement, the subject matter, and, if applicable, the
assertion related thereto.
4. The report shall state the use of the report is restricted to specified parties, in certain circumstances.
Peer Review Program

CPA firms must be enrolled in the AICPAs Peer Review Program for members in the firm to be eligible for
membership in the AICPA. A peer review is the review, by a CPA firm, of another CPA firms compliance with its
quality control system. The purpose of a peer review is to determine and report whether the CPA firm being
reviewed has developed adequate quality control policies and procedures and follows them in practice.
The AICPA Peer Review Program is administered by the state CPA societies under the overall direction of
the AICPA peer review board. Reviews are conducted every three years by a CPA firm selected by the firm being
reviewed. CPA firms in the Securities and Exchange Commission Practice Section (the SECPS part) who are
reviewed (inspected) by the PCAOB must be reviewed by the AICPA National Peer Review Committee to evaluate
the non-SECPS part; i.e., the Private Companies Practice Section (PCPS) part of the firms accounting and auditing
practice which is not reviewed (inspected) by the PCAOB. After the review is completed, the reviewer CPA firms
issue a report stating their conclusions and recommendations. Results of the peer review are included in a public file
by the AICPA.
Code of Professional Conduct
The AICPA Code of Professional Conduct defines both ideal principles and a set of specific, mandatory rules
describing minimum levels of conduct a CPA must maintain. The Professional Ethics Executive Committee (PEEC)
enforces the Code of Professional Conduct (CPC) and interprets Rules of Conduct (more discussion in Chapter 3).
In addition, because the CPC has been adopted by most State Boards of Accountancy, which have authority to grant
27
28
or revoke professional CPA licenses, violations of the CPC can result in suspension or revocation of a CPAs right
to practice.
Five Elements of Quality Control (PCAOB)
The Quality Control Standards Committee previously established five elements of quality control that CPA firms
should consider in setting up their policies and procedures in order to conform to professional standards. The five
elements of quality control are shown in Table 2-5 with a brief description of the requirements for each element.
The PCAOB adopted and retained the five elements of quality control as part of its interim auditing standards.
Table 2-5 Five Elements of Quality Control (PCAOB)
Element
Independence, integrity, and
Objectivity
Personnel management
Acceptance and continuation

of clients and engagement
Engagement performance
Monitoring
Brief Description of Requirements

All personnel on engagements should maintain independence in fact and in appearance, perform all
professional responsibilities with integrity, and maintain objectivity in performing their professional
responsibilities.
Policies and procedures should be established to provide the CPA firm with reasonable assurance that
(1) all new personnel should be qualified to perform their work competently, (2) work is assigned to
personnel who have adequate technical training and proficiency, (3) all personnel should participate in
continuing professional education and professional development activities that enable them to fulfill
their assigned responsibilities, and (4) personnel selected for advancement have the qualifications
necessary for the fulfillment of their assigned responsibilities.
Policies and procedures should be established for deciding whether to accept or continue a client
relationship. These policies and procedures should minimize the risk of associating with a client whose
management lacks integrity. They include inquiring of the prospective clients banker, legal counsel,
investment banker, underwriter, or other persons who do business with company for information about
the company and its management. Also, the CPA firm should only undertake engagements that can be
completed with professional competence.
Policies and procedures should exist to ensure that the work performed by engagement personnel meets
applicable professional standards, regulatory requirements, and the CPA firms standards of quality.
They include establishing procedures for (1) planning engagements, (2) maintaining the firms standards
of quality, and (3) reviewing engagement working papers and reports.
Policies and procedures should exist to ensure that the other four quality control elements are being
effectively applied.
Six Elements of Quality Control (AICPA)

The Quality Control Standards Committee of the AICPA replaced the previously established five elements of quality
control with six elements of quality control in Statement on Quality Control Standards (SQCS No.8), A Firms
System of Quality Control. Table 2-6 provides a brief description of the requirements for each element. A CPA
firms system of quality control should be designed to provide the firm with reasonable assurance that the firm and
its personnel comply with professional, legal, and regulatory requirements and that the partners issue appropriate
reports. The nature and extent of a CPA firms quality control policies and procedures depend on a number of
factors, such as the firms size, the degree of operating autonomy allowed, its personnel policies, the nature of its
practice and organization, and appropriate cost-benefit considerations. For example, a sole practitioner with small
professional staff members may use a simple checklist and conduct periodic informal discussions to monitor his or
her firms compliance with professional standards. On the other hand, a large international CPA firm may develop
in-house procedures and assign full- or part-time staff to oversee and ensure compliance with the firms quality
control system. While not required, communication of the firms quality control system normally should be in
writing, with the extent of documentation varying with the size of the firm. A firms quality control policies and the
Code of Professional Conduct should be covered in the firms training programs.
As mentioned earlier, the PCAOB adopted and retained the five elements of quality control as part of its
interim auditing standards. Thus, a CPA firm performing an integrated audit for a public company must continue to
follow the five elements of quality control until they have been superseded by a PCAOB element.
Table 2-6 Six Elements of Quality Control (AICPA)
Element
Leadership responsibilities
for quality within the firm

The firm should promote a culture that quality is essential in performing engagements and should
establish policies and procedures that support that culture. For example, the firms training programs
Element
(tone at the top)

Relevant ethical
requirements
Acceptance and continuation

of clients and engagement
Human resources
Engagement performance
Monitoring

emphasize the importance of quality work, and this is reinforced in performance evaluation and
compensation decisions.
All personnel on engagements should maintain independence in fact and in appearance, perform all
professional responsibilities with integrity, and maintain objectivity in performing their professional
responsibilities. For example, each partner and employee must answer an independence questionnaire
annually, dealing with such things as stock ownership and membership on boards of directors.
Policies and procedures should be established for deciding whether to accept or continue a client
relationship. These policies and procedures should minimize the risk of associating with a client whose
management lacks integrity. The firm should only undertake engagements that can be completed with
professional competence. For example, a client evaluation form, dealing with such matters as
predecessor auditor comments and evaluation of management, must be prepared for every new client
before acceptance.
Policies and procedures should be established to provide the firm with reasonable assurance that (1) all
new personnel should be qualified to perform their work competently, (2) work is assigned to personnel
who have adequate technical training and proficiency, (3) all personnel should participate in continuing
professional education and professional development activities that enable them to fulfill their assigned
responsibilities, and (4) personnel selected for advancement have the qualifications necessary for the
fulfillment of their assigned responsibilities. For example, each professional must be evaluated on every
engagement using the firms individual engagement evaluation report.
Policies and procedures should exist to ensure that the work performed by engagement personnel meets
applicable professional standards, regulatory requirements, and the firms standards of quality. For
example, the firms director of accounting and auditing is available for consultation and must approve all
engagements before their completion.
Policies and procedures should exist to ensure that the other quality control elements are being
effectively applied. For example, the quality control partner must test the quality control procedures at
least annually to ensure the firm is in compliance.
Audit Practice and Quality Centers (CAQ)

The AICPA has established audit practice and quality centers as resource centers to improve audit practice quality.
The Center for Audit Quality (CAQ) is an autonomous public policy organization affiliated with the AICPA serving
investors, public company auditors, and the capital markets. The Centers mission is to foster confidence in the audit
process and to make integrated audits even more reliable and relevant for investors. In addition to these resource
centers for CPA firms, the AICPA has established audit quality centers for governmental audits and employee
benefit plan audits.
SECs Influence on Auditors Professional Environment
The Securities and Exchange Commission (SEC) is a federal government agency that regulates the trading of
securities. It influences the auditors professional environment in: 1. Enforcement of the Securities Act of 1933 and
the Securities Exchange Act of 1934 and publication of important regulations such as Regulation S-X. 2.
Establishment of the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley Act of
2002. 3. Monitoring of corporate frauds under the Corporate Criminal Fraud Accountability Act of 2002. The SECs
influence on the auditors professional environment is shown in Figure 2-2.
29
30
Figure 2-2 SECs Influence on Auditors Professional Environment

Securities and Exchange Commission (SEC)
Influences CPA firms and individual CPAs through
Securities Act 1933

Securities Exchange Act 1934
Sarbanes-Oxley Act 2002
Corporate and Criminal Accountability Act 2002
Require filing of
Publication of
Establishment of
Monitoring of Corporate Fraud
Forms S-1 to S-16

Form 8K
Form 10K
Form 10Q
Regulation S-X
Public Company Accounting Oversight Board (PCAOB)
Regulation S-K
Accounting Series Releases
Accounting & Auditing
Enforcement Releases
Register CPA firms Establish Standards Inspect CPA firms Take Disciplinary Actions
Enforce Compliance
The Securities Act 1933 and Securities Exchange Act 1934

The Securities Act of 1933 and Securities Exchange Act 1934 of the SEC impose a variety of reports to be filed by
its members. Auditors whose clients are members of the SEC must perform certain duties associated with these
reports and must make sure their clients have filed the appropriate reports. The SEC also exerts strong influence
over the Financial Accounting Standards Board (FASB) in the development of generally accepted accounting
principles (GAAP). Furthermore, the SEC publishes publications such as Accounting and Auditing Enforcement
Releases, which announce accounting and auditing matters related to the SEC's enforcement activities. Sanctions
against independent auditors include restrictions for specified periods against mergers with other firms and prohibits
for specified periods against undertaking new engagements. Table 2-7 provides brief comments on the SECs filing
requirements and publications.
Table 2-7 SECs Reporting Requirements and Publications
Filing Requirements
Of the Securities Acts
Forms S-1 to S-16
Form 8-K
Brief comments
A registration statement that consists of a prospectus and Forms S-1 to S-16 is to be filed whenever a
company plans to issue new securities. The auditor's responsibilities include auditing the accompanying
financial statements, performing a subsequent events review and issuing a comfort letter to the underwriters.
Form 8-K to be filed when one of the following significant corporate occurred: (1) changes in auditor; (2)
changes in control; (3) changes in code of ethics; (4) resignation of directors; (5) acquisition or disposition of
a significant amount of assets, and (6) bankruptcy or receivership. The auditor's responsibilities include
issuing a letter of agreement concerning a change of auditor.
Effective August 2004, the SEC adds eight new disclosure items which will trigger an 8-K filing: (1) entry
into a material agreement that is not in the ordinary course of business; (2) termination of such a material
non-ordinary course agreement; (3) creation of a material direct financial obligation or a material obligation
under an off-balance sheet arrangement; (4) triggering events that accelerate or decrease a material direct
financial obligation or a material obligation under an off-balance sheet arrangement; (5) material costs
associated with exit or disposal activities; (6) material impairments; (7) notice of the listing or failure to
satisfy a continued listing rule or standard; and (8) non-reliance on or restatements of previously issued
financial statements or a related audit report or completed interim review.
In addition, disclosures as to the sale of unregistered securities, modifications of shareholder's rights,
Filing Requirements
Of the Securities Acts
Form 10-K
Form 10-Q
Brief comments
departure or the election of directors or principal officers and amendments to the corporate charter or by-laws
were transferred from other periodic filings (forms) to trigger an 8-K filing. Finally, in view of the complexity
of some of the issues and computations involved in the new requirements, the SEC's requirement to file an 8K within two days was changed to four days.
Form 10-K to be filed annually that consists of detailed financial information. The auditor's responsibilities
include auditing the accompanying financial statements.
Form 10-Q to be filed quarterly. The auditor's responsibilities include issuing a letter to be filed with the
interim financial statements. The letter states whether, in the auditor's opinion, any change in accounting
principle or practice is preferable in the circumstances.
Publications of
Enforced Activities
Regulation S-X
Regulation S-K
Financial Reporting
Releases
Staff Accounting
Bulletins
Regulation S-X is the principle accounting regulation of the SEC and it covers the requirements for auditor's
independence, audit reports, and financial statements to be filed with the SEC.
Regulation S-K is the uniform disclosure regulation and it covers the disclosure requirements for nonfinancial statements or tax information.
Financial Reporting Releases announce the SEC's current positions on accounting and auditing rules and
regulations.
Staff Accounting Bulletins, which are unofficial interpretations of Regulation S-X and GAAP and they
provide guideline for handling events and transactions with similar accounting implications.
Sarbanes-Oxley Act 2002

In 2002, the SEC established the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley
Act of 2002. Many duties of the PCAOB influence the auditors professional environment. See Appendix B for the
POAOBs Rules and Standards relating to the various duties. Table 2-8 provides brief comments on the duties of the
PCAOB.
Table 2-8 Duties of the PCAOB
Duties
Register CPA firms
Establish, or adopt, by
rule,
auditing,
quality
control, ethics, independence,
and other standards relating
to the preparations of audit
reports for issuers
Conduct
inspections
(reviews) of CPA firms

In order to audit a public company, a CPA firm must register with the PCAOB. Foreign CPA firms who audit
a U.S. company or perform some audit work in a foreign subsidiary of a U.S. company must also register with
the PCAOB.
The PCAOB is required to cooperate with designated standard-setting bodies, such as the AICPA, in setting
standards, and it has the legal authority to adopt, amend, modify, repeal, and reject any standards suggested by
those bodies. The PCAOB adopted and retained the 10 GAAS and the AUs established by the AICPAs
Auditing Standards Board (ASB) as its interim auditing standards. In addition, the PCAOB has issued a
number of its own auditing standards; refer to as Auditing Standards (ASs). For example, effective May 2004,
the PCAOBs Auditing Standard No.1 (AS 1), References in Auditors' Reports to the Standards of the Public
Company Accounting Oversight Board, requires that auditors' reports on integrated audits of public
companies include a reference that the engagement was performed in accordance with the standards of the
PCAOB. This replaces the previous reference that the engagement was performed in accordance with the
standards of the AICPA. See Appendix B for the POAOBs Rules and Standards
The PCAOB also requires (1) CPA firms to prepare and maintain audit working papers and other information
related to any audit report for a period of not less than seven years, (2) A second partner review and approval
of audit reports, (3) CPA firms must adopt quality control standards, (4) The partner-in-charge and the
reviewing partner of an audit must rotate off the audit every five years, and (5) The auditor must report to the
audit committee.
The PCAOB is required to conduct annual quality inspections (reviews) of CPA firms that audit more than
100 clients; all others must be inspected (reviewed) every three years. Moreover, the PCOAB planned to
inspect 5% of the Big 4s audit engagements, 15% of the next four largest (second-tier) audit firms audit
engagements, and 50% of the audit engagements of CPA firms with fewer than 100 audit clients.
It should be noted that the PCAOB does not make public certain results of its inspections. The SarbanesOxley Act of 2002 requires that the results of inspections be forwarded to the SEC, the appropriate state-level
licensing board, and, in a limited form, to the public. Specifically, the PCAOB is prohibited from releasing to
the public:
(1) Criticisms of, or potential defects in, a (CPA) firms quality control systems.
Problems relating to a CPA firms quality control systems will be made public only if, in the opinion of the
PCOAB, the CPA firm fails to correct the deficiencies within 12 months and the CPA firms likely appeal to
the SEC is denied. The PCOAB will also remove from the public portion of the inspection report any other
discussion of the firms quality control systems because discussing aspects of a firms quality controls, in a
context where criticisms and potential defects cannot be discussed, may create a distorted and misleading
31
32
Duties
Conduct investigations
and disciplinary proceedings,
and
impose appropriate
sanctions
Enforce
compliance
with the Sarbanes-Oxley Act
2002, the rules of the Board,
professional standards, and
the securities laws relating to
the preparation and issuance
of audit reports.
impression.
(2) Specific information concerning issuers (audit clients) financial statements.
When the PCOAB identifies possible departures from GAAP, materiality will determine whether the client
needs to restate its financials. If the departure is not material, the PCOAB will advise the CPA firm to discuss
the matter with the audit client. If the departure is material, the PCOAB will notify the SEC the only agency
authorized to direct a restatement. Since restated financial statements are a matter of public record, the public
(investors) could face with a situation where a company (audit client) issues restated financial statements,
which have originally given an unqualified (clean) opinion by its auditor (CPA firm).
(3) Violations of law, rules, or professional standards triggering investigations, disciplinary action, or referral
to other regulators or law enforcement authorities.
Sometime the PCOABs inspection process will uncover information that results in an investigation,
disciplinary action, or referral to other regulatory/enforcement authorities. The Sarbanes-Oxley Act of 2002
requires that such proceedings be kept confidential unless all parties agree to public disclosure or until the
investigatory/disciplinary process has run its course and the SEC has ruled on any appeal.
The PCAOB must notify the SEC of pending investigation involving potential violations of the securities
laws, and coordinate its investigation with the SEC Division of Enforcement.
All documents and information prepared or received by the PCAOB as evidence in connection with a
disciplinary action are confidential and privileged.
The PCAOB may sanction a CPA firm if it fails to adopt quality control standards including temporary
suspension or permanent revocation to practice in respect of audits of public companies.
The PCAOB is to enforce compliance with the SEC rules such as the independent rule issued in November
2001. Chapter 3 discusses further this rule.
The PCAOB is to enforce compliance with the auditing standards including the audit report on internal
controls. The audit report (or a separate report) is to be expanded to address internal controls of the company
by attesting and reporting on managements control assessments, including whether such internal controls (1)
include the maintenance of records that in reasonable details accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of the financial statements in accordance with GAAP, and that receipts and
expenditures are being made only in accordance to authorizations of management and directors of the
company.
As described in Table 2-1, AICPA members (CPAs) who perform auditing and other related professional
services are required to comply with the Four Fundamental Principles and the Statements on Auditing Standards
(AUs) promulgated by the AICPAs Auditing Standard Board (ASB). However, as described in Table 2-7, as a
result of the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public
companies (integrated audits) are to be established by the Public Company Accounting Oversight Board (PCAOB).
Consequently, the AICPA reconstituted its ASB as a body with the authority to establish the auditing standards to be
used in the audits of private companies (financial audit). This means that a CPA practicing in the United States
normally performs an integrated audit of a public company in accordance with the auditing standards (ASs)
established by the PCAOB, and normally performs a financial audit of a private company in accordance with the
auditing standards (AUs) established by the ASB. In addition, a CPA practicing in the United States normally
performs an integrated audit of a foreign public company in accordance with the International Standards on Auditing
(ISAs) promulgated by the International Auditing and Assurance Standards Board (IAASB) of the International
Federation of Accountants (IFAC) and the ASs established by the PCAOB. Likewise, a CPA practicing in the
United States normally performs a financial audit of a foreign company in accordance with the ISAs promulgated by
the IAASB and the AUs established by the ASB. Figure 2-3 shows the multiple sets of standards for the audit of
public, private, and foreign companies.
Figure 2-3 Multiple Sets of Standards for the Audit of Public, Private, and Foreign Companies
Multiple Sets of Standards
U.S. Public Companies
U.S. Private Companies
Foreign
Public Companies
Follow ASs
Follow AUs and ISAs
Issued by PCAOB
Follow ISAs and ASs Follow ISAs and AUs
Issued by ASB
Conduct Integrated Audit
Private Companies
Issued by IAASB
Conduct Financial Audit
Conduct Integrated
Audit for Foreign
Public Companies
Conduct Financial
Audit for Foreign
Private Companies
ASs = Auditing Standards

AUs = Statements of Auditing Standards
ISAs = International Standards on Auditing
Terms Used in Auditing Standards and Levels of Auditors Responsibility
Both the PCAOB and the ASB have issued auditing standards that define the use of certain terms in auditing
standards and the levels of auditors responsibility. The PCAOB issued PCAOB Rule 3101 Certain Terms Used in
Auditing and Related Professional Practice Standards that is very similar to AU 200 Defining Professional
Requirements in Statements on Auditing Standards issued by the ASB. For examples, if a standard issued by both
the PCAOB and the ASB states that an auditor must perform a particular procedure, there are no exceptions the
procedure must be performed on an audit. On the other hand, if a standard states that a procedure should be
performed, they may be circumstances in which alternate procedures may be performed instead. Table 2-9
summarizes the terms used and the levels of responsibility in both standards.
Table 2-9 Terms Used in Auditing Standards and Levels of Auditors Responsibility
Terms Used in
Auditing Standards
Levels of Auditors
Responsibility
Meaning
Unconditional responsibility
Auditors must fulfill the requirements in all cases.
should
Presumptively mandatory
responsibility
may
Responsibility to consider
Auditors must comply with the requirements unless the auditors

demonstrate and document that alternative actions were sufficient
to achieve the objectives of the standards.
Auditor should consider the requirements. Whether the auditors
comply with the requirements will depend on the exercise of
professional judgment in the circumstances.
must
is required
shall [by PCAOB
only]
might
33
34
Terms Used in
Auditing Standards
Levels of Auditors
Responsibility
Meaning
could
should consider [by
ASB only]
Corporate and Criminal Fraud Accountability Act 2002

In light of the ENRON scandal in 2001, the SEC steps up its monitoring of public companies under the Corporate
and Criminal Fraud Accountability Act of 2002. This act has significant influence on the auditors professional
environment concerning the detection of fraud. Table 2-10 summarizes some provisions of the act.
Table 2-10 Provisions of the Corporate and Criminal Fraud Accountability Act 2002
Provisions of the Corporate and Criminal Fraud Accountability Act 2002

Auditors are required to maintain all audit working papers for seven years.
It is a felony to knowingly destroy or create documents (including audit working papers) to impede, obstruct or influence any existing or
contemplated federal investigation.
The statute of limitations on securities fraud claims is extended to five years from the fraud, or two years after the fraud was discovered.
Employees of CPA firms (and audit clients) are extended whistleblower protection that would prohibit the employer from taking certain
actions against employees. Whistle blower employees are also granted a remedy of special damages and attorneys fee.
Securities fraud by CPAs (and audit clients) is punishable up to ten years in prison.
Other Forces that Influence the Auditors Professional Environment

Besides the AICPA and SEC, there are other forces that influence the auditors professional environment. A brief
description of these other forces and their influences is given in Table 2-11.
Table 2-11 Other Forces that Influence the Auditors Professional Environment
Other Forces
Financial Accounting Standards Board
(FASB)
Governmental Accounting Standards Board

(GASB)
International Federation of Accountants

(IFAC)
Their Influences
The Financial Accounting Standards Board is an independent private body that develops
generally accepted accounting principles (GAAP). The board consists of seven members
who are assisted by a large research staff and an advisory council. It issues Statements of
Financial Accounting Standards (SFASs) that are officially recognized by the AICPA.
See http://www.fasb.org/ for more information.
The governmental accounting standards board sets accounting and auditing standards for
the government sector. The board consists of five members who have the authority to
promulgate accounting and auditing standards for the state and local governmental
agencies, such as the Statement of Governmental Accounting Standards (SGASs).
See http://www.gao.gov/ for more information.
The International Federation of Accountants (IFAC) is a worldwide organization of
national accounting bodies (e.g. AICPA) that fosters a coordinated worldwide accounting
profession with harmonized standards. One of its committees, the International Auditing
and Assurance Standards Board (IAASB) issues international standards on auditing and
reporting practices that is intended to improve uniformity of auditing services throughout
the world. The pronouncements of the IAASB do not override its members' respective
national auditing standards. However, members from countries that do not have such
standards are encouraged to adopt IAASB standards while members from countries that
already have such standards are encouraged to compare them to IAASB standards and
seek to eliminate any material inconsistencies.
As mentioned earlier, members of AICPA who perform auditing and other related
professional services have been required to comply with the four fundamental principle
established by AICPA and the AUs promulgated by the AICPAs Auditing Standard
Board (ASB). However, as a result of the passage of the Sarbanes-Oxley Act of 2002, the
auditing standards to be used in the audits of public companies (integrated audits) are to
be established and promulgated by the PCAOB. Consequently, the AICPA reconstituted
its ASB as a body with the authority to establish the auditing standards to be used in the
audits of private companies (financial audit). This means that a CPA practicing in the
United States normally performs an integrated audit of a public company in accordance
Other Forces
Their Influences
State Society (or Association) of CPAs
State Board of Accountancy
Audit Committee
with the auditing standards (ASs) established by the PCAOB, and normally performs a
financial audit of a private company in accordance with the auditing standards (AUs)
established by the ASB. In addition, a CPA practicing in the United States normally
performs an integrated audit of a foreign public company in accordance with the
International Standards on Auditing (ISAs) promulgated by the International Auditing and
Assurance Standards Board (IAASB) of the International Federation of Accountants
(IFAC) and the ASs established by the PCAOB. Likewise, a CPA practicing in the United
States normally performs a financial audit of a foreign company in accordance with the
ISAs promulgated by the IAASB and the AUs established by the ASB. See Figure 2-3 for
the multiple sets of standards for the audit of public, private, and foreign companies.
See http://www.ifac.org/ for more information.
Each state has a State Society (or Association) of CPAs. Its membership is voluntary,
however, many CPAs are both members of a State Society (or Association) of CPAs and
the AICPA. Each State Society (or Association) has its own codes of professional ethics
that closely parallel the AICPA's Code of Professional Conduct.
See http://www.calcpa.org/ for more information.
Each state has a State Board of Accountancy. A State Board of Accountancy usually
consists of five to seven CPAs and at least one public member, who are generally
appointed by the governor of each state. The State Board of Accountancy works
independently of the AICPA and the State Society (or Association) of CPAs. It issues,
renews, suspends or revokes a CPA's licenses to practice.
See http://www.dca.ca.gov/ for more information.
An audit committee is a subcommittee of the board of directors that is composed of
independent, outside directors. The committee monitors audit activities and serves as a
surrogate for the interests of stockholders. In 1999, the SEC adopted a report from the
New York Stock Exchange and the National Association of Securities Dealers that
addresses the effectiveness of the audit committee. Table 2-12 describes some key
changes affecting the audit committee.
See http://www.pcaobus.org/ for more information.
Table 2-12 Key Changes Affecting the Audit Committee
Requirements
The audit committee should be

composed of outside independent
directors.
All members should be

financially literate, and at least one
member should have accounting or
related
financial
management
expertise.

responsible for
the selection,
evaluation, and replacement of the
external auditor.

responsible
for
assessing
the
independence of the external auditor.
The external auditor should

discuss with the audit committee the
auditors judgments about the quality,
the degree of aggressiveness or
conservatism, and the underlying
estimates
of
the
companys
accounting principles.
Brief Descriptions
The outside independent directors must have no material relationship with the company. Former
partners or employees of the external auditors who worked on the companys audit engagement are
not deemed independent. Restrict payment to the outside independent directors for audit committee
service to $60,000 or less. Each independent director is generally limited to three public company
audit committees.
Financially literate means that all audit committee members are able to read and understand
financial statements at the time of their appointment to the audit committee.
Financial expertise takes into account the following: (1) prior experience as a public accountant or
auditor, CFO, controller, chief accounting officer, or similar position; (2) an understanding of GAAP
and financial statements; (3) experience in the preparation or auditing of financial statements of a
similar company; (4) experience with internal accounting controls; (5) an understanding of
accounting for estimates, accruals, and reserves, and (6) an understanding of audit committee
functions.
Under Section 301 of the Sarbanes-Oxley Act, audit committees are now directly responsible for the
appointment, compensation, and oversight of the external auditor. Moreover, Section 202 of the
Sarbanes-Oxley Act amends section 10A of the Securities Exchange Act of 1934 to require that the
audit committee must also pre-approve all audit and non-audit services provided by the external
auditor.
The audit committee must endure compliance with Section 303 of the Sarbanes-Oxley Act, which
makes it unlawful for any officer or director of a company to fraudulently influence, coerce,
manipulate, or mislead any external auditor engaged in the performance of an audit.
Section 206 of the Sarbanes-Oxley Act makes it unlawful for a registered CPA firm to perform the
audit of a company if the CEO, CFO, chief accounting office, or controller (or equivalent) was
employed by the accounting firm and participated in the audit of the company during the one-year
period preceding the date of the audit engagement.
The audit committee should review with the external auditor any audit problems or difficulties and
managements response including: (1) Accounting adjustments noted or proposed but passed (as
immaterial or otherwise). (2) National office consultations. (3) Review with the external auditor of
the responsibilities, budget, and staffing of the internal audit function.
35
36
Requirements
Brief Descriptions
The external auditor should

review the companys quarterly
financial statements before they are
filed (10-Q filing) with the SEC.
The audit committee to review

specific accounting issues.
The audit committee

establish
procedures
whistleblower communication.
to
for
The audit committee must be informed of any significant matters identified during the quarterly
review of the financial statements by the external auditor.
The audit committee is also required to include in the proxy statement its Report to Shareholders,
which indicates the audit committee has reviewed and discussed the audited year-end financial
statements (10-K filing) including managements discussion and analysis (MD&A) with management
and the external auditor.
The audit committee to review the effect of regulatory and accounting initiatives, as well as offbalance-sheet structures, on the financial statements.
The audit committee or a comparable body of the board of directors to review and approve all
related-party transactions.
The audit committee to ensure that a going concern qualification issued by the external auditor is
disclosed by the company through the issuance of a press release.
Section 310 of the Sarbanes-Oxley Act requires the audit committee to establish procedures for the
receipt, retention, and treatment of complaints received by the company regarding accounting,
internal controls, or auditing matters. This must include the ability of the employees to submit, on a
confidential and anonymous basis, concerns regarding questionable accounting or auditing matters.
2-1
An individual's license to practice as a CPA may be revoked by

a. the State Boards of Accountancy.
b. the SEC.
c. the State Society of CPAs.
d. the AICPA.
2-2
Generally accepted auditing standards may not be followed by

a. every independent audit service.
b. every CPA who is a member of the AICPA.
c. every independent audit service on clients who are members of the SEC.
d. every compilation service.
2-3
The standards of field work of the Generally Accepted Auditing Standards emphasize
a. adequate training.
b. adequate planning.
c. informative disclosure.
d. independence.
2-4
Which of the following characteristics is not in the general standards of the Generally Accepted Auditing Standards?
a. Due professional care and independence.
b. Adequate training and due professional care.
c. Sufficient appropriate evidence and understanding internal controls.
d. Independence.
2-5
Which of the following is an element of a CPA firms quality control that should be considered in establishing its quality
control policies and procedures?
a. Independence, integrity, and objectivity.
b. Considering risk and materiality.
c. Complying with laws and regulations.
d. Using statistical sampling techniques.
2-6
In a situation where no specific guideline or standard exists, an auditor should look to which of the following authorities for
guideline:
a. Statements on Auditing Standards (AUs).
b. Statements on Standards for Accounting and Review Services (ARs).
c. Statements on Standards for Attestation Engagements.
d. The AICPA code of professional conduct (CPC).
2-7
The SEC requirements of greatest interest to CPAs are set forth in the SECs
a. Forms 8-K, 10K, and 10Q.
b. Directors newsletter.
c. S-1 through S-16 forms.
d. Regulation S-X and Accounting Series Releases.
2-8
Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (AUs) should be looked upon by
practitioners as
a. ideals to work towards, but which are not achievable.
b. maximum standards which denote excellent work.
c. minimum standards of performance, which must be achieved in each audit engagement.
d. benchmarks to be used on all audits, reviews, and compilations.
2-9
The AICPAs division for CPA firms has two sections: the SEC Practice Section and the Private Companies Practice
Section. Which one of the following is not a requirement for belonging to the Private Companies Section?
a. Adherence to quality control standards.
b. Mandatory peer review program.
c. Partner rotation after a period of seven consecutive years.
d. Continuing education.
37
38
2-10
A basic objective of a CPA firm is to provide professional services to conform to professional standards. Reasonable
assurance of achieving this basic objective is provided through
a. a system of quality control.
b. continuing professional education.
c. compliance with generally accepted reporting standards.
d. a system of peer review.
2-11
Which of the following best describes the purpose of attestation standards and GAAS?
a. Measures of quality for attestation and audit services.
b. Methods to discharge professional responsibilities in attestation and audit services.
c. Rules that represent the publics expectations on attestation and audit services.
d. Objectives used to select evidence for attestation and audit services.
2-12
An audit committee should do all of the following except

a. Recommend the retention or dismissal of the external auditor.
b. Determine whether material financial fraud ought to be reported in a companys financial statements.
c. Consult with the external auditor prior to the audit engagement to convey any special concerns the committee has and to request any
special investigations.
d. Review the audit fees for reasonableness and investigate the reasons why audit fees may be higher than proposed.
2-13
Which of the following is not a duty of the Public Company Accounting Oversight Board?
a. Conduct inspection of CPA firms.
b. Freeze the payment of audit fee to CPA firms during an investigation of possible violations of securities laws.
c. Establish auditing standards and quality control.
d. Enforce compliance with the Sarbanes-Oxley Act of 2002.
2-14
Which of the following is not a provision in the Corporate and Criminal Fraud Accountability Act of 2002?
a. It is a felony for auditors to destroy audit working papers.
b. Auditors must maintain audit working papers for seven years.
c. The status of limitation extended to two years after the fraud was discovered by the auditors.
d. Whistleblower auditors are not granted special damages and attorneys fees.
2-15
Which of the following is the authoritative body designated to promulgate attestation standards?
a. Auditing Standard Board.
b. Government Accounting Standard Board.
c. Financial Accounting Standard Board.
d. Government Accountability Office.
2-16
Which of the following is a conceptual difference between the attestation standards and generally accepted auditing
standards?
a. The attestation standards provide a framework for the attest function beyond historical financial statements.
b. The requirement that the practitioner by independent in mental attitude is omitted from the attestation standards.
c. The attestation standards do not permit an attest engagement to be part of a business acquisition standards.
d. None of the standards of field work in generally accepted auditing standards are included in the attestation standards.
2-17
Which of the following is not an attestation standard?

a. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report.
b. The report shall identify the assertion being reported on and state the character of the engagement.
c. The work shall be adequately planned and assistants, if any, shall be properly supervised.
d. A sufficient understanding of internal control shall be obtained to plan the engagement.
2-18
The third general standard states that due professional care is to be exercised in the planning and performance of the audit
and the preparation of the report. This standard requires
a. thorough review of the existing safeguards over access and records.
b. limited review of the indications of employee fraud and illegal acts.
c. objective review of the adequacy of the technical training and proficiency of firm personnel.
d. supervision of assistants by the auditor with final responsibility for the audit.
2-19
Which of the following is an element of a CPA firms quality control system that should be considered in establishing its
quality control policies and procedures?
a. Complying with laws and regulations.
b. Using statistical sampling techniques.
c. Managing personnel.
d. Considering audit risk and materiality.
2-20
The primary purpose of establishing quality control policies and procedures for deciding whether to accept a new client is
to
a. enable the CPA firm to attest to the reliability of the client.
b. satisfy the CPA firms duty to the public concerning the acceptance of new clients.
c. minimize the likelihood of association with client whose management lacks integrity.
d. anticipate before performing any field work whether an unqualified opinion can be expressed.
2-21
A CPA firms quality control procedures pertaining to the acceptance of a prospective audit client would most likely
include
a. inquiry of management as to whether disagreement between the predecessor auditor and the prospective client were
resolved satisfactorily.
b. consideration of whether sufficient appropriate evidential matter may be obtained to afford a reasonable basis for an
opinion.
c. inquiry of third parties, such as the prospective clients bankers and attorneys, about information regarding the
prospective client and its management.
d. consideration of whether internal control is sufficiently effective to permit a reduction in the extent of required
substantive tests.
2-22
Which of the following are elements of a CPA firms quality control that should be considered in establishing its quality
control policies and procedures?
a.
b.
c.
d.
2-23
Monitoring
Yes
Yes
Yes
No
Engagement Performance
No
Yes
Yes
Yes
The nature and extent of a CPA firms quality control policies and procedures depend on
a.
b.
c.
d.
2-24
Human resources
Yes
Yes
No
Yes
The CPA Firms Size

Yes
Yes
Yes
No
The Nature of the CPA Firms Practice

Yes
Yes
No
Yes
Cost-Benefit Consideration
Yes
No
Yes
Yes
A CPA firm should establish procedures for conducting and supervising work at all organizational levels to provide
reasonable assurance that the work performed meets the firms standards of quality. To achieve this goal, the firm most likely would
establish procedures for
a. evaluating prospective and continuing client relationships.
b. reviewing engagement working papers and reports.
c. requiring personnel to adhere to the applicable independence rules.
d. maintaining personnel files containing document related to the evaluation of personnel.
2-25
Which of the following statements best explains why the CPA profession has found it essential to promulgate ethical
standards and to establish means for ensuring their observance?
a. A distinguishing mark of a profession is its acceptance of responsibility to the public.
b. A requirement for a profession is to establish ethical standards that stress primarily a responsibility to clients and
colleagues.
c. Ethical standards that emphasize excellence in performance over material rewards establish a reputation for competence
and character.
d. Vigorous enforcement of an established code of ethics is the best way to prevent unscrupulous acts.
39
40
2-26
Which of the following is not required by the SEC regarding an outside independent member of an audit committee?
a. The member must be paid $60,000 or less for the audit committee service.
b. The member must have no material relationship with the company.
c. The member must be financially literate.
d. The member must be former outside auditor of the company.
2-27
Which of the following is not a correct statement regarding the composition of the members of an audit committee?
a. All audit committee members should be financially literate within a reasonable period of time after their appointment.
b. At least one member should have accounting or related financial management expertise.
c. All audit committee members should not be affiliated persons of the company or a subsidiary.
d. The audit committee should be composed of outside directors.
2-28
Which provision of the Sarbanes-Oxley Act of 2002 does not apply to the audit committees?
a. Under Section 301 of the Sarbanes-Oxley Act, audit committees are now directly responsible for the appointment,
compensation, and oversight of the external auditor.
b. Under Section 202 of the Sarbanes-Oxley Act, audit committees are now to pre-approve all audit and non-audit services
provided by the external auditor.
c. Under Section 310 of the Sarbanes-Oxley Act, audit committees are now to establish procedures for the receipt,
retention, and treatment of complaints received by the company regarding accounting, internal controls, or auditing
matters, including whistleblower communication.
d. Under Section 204 of the Sarbanes-Oxley Act, audit committees are now to receive reports on the results of all tests of
control and tests of balances conducted by the external auditor.
2-29
The Sarbanes-Oxley Act of 2002 expands an audit committees responsibilities concerning specific accounting issues.
Which of the following specific accounting issues is not part of the expanded responsibility?
a. The audit committee is responsible to review the effect of off-balance-sheet structures on the financial statements.
b. The audit committee is responsible to review the effect of subsequent events on the financial statements.
c. The audit committee is responsible to review and approve all related-party transactions.
d. The audit committee is responsible to disclose a going concern qualification issued by the external auditor through the
issuance of a press release.
2-30
Which of the following is not a characteristic of the Public Company Accounting Oversight Board (PCAOB)?
a. PCAOB is responsible to oversee the audits of public companies that are subject to the securities laws.
b. PCAOB is non-governmental, not-for-profit corporate entity that will be funded by fees imposed on all public
companies, and fees from CPA firms that must register with the PCAOB in order to audit public companies.
c. PCAOB may not regularly inspect a registered CPA firms operation and it may not sanction the CPA firm if it fails to
adopt quality control standards.
d. PCAOB consists of five board members, two of which must be or must have been CPAs, and the Chair may be held by
one of the two CPAs, but must not have practiced accounting during the five years preceding his or her appointment.
2-31
Which of the following is not a duty of the Public Company Accounting Oversight Board?
a.
b.
c.
d.
2-32
Register foreign CPA firms who audit a foreign subsidiary of a U.S. company.
Enforce compliance with the Sarbanes-Oxley Act of 2002.
Notify the SEC of pending investigation involving potential violations of the securities laws.
Require the partner-in-charge of an audit to rotate off the audit every seven years.
Which of the following is a correct statement concerning the auditing standards of the Public Company Accounting Oversight Board
(PCAOB)?
a. The PCAOBs auditing standards replace the AICPAs Generally Accepted Auditing Standards (GAAS).
b. The PCAOBs auditing standards supplement the AICPAs Generally Accepted Auditing Standards (GAAS).
c. The PCAOBs auditing standards and the AICPAs Generally Accepted Auditing Standards (GAAS) are one and the
same.
d. The PCAOBs auditing standards change the audit procedures performed by an auditor.
2-33
Effective August 2004, the SEC adds eight new disclosure items which will trigger an 8-K filing. Which of the following is not one of
the new requirements?
a. Entry into a material agreement that is in the ordinary course of business.
b. Creation of a material direct financial obligation under an off-balance sheet arrangement.
c. Material costs associated with exit or disposal activities.
d. Material impairments.
2-34
Regarding the quality inspection of CPA firms, the PCOAB is not prohibited from releasing to the public the following
information in its inspection reports:
a. Specific information concerning an audit clients financial statements.
b. Criticisms of, or potential defects in, an audit firms quality control systems.
c. Violations of law, rules, or professional standards triggering investigations, disciplinary action, or referral to other
regulators or law enforcement authorities.
d. Failure of an audit firm to perform and document sufficient audit procedures related to the existence and valuation of
reported inventories.
2-35
Which of the following is true as a result of the passage of the Sarbanes-Oxley Act of 2002?
a. The AICPA reconstituted the ASB (Auditing Standard Board) as a body with the authority to establish the GAAS
(generally accepted auditing standards) to be used in the audits of public companies in the United States of America.
b. A CPA practicing in the United States of America normally audits the financial statements of a public company in
accordance with the GAAS established by the ASB (Auditing Standard Board).
c. A CPA practicing in the United States of America normally audits the financial statements of a public company in
accordance with the ISAs (International Standards on Auditing) promulgated by the IAASB (International Auditing and
Assurance Standards Board) of the IFAC (International Federation of Accountants).
d. A CPA practicing in the United States of America normally audits the financial statements of a non-public company in
accordance with the GAAS established by the ASB and the International Standards on Auditing (ISAs) promulgated by
the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants
(IFAC).
2-36
A duty of the PCOAB is to ensure that:

a. The partner-in-charge and the reviewing partner of an audit must rotate off the audit every five years
b. The partner-in-charge and the reviewing partner of an audit must rotate off the audit every seven years
c. CPA firms to maintain audit working papers related to an audit report for more than seven years.
d. CPA firms to maintain audit working papers related to an audit report for two years on-site and five years off-site.
2-37
The ASB (Auditing Standard Board) issued AU 230 Audit Documentation, which states Audit
documentation should include abstracts or copies of significant contracts or agreements that were examined to evaluate the
accounting for significant transactions. With regard to this particular audit procedure:
a. Auditors must fulfill the procedure in all cases.
b. Auditors must comply with the procedure unless the auditors demonstrate and document that alternative actions were
sufficient to achieve the objectives of the standards.
c. Auditor should consider the procedure. Whether the auditors comply with the procedure will depend on the exercise of
professional judgment in the circumstances.
d. Auditors should consider the procedure and must comply with the procedure after the consideration.
2-38
With the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public companies (integrated
audits) are to be established and promulgated by the
a. Auditing Standard Board (ASB).
b. Public Company Accounting Oversight Board (PCAOB).
c. International Auditing and assurance Standards Board (IAASB).
d. State Board of Accountancy.
2-39
With the passage of the Sarbanes-Oxley Act of 2002, auditors performing an integrated audit for a public company must
a. continue to follow the four fundamental principles of the AICPA until they have been superseded by a PCAOB principle.
b. continue to follow the six elements of quality control of the AICPA until they have been superseded by a PCAOB element.
c. continue to follow the 10 GAAS until they have been superseded by a PCAOB standard.
d. continue to follow the International Standards on Auditing (ISAs) until they have been superseded by a PCAOB standard.
41
42
2-40
Which of the following is not a correct statement of the four fundamental principles underlying an audit?
a. An auditors opinion enhances the degree of confidence that intended users can place in the financial statements.
b. To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error.
c. The auditor is unable to obtain absolute assurance that the financial statements are free from all misstatements because of inherent
limitations.
d. Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in
accordance with the auditors findings, or states that an opinion cannot be expressed.
2-41
With regard to the six elements of quality control, the element of Engagement performance requires that
a. policies and procedures should be established to provide the firm with reasonable assurance that work is assigned to personnel who
have adequate technical training and proficiency.
b. policies and procedures should be established for deciding whether to accept or continue a client relationship.
c. policies and procedures should exist to ensure that the other quality control elements are being effectively applied.
d. policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional
standards, regulatory requirements, and the firms standards of quality.
2-42
Which of the following is not a characteristic of the AICPAs Peer Review Program?
a. CPA firms in the Securities and Exchange Commission Practice Section (the SECPS part) who are reviewed (inspected) by the
PCAOB must also have their non-SECPS parts reviewed by the PCAOB.
b. After the review is completed, the reviewer CPA firms issue a report stating their conclusions and recommendations.
c. The AICPA Peer Review Program is administered by the state CPA societies under the overall direction of the AICPA peer review
board.
d. Reviews are conducted every three years by a CPA firm selected by the firm being reviewed.
2-43
A CPA practicing in the United States of America normally performs an integrated audit of a foreign public company in accordance
with
a. the auditing standards (AUs) established by the Auditing Standard Board (ASB).
b. the auditing standards (ASs) established by the Public Company Accounting Oversight Board (PCAOB).
c. the auditing standards (ISAs) established by the International Auditing and Assurance Standards Board (IAASB).
d. the auditing standards (ISAs) established by the IAASB and the auditing standards (ASs) established by the PCAOB.

2-1 a. 2-2 d. 2-3 b. 2-4 c. 2-5 a. 2-6 c. 2-7 d. 2-8 c. 2-9 c. 2-10 a. 2-11 a.
2-12 b. 2-13 b. 2-14 d. 2-15 a. 2-16 a. 2-17 d. 2-18 d. 2-19 c. 2-20 c. 2-21 c.
2-22 b. 2-23 a. 2-24 b. 2-25 a. 2-26 d. 2-27 a. 2-28 d. 2-29 b. 2-30 c. 2-31 d.
2-32 c. 2-33 a. 2-34 d. 2-35 d. 2-36 a. 2-37 b. 2-38 b. 2-39 c. 2-40 c. 2-41 d.
2-42 a. 2-43 d.

Simulation Question 2-1 is an adaptation with permission from a case by Knapp M.C. in Contemporary Auditing: Real Issues & Cases, a
publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however,
the names and places have been changed.
Anna Chan graduated from San Francisco State University in the spring of 2003 with a bachelors degree in accounting. During her
study at the College of Business, Chan earned a 3.9 grade point average and participated in many extracurricular activities, including the Beta
Alpha Psi Chapter and Accounting Students Organization. During the fall semester of 2002, Chan participated in the on-campus Meet the
Firms night. Subsequently, she interviewed with several public accounting firms and large corporations and received six job offers. After
considering those offers, she decided to accept an entry-level position on the auditing staff of a Big Four CPA firm. Chan was not sure whether
she wanted to pursue a partnership position with her new employer. However, she believed that the training programs the CPA firm provided and
the breadth of experience she would receive from a wide array of client assignments would get her career off to a good start.
Chan spent the first two weeks on her new job at her firms regional audit staff training seminar in San Jose. On returning to her office
in San Francisco in early June 2003, she was assigned to work on the audit of UCSF Hospital. Chans immediate supervisor on the UCSF
Hospitals engagement was Amy Wright, a third year senior. On her first day on the UCSF Hospitals audit, Chan learned that she would audit
the hospitals cash accounts and assist with accounts receivable. Chan was excited about her first client assignment and pleased that she would be
working for Wright. Wright had a reputation as a demanding supervisor who pushed for her engagements to be completed under budget. She was
also known for having an excellent rapport with her audit clients, and for being fair and straightforward with her subordinates.
Like many newly hired staff auditors, Chan was apprehensive about her new job. She understood the purpose of independent audits
and was familiar with the work performed by auditors but doubted that one auditing course, ACCT506, and a two-week staff-training seminar
had adequately prepared her for her new work role. After being assigned to work under Wrights supervision, Chan was relieved. She sensed that
although Wright was demanding, the senior supervisor would be patient and understanding with a new staff auditor. More importantly, Chan
believed that she could learn a lot working under the direct supervision of Wright. Thus, Chan resolved that she would work hard to impress
Wright and had hopes that the senior supervisor would mentor her through the first few years of her career at the CPA firm.
During Chans second week of audit at UCSF Hospital, Wright casually asked her over lunch whether she had taken the CPA exam in
May. After a brief pause, Chan replied that she had not but planned to enroll in a CPA Review Course and study intensively for the exam during
the next five months and then take the exam in November. Wright agreed that was a good strategy and offered to lend Chan a set of CPA review
books an offer Chan declined. The truth is that Chan has returned to her home state of Arizona during the first week of May and sat for the CPA
exam. For fear of admitting failure, Chan decided not to tell her co-workers that she had taken the exam. Moreover, Chan realized that she and
her co-workers might not pass all parts of the exam on their first attempt. She did not want to be labeled with her co-workers as not a first timer
of the CPA exam for the rest of her career.
Chan continued to work on the USCF Hospital audit throughout the summer. She completed the cash audit within budget. Moreover,
she submitted very thorough documentations of her work in the working paper file. Wright was pleased with Chans work and frequently
complimented and encouraged her. As the audit of the UCSF Hospital was near completion in early August, Chan received her grades on the
CPA exam in the mail one Friday evening. To her surprise, she had passed all parts of the exam in her first attempt. She immediately called
Wright to let her know of the impressive accomplishment. To Chans surprise, Wright seemed irritated, if not disturbed, by the good news. Chan
then remembered having told Wright earlier on that she had not taken the exam in May. Chan immediately apologized and explained why she had
chosen not to tell the truth. Following her explanation, Wright still seemed annoyed, so Chan decided to drop the subject and pursue it later in
person.
The following week, Wright spent Monday through Wednesday with another audit client, while Chan and the other staff assigned to
the UCSF audit continued to wrap up the engagement. On Wednesday morning, Chan received a call from Robert Moore, the partner-in-charge of
the UCSF Hospital audit. Moore asked Chan to meet with him late that afternoon in his office. She assumed that Moore simply wanted to
congratulate her on passing the CPA exam.
The usually upbeat Moore was somber when Chan stepped into his office that afternoon. After she was seated, Moore informed her
that he had spoken with Amy Wright several times during the past few days and that he had consulted with the three other audit partners in the
office regarding a situation involving Chan. Moore told Chan that Wright was very upset by the fact that she (Chan) had lied regarding the CPA
exam. Wright had indicated that she would not be comfortable having a subordinate on future audit engagements whom she could not trust to be
truthful. Wright had also suggested that Chan be dismissed from the CPA firm because of the lack of professional integrity she had demonstrated.
After a brief silence, Moore told a stunned Chan that he and the other audit partners agreed with Wright. He informed Chan that she
would be given 60 days to find another job. Moore also told Chan that he and the other partners would not disclose that she had been counseled
out of the firm if contacted by employers interested in hiring her.
Required
1.
2.
3.
4.
5.
Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to Wrights
rationale in dealing with Chans white lies? Explain.
How would you have dealt with the situation if you had been in Chans position? Explain.
How would you have dealt with the situation if you had been in Wrights position? Explain.
How would you have dealt with the situation if you had been in Moores position? Explain.
What lessons have you learned from this simulation question regarding the auditors professional environment discussed in Chapter 2?
43
44

Simulation Question 2-2 is an adaptation with permission from a case by Knapp M.C. in Contemporary Auditing: Real Issues & Cases, a
After spending much of the prior three months working elbow-to-elbow with as many as six colleagues in a cramped and poorly
ventilated conference room, Kevin Nguyen was look forward to moving on to his next assignment. Nguyen was an in-charge accountant on the
audit staff of the San Francisco office of a large international CPA firm, the firm that had offered him a job two years earlier as he neared
completion of his accounting degree at San Francisco State University. His current client, Discovery & Things, Inc., a public company and the
second largest client of Nguyens office, owned a chain of retail stores in the western United States that stretched from Seattle to San Diego and
as far east as Denver and Albuquerque.
Although Discovery and Things stores operated under different names in different cities, each stocked the same general types of
merchandise, including briefcases and other leather goods, luggage and travel accessories, and a wide range of gift items, such as costume
jewelry, imported from Pacific Rim countries. The company also has a wholesale division that marketed similar merchandise to specialty retailers
throughout the United States. The wholesale division accounted for approximately 60 percent of the companys annual sales.
A nondescript building in downtown San Francisco, just one block from bustling Market Street, served as Discovery and Things
corporate headquarters. The companys fiscal year-end fell on the final Saturday of January. With the end of March just a few days away, Nguyen
and his fellow Dizzies the nickname that his office assigned to members of the Discovery and Things audit engagement team were quickly
running out of time to complete the audit. Nguyen was well aware that the audit was behind schedule since he collected, coded, and input into an
electronic spreadsheet the time worked each week by the individual Dizzies. He used the spreadsheet package to generate a weekly time and
progress report that he submitted to Jessica Lee, the senior who supervised the field work on the Discovery and Things audit.
In addition to Nguyen and Lee, another in-charge accountant, Melissa Wan, and four staff accountants had worked on the Discovery
and Things audit since early January. Nguyen and Wan knew each other well. They had shared the same start date with their employer and the
past two summers had attended the same weeklong staff and in-charge training sessions at their firms national education headquarters. Wans
primary responsibility on the current years audit was the receivables account but she also audited the PP&E (Property, plant, and equipment) and
leases accounts. Besides his administrative responsibilities, which included serving as the engagement timekeeper and maintaining the
correspondence file for the audit, Nguyen supervised and coordinated the audit procedures for inventory accounts payable, and a few smaller
accounts.
Nguyen was thankful that it was Friday afternoon. In recent weeks with the audit deadline looming, Jessica Lee had required the
Discovery and Things crew to work until at least 8 p.m. each weekday except Friday, when she allowed them to leave early at 5 p.m. The
engagement team had spent three consecutive Saturdays in the clients headquarters and would be spending both Saturday and Sunday of the
coming weekend hunched over their audit workpapers. Nguyen had just completed collecting and coding the hours worked during the current
week by the other members of the engagement team. Now it was time for him to enter in the electronic spreadsheet his chargeable hours, which
he dutifully recorded at the end of each work day in his little black book.
Before entering his own time, Nguyen decided to walk across the hall and purchase a snack in the employees break room. In fact, he
was stalling, trying to resolve a matter that was bothering him. Less than 30 minutes earlier, Melissa Wan had told him that during the current
week, which included the previous weekend, she had spent 31 hours on the receivables account, 18 hours on the leases account, and three hours
on PP&E. What troubled Nguyen was the fact that he knew Wan had worked several more hours during the current week on the Discovery and
Things audit.
This was not the first time Wan had underreported her hours worked. On several occasions, Nguyen had noticed her secretively
slipping workpaper files into her briefcase before leaving for home. The next morning, those files included polished memos or completed
schedules that had not existed the previous day. Nguyen was certain that Wan was not reporting the hours she spent working at home on her audit
assignments. He was just as certain that each week she consciously chose to shave a few hours off the total number she had spent working at the
clients headquarters. Collectively, Nguyen estimated that Wan had failed to report at least 80 hours she had worked on the audit.
Eating Time was a taboo subject among auditors. Although the subject was not openly discussed, Nguyen was convinced that many
audit partners and audit managers subtly encouraged subordinates to underreport their time. By bringing their jobs in near budget, those partners
and managers enhanced their apparent ability to manage engagements. The most avid time-eaters among Nguyens peers seemed to be the
individuals who had been labeled as fast-track superstars in the office.
After Wan had reported her time to Nguyen that afternoon, he had nonchalantly but pointedly remarked, Melissa, who are you trying
to impress by eating so much of your time? His comment had caused the normally mild-mannered Wan to snap back, Hey, Dude, you are the
timekeeper, not the boss. So just mind your own #$&! business. Immediately, Nguyen regretted offending Wan, whom he considered his friend.
But she stomped away before he could apologize.
Nguyen knew who Wan was trying to impress. Jessica Lee would almost certainly be promoted to audit manager in the summer and
then become the audit manager on the Discovery and Things engagement, meaning that there would be a vacancy in the all-important senior
position on the engagement team. Both Wan and Nguyen also anticipated being promoted during the summer. The two new seniors would be the
most likely candidates to take over the job of overseeing the field work on the Discovery and Things audit. The in-charge accountant who
handled the administrative responsibilities on the engagement was typically the person who had been tabbed to take over the seniors role. But
Nguyen worried that the close friendship that had developed between Wan and Lee might affect his chances of landing the coveted assignment.
Almost every day, Wan and Lee went to lunch together without extending even a token invitation to Nguyen or their other colleagues to join
them. Baron Davis , the audit engagement partner would choose the new senior for the Discovery and Things engagement, but Jessica Lee would
certainly have a major influence on his decision.
There was little doubt in Nguyens mind that Wan routinely underreported the time she worked on the Discovery and Things audit to
enhance her standing with Lee and Davis. Not that Wan needed to spruce up her image. She had passed the CPA exam on her first attempt, had a
charming personality that endeared her to her superiors and client executives, and, like both Lee and Davis, was a UC Berkeley graduate.
Nguyen, on the other hand, had suffered through three attempts at the CPA exam before finally passing, was shy by nature, and graduated from
San Francisco State University.
What irritated Nguyen the most about his subtle rivalry with Wan was that the past two weekends he had spent several hours helping
her research contentious technical issues for Discovery and Things complex lease contracts on its retail store sites. Earlier in the engagement,
Wan had also asked him to help analyze some tricky journal entries involving the clients allowance for bad debts. In each of those cases, Nguyen
had not charged any time to the given accounts, both of which were Wans responsibility.
Before entering his time for the week, Nguyen checked once more the total hours that he had charged to date to his major accounts.
For both inventory and accounts payable, he was already over budget. By the end of the audit, Nguyen estimated that he would bust the
assigned time budgets for those two accounts by 20 to 25 percent each. On the other hand, Wan, thanks to her superior time management skills,
would likely exceed the time budget on her major accounts by only a few hours and might even come in under budget, which was almost unheard
of, at least on the dozen or so audits to which Nguyen had been assigned.
After finishing the bag of chips he had purchased in the snack room, Nguyen reached for the computer keyboard in front of him. In a
few moments, he had entered his time for the week and printed the report that he would give to Jessica Lee the following morning. After briefly
glancing at the report, he slipped it into the appropriate workpaper file, turned off the light in the empty conference room, and locked the door
behind him as he resolved to enjoy his brief sixteen-hour weekend.
Required
1.
2.
3.
4.
5.
6.
Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to Wans
rationale in underreporting the time she worked? Explain.
If you had been in Wans position, would you underreport the time you worked? Explain.
If you had been in Nguyens position, would you underreport the time you worked? Explain.
Suggest several measures that Nguyens CPA firms can take to ensure that time budgets do not interfere with the
successful completion of the Discovery and Things audit or become dysfunctional in other ways.
Suggest several measures that Nguyens CPA firms can take to reduce the likelihood that personal rivalries among auditors
of the same rank will become dysfunctional.

Simulation Question 2-3 is an adaptation with permission from a case by Knapp M.C. in Contemporary Auditing: Real Issues & Cases , a
It was nearly 8:30 p.m. on a Friday evening in early August. Fred Choo, an audit manager for a large international accounting firm,
had spent several minutes shuffling through the audit workpapers and correspondence stacked on his desk, trying to decide what work he should
take home over the weekend. Finally, only one decision remained. Choo could not decide whether to take the inventory file with him.
Compulsive by nature, Choo knew that if he took the inventory file home, he would have to complete his review of that file, which would
increase his weekend workload from 6 hours to more than 12 hours. As he stewed over his decision, Choo stepped to the window of his office
and idly watched the evening traffic on the downtown streets several stories below.
Choo had suffered through a tough week. His largest audit client was negotiating to acquire a competitors company within its
industry. For the past two months, Choo had supervised the field work on an intensive acquisition audit of the competitors accounting records.
The clients chief executive officer (CEO) suspected that the competitors executives had embellished their firms financial data in anticipation of
the proposed acquisition. Since the audit client was overextending itself financially to acquire the competitor company, the CEO wanted to be
sure that the competitor companys financial data were reliable. The CEOs principal concern was the valuation of the competitor companys
inventory, which accounted for 45 percent of its total assets. The clients CEO had requested that Choo be assigned to the acquisition audit
because he respected Choo and quality of his work. Normally, an audit manager spends little time on the trenches supervising day-to-day audit
procedures. Because of the nature of the this engagement, however, Choo had felt it necessary to spend 10 hours per day, six and seven days per
week, poring over the accounting records of the targeted takeover company with his audit staff assistants. As Choo stared at the gridlocked streets
below, he was relieved that the acquisition audit was almost complete. After he tied up a few loose ends in the inventory file, he would turn the
workpapers over to the audit engagement partner for a final review.
Choos tough week had been highlighted by several contentious meetings with client personnel, a missed birthday party for his young
daughter, and an early breakfast Thursday morning with his office managing partner, Ken Trotman. During that breakfast, Trotman had notified
Choo that he had been passed over for promotion to partner-for the second year in a row. The news had been difficult for Choo to accept. For
more than 10 years, Choo had been a hardworking and dedicated employee of the large accounting international accounting firm. He had never
turned down a difficult assignment, never complained about the long hours his work required, and made countless personal sacrifices, the most
recent being the missed birthday party. After informing Choo of the bad news, Trotman encouraged him to stay with the firm. Trotman promised
the following year he would vigorously campaign for Choos promotion and call in all favors owed to him by partners in other offices. Despite
that promise, Choo realized that he had only a minimal chance of being promoted to partner. Seldom were two-time losers ticketed for
promotion.
Although he had been hoping for the vest, Choo had not expected a favorable report from the Partner Selection Committee. In recent
weeks, he had gradually admitted to himself that he did not have the profile for which the committee was searching. Choo was not a rainmaker
like his friend and fellow audit manager, Kim Park, whose name appeared on the roster of new partners to be formally announced the following
week. Park was a member of several important civic organizations and had a network of well-connected friends at the local golf club. Those
connections had served Park well, allowing him to steer several new clients to the firm in recent years.
Instead of a rainmaker, Choo was a technician. If someone in the office had a difficult accounting or auditing issue to resolve, that
individual went first to Choo, not to one of the offices six audit partners. When a new client posed complex technical issues, the audit
engagement partner requested that Choo be assigned to the job. One reason Choo was a perfect choice for difficult engagements was that he
micromanaged his jobs, insisting on being involved in every aspect of them. Choos management style often resulted in his busting time
budgets for audits, although he seldom missed an important deadline. To avoid missing deadlines when a job was nearing completion, Choo and
the staff assistants in his audit engagement team would work excessive overtime, including long weekend stints.
45
46
Finally, Choo turned away from his window and slumped into his chair. As he sat there, he tried to drive away the bitterness that he
was feeling. If William Lee hadnt left the firm, maybe I wouldnt be in this predicament, Choo thought to himself. Three years earlier, William
Lee, an audit partner and Choos closest friend within the firm, had resigned to become the chief financial officer (CFO) of a large client. After
Lees resignation, Choo had no one within the firm to sponsor him through the tedious and political partner selection process. Instead, Choo had
been lost in the shuffle with the dozens of other hardworking, technically inclined audit manager within the firm who aspired to a partnership
position.
Near the end of breakfast Thursday morning, Trotman had mentioned to Choo the possibility that he could remain with the firm in a
senior manager position, IN recent years, Choos CPA firm had relaxed its up or out promotion policy. But Choo was not sure he wanted to
remain with the firm as a manager with no possibility of being promoted to partner. Granted, there were clearly advantages associated with
becoming a permanent senior manager. For example, no equity interest in the firm meant not absorbing any portion of its future litigation losses.
On the other hand, in Choos mind accepting an appointment as a permanent senior manager seemed equivalent to having career failure
stenciled on his office door.
Ten minutes till nine, time to leave. Choo left the inventory file lying on his desk s he closed his laptop and then stepped toward the
door of his office. After flipping off the light switch, Choo paused momentarily. He then grudgingly turned and stepped back to his desk, picked
up the inventory file, and tucked it under his arm.
Required
1.
2.
3.
4.
5.
6.
Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to Choos
rationale in working excessive overtime to meet deadlines? Explain.
If you had been in Choos position, would you work excessive overtime to meet deadlines? Explain.
Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to the up or
out promotion policy in Choos CPA firm? Explain.
If you had been in Choos position, would you remain with the CPA firm as a permanent senior audit manager? Explain.
Suggest several measures that Choos CPA firms can take to reduce the likelihood that aspiring audit managers will not be lost in the
shuffle through the tedious and political partner selection process.
Chapter 3
The Auditors Ethical Environment
LO3-1 Apply the American Institute of Certified Public Accountants (AICPAs) Rules
of Conduct.
LO3-2 Understand the interpretations of Rule 101 Independence.
LO3-3 Differentiate between the AICPA and the Public Company Accounting
Oversight Boards (PCAOBs) rules on independence.
LO3-4 Identify some threats to and examples of auditors non-independence.
LO3-5 Describe the enforcement mechanisms for the AICPAs Code of Professional
Conduct (CPC) and the PCAOBs Auditor Independence rules.
47
48
Chapter 3 The Auditors Ethical Environment

The AICPA Code of Professional Conduct (CPC), labeled as ETs, provides the principles and rules an auditor
should follow in the practice of public accounting (see Appendix E for a list of ETs). The CPC consists of two
sections: Principles of Professional Conduct and Rules of Conduct. Additional guidance for applying the Rules of
Conduct is provided by the Interpretations of Rules of Conduct and Ethics Rulings. The guidance provided by the
CPC starts at a conceptual level with the principles and progressively moves to general rules and their interpretations
and then to specific rulings on individual cases. Figure 3-1 shows the four parts of the CPC.
Figure 3-1 Code of Professional Conduct
Not enforceable
Principles of Professional Conduct
Specifically enforceable
Rules of Conduct
Interpretations of Rules of Conduct
Not specifically
enforceable, but
departure must be
justified
Ethics Rulings

The Principles of the Code of Professional Conduct express the profession's recognition of its responsibilities to the
public, to clients, and to colleagues. They form the basis of ethical and professional conduct and guide members of
the AICPA in the performance of their professional responsibilities. Moreover, they demand from its members an
unswerving commitment to honorable behavior, even at the sacrifice of personal advantage. However, these
principles are not enforceable. Rather, they provide a framework for the Rules of Conduct, which are enforceable.
The six ethical principles and their requirements are shown in Table 3-1 below:
Table 3-1 Principles of Professional Conduct
Principles
Responsibilities
The public interest
Integrity
Objectivity and
independence
Due care
Requirements
Members of the AICPA have responsibilities to all those who use their professional services. They also
have a continuing responsibility to cooperate with each other to improve the methods of accounting and
reporting, to maintain the public confidence, and to carry out the profession's special responsibilities of
self-governance.
The accounting profession's public consists of clients, creditors, governments, employers, investors, and
the business and financial community. These groups of people rely on the CPAs' objectivity and
integrity to maintain the orderly functioning of commerce. This reliance imposes a public interest
responsibility on CPAs.
For the public to trust the accounting profession, members of the AICPA must act with integrity in
making all decisions. Integrity requires CPAs to be honest and that service and public trust not to be
subordinated to personal gain and advantage. Moreover, integrity can accommodate the inadvertent
error and the honest difference of opinion. However, it cannot accommodate deceit or subordination of
principle.
The principle of objectivity requires a CPA to be impartial, intellectually honest, and free of conflict of
interest. On the other hand, the principle of independent in fact and in appearance precludes
relationships that may appear to impair a CPA's objectivity in rendering attestation services. For a CPA
in public practice, the maintenance of objectivity and independence requires a continuing assessment of
client relationships and public responsibility.
The principle of due care requires CPAs to pursue excellence in providing professional services. In
doing so, CPAs must discharge their professional responsibilities with competence and diligence. A
CPA obtains competence through both education and experience. Competence also requires a CPA to
continue to learn throughout his/her career. Diligence imposes the responsibility to render services
promptly and carefully, to be thorough, and to observe applicable technical and ethical standards.
Principles
Scope and nature of services
Requirements
In determining whether or not to perform specific services, members of the AICPA in public practice
should consider whether such services are consistent with the principles of professional conduct for
CPAs. There are no hard-and-fast rules to help members in determining whether or not to provide
specific services in this regard; however, they must be satisfied that they are meeting the spirit of the
principles of professional conduct for CPAs.
Rules of Conduct
The bylaws of the AICPA require its members to adhere to the Rules of the Code of Professional Conduct. These
rules establish minimum standards of acceptable conduct in the performance of professional services. These Rules
are specifically enforceable in that the bylaws of the AICPA provide its Professional Ethics Executive Committee
(PEEC) the authority to discipline a CPA guilty of violating the Rules.
In addition to the Principles and Rules of Conduct, the AICPAs PEEC promulgates the Interpretations of
the Rules of Conduct and Ethics Rulings:
Interpretations of the Rules of Conduct
The Interpretations of the Rules of Conduct are promulgated by the PEEC to provide guidelines as to the scope and
applicability of specific rules. They are not specifically enforceable but CPAs must justify departures from the
Interpretations in disciplinary hearings.
Ethics Rulings
The PEEC also promulgates Ethics Rulings, which are questions and answers to specific ethical situations. They
indicate the applicability of the Rules of Conduct and Interpretations of the Rules of Conduct to a particular set of
factual circumstances. Ethics Rulings are not specifically enforceable but CPAs must justify departures from the
Ethics Rulings in disciplinary hearings.
Specific Rules of Conduct
Rule 101 - Independence
A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies
designated by Council.
Independence is the most important rule of conduct for CPAs. Without independence, a CPA's opinion on the
financial statements would be of little value. Owing to its importance, Rule 101 has been the subject of many
Interpretations of the Rules of Conduct and Ethics Rulings. An important interpretation of Rule 101 relates to the
phrase a member in public practice which simply means a CPA in practice. The interpretation of the Rules
relates the phrase a member in public practice to covered members who are in a position to influence an attest
engagement. Covered members include: 1. Individuals on the attest engagement team. 2. An individual in a position
to influence the attest engagement, such as individuals who supervise or evaluate the engagement partner. 3. a
partner or manager who provides non-attest services to the client. 4. A partner in the office of the partner responsible
for the attest engagement. 5. The firm and its employee benefit plans. 6. An entity that can be controlled by any of
the covered members listed above or by two or more of the covered individuals or entities operating together.
SECs Auditor Independence Rules
The Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB), whose
responsibilities are to oversee the audits of public companies that are subject to the securities laws. These
responsibilities include overseeing SECs Auditor Independence Rules under Section 103 of the Act; specifically,
the PCAOBs Auditor Independence Rule 3520. The PCAOB Rule 3520 is summarized as follows:
Services Outside the Scope of Practice of Auditors

The PCAOB uses the following general principles to evaluate the effect of non-audit services on auditor
independence: 1. an auditor cannot function in the role of management; 2. an auditor cannot audit his or her own
work, and 3. an auditor cannot serve as an advocate for the client. Based on these general principles, it is unlawful
for a registered CPA firm to provide non-audit services to an a public company, including: 1. bookkeeping or other
services related to the accounting records or financial statements of the audit client; 2. financial information systems
49
50
design and implementation; 3. appraisal, valuation, and actuarial services; 4. internal audit outsourcing services; 5.
management functions or human resources; 6. various investment services such as broker or dealer, investment
adviser, or investment banking services; 7. legal services and expert services unrelated to the audit, and 8. any other
services that the PCAOB determines, by regulation, to be impermissible such as certain tax services.
Auditor Communicates to Audit Committee
Before accepting a new or continuing audit engagement, the audit firm must communicate in writing to the audit
committee all relationships between the audit firm and the client that may reasonably be thought to bear on the audit
firms independence.
Auditor Reports to Audit Committee
The auditing firm must report to the audit committee all: 1. critical accounting policies and practices to be used, and
2. all alternative treatments of financial information within GAAP that have been discussed with management,
ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the accounting
firm.
Conflicts of Interest
The CEO, Controller, CFO, Chief Accounting Officer or person in an equivalent position cannot have been
employed by the companys audit firm during the 1-year period preceding the audit. In other words, an auditing firm
is not independent of a client that employs the auditing firms employees (auditors) within the one year period
preceding the audit.
Partner Rotation
A lead (coordinating) partner and a review (concurring) partner must rotate off of an engagement after five
consecutive years.
Audit Committee Pre-approve
Audit committee to pre-approve audit services and non-audit services, unless non-audit service fees are less than 5
percent of total audit fees. For example, certain non-audit services, such as tax services, may be provided if they are
pre-approved by the audit committee, or their fees are less than 5 percent of total audit fees. The audit committee
must disclose to investors in periodic reports its decision to pre-approve non-audit services.
Partner Compensation
An auditing firm is not independent of an audit client if any audit partner is compensated for securing with the client
billable work for services other than audit or attestation.
Expanded Disclosure
Public companies disclose audit fees and fees for an explanation of audit-related, tax, and all other services.
Study of Mandatory Rotation of Registered Public Accountants
The PCOAB is to conduct a study on the potential effects of requiring the mandatory rotation of audit firms.
In addition, the SEC issued Regulation S-X Rule 2-10 to strengthen requirements of the PCAOBs Auditor
Independence Rule 3520 regarding auditor independence. The Regulation S-X Rule 2-01 describes four overarching
independence principles indicating that a relationship between the accountant and the audit client should not:
1. Create a mutual or conflicting interest between the accountant and the audit client;
2. Place the accountant in the position of auditing his or her own work;
3. Result in the accountant acting as management or an employee of the audit client; or
4. Place the accountant in the position of being an advocate for the audit client.
Rule 2-01 also prohibits specific relationships including financial relationships, employment relationships, business
relationships, relationships whereby the audit firm provides non-audit services to the audit client, and relationships
involving contingent fees. Finally, Rule 2-01 includes requirements regarding partner rotation and audit committee
administration of the engagement.
CPAs who audit non-public (private) companies must follow AICPAs Independence Rule 101. On the
other hand, CPAs who audit public companies must follow PCAOBs Auditor Independence Rule 3520. When there
is a different requirement between the two set of rules; for example, a CPA applies both AICPA and PCAOBs
independence rules to a non-public audit client, PCAOB Independence Rules takes precedent over the AICPAs
Independence Rules. One example of such different requirement is that AICPAs Independence Rules requires an
engagement partner to rotate off an engagement every seven years, whereas PCAOB Independence Rules require the
partner to rotate off every five years. In this situation, PCAOBs five years rotation requirement applies.
It is difficult to interpret the independent rules because independence is primarily a state of mind. The
AICPA Conceptual Framework for Independence Standards suggests that CPAs interpret the independent rules by
evaluating whether a particular threat would lead to a reasonable person, aware of all the relevant fats, to conclude
that s/he is not independent. Table 3-2 describes some of these threats and examples of non-independence. Based on
this threat framework, Table 3-3 provides interpretations and brief comments of AICPAs Rule 101 Independence
and the different requirements of the PCAOBs Auditor Independence Rule 3520.
Table 3-2 Threats and Examples of Non-independence
Threat
(1) Financial Interest A potential benefit to an auditor from a

financial interest in, or some other financial relationship with,
an audit client.
(2) Familiarity An auditor has a close or longstanding
relationship with client personnel or with individuals who
performed non-audit services to the same client.
(3) Undue Influence An audit clients management coerces

the auditor or exercises excessive influence over the auditor.
(4) Management Participation An auditor taking on the role of

client management or perform client management functions.
(5) Adverse Interest Actions between the auditor and the audit
client that are in opposition.
(6) Advocacy Actions taken by the auditor to promote the
audit clients interest or position.
(7) Self-audit As a part of an audit engagement, an auditor
uses evidence that results from non-audit services provided to
the audit client.
Examples
(a) An auditor has a direct financial interest or a material indirect financial
interest in the audit client.
(b) An auditor has a loan from the audit client.
(c) An auditor is excessively relied on revenue from a single audit client.
(d) An auditor has a material joint venture with the audit client.
(a) A spouse of the auditor holds a key position with the client, e.g., CEO.
(b) An auditor has provided audit services to the same client for a prolonged
period.
(c) An auditor performs insufficient audit procedures because of his/her
familiarity with the client.
(d) An auditor for the CPA firm recently was a director or officer of the
audit client.
(a) Managements threat to replace the auditor over a disagreement on the
application of an accounting principle.
(b) Managements pressure to reduce audit procedures for purpose of
reducing audit fees.
(c) An auditor receives a gift from the audit client that is significant.
(a) An auditor serves as an officer or director of the audit client.
(b) An auditor establishes and maintains internal controls for the audit
client.
(c) An auditor hires, supervises, or terminates the audit clients employees.
(a) Threatened or actual litigation between the auditor and the audit client.
(a) An auditor promotes the audit clients securities as part of an initial
public offering.
(b) An auditor represents the audit client in U.S. tax court.
(a) An auditors CPA firm has provided non-audit services relating to the
audit clients information system and the auditor is now considering results
obtained from that information system in the audit of the same client.
Table 3-3 Interpretations of Rule 101 Independence
Interpretation
Auditor and client relationship
Financial interests
Brief Comments
Rule 101 prohibits a CPA from auditing a client while holding a position as director, officer, or
employee of that client. However, a CPA may serve as an honorary director or a trustee of a not-forprofit organization while auditing the same not-for-profit organization (not-for-profit client). In such
a case, independence is not impaired if the CPA's position is purely honorary (and identified as
honorary in all letterheads and externally circulated materials), the CPA restricts involvement to the
use of his/her name only (that is, only lends the prestige of his/her name to the not-for-profit
organization), and the CPA must not vote or participate in the management functions of the not-forprofit organization.
It should be noted that PCAOB Rules prohibit a public company from employing the CEO,
Controller, CFO, Chief Accounting Officer or person in equivalent position from the companys
audit firm during the 1-year period preceding the audit.
It should also be noted that PCAOB Rules require the lead and reviewing partner to rotate off an
audit engagement after five consecutive engagements. In contrast, Rule 101 requires the partner to
rotate off an audit engagement after seven consecutive engagements.
Lastly, before accepting a new or continuing audit engagement, PCOAB Rule 3526 requires the
audit firm to communicate in writing to the audit committee all relationships between the audit firm
and the client that may reasonably be thought to bear on the audit firms independence.
Rule 101 prohibits a CPA (including immediate family members of the CPA who are defined as
spouse, spousal equivalent, and dependents) from having a direct financial interest (e.g., owning any
stock) in the audit client.
Note: Materiality of the direct financial interest is not relevant here.
It also prohibits a CPA (including close family relatives of the CPA who are defined as parent,
siblings, and non-dependent children) from owning material indirect financial interest in the audit
client. Examples of indirect financial interests are: a CPA has investments in a bank that loans
money to an audit client, or a CPA owns stock in a mutual fund that, in turn, owns stock in the audit
client, or a CPA's own stock in an audit client. Independence is impaired in the foregoing examples
51
52
Interpretation
Joint investor or investee

Relationship with client
Auditing and accounting

services for the same client
Auditing and management

advisory services to the same
client
Brief Comments
only if either the CPA's investments in the bank or the mutual fund's holdings in the audit client are
material in relation to the CPA's personal wealth, or the close family relative's financial interest in
the audit client is material to his or her own personal wealth and the CPA has knowledge of the
interest. As a rule of thumb, a financial interest is presumed to be material if it exceeds 5% of the
CPA's personal net worth or the personal net worth of the CPA's close family relatives.
See Table 3-4 for a summary of the effect of Rule 101 on family members, relatives, and friends.
It should be noted that PCAOB Rules clearly define immediate family members and close family
relatives as: (1) immediate family members a persons spouse, spousal equivalent (including
cohabitant), and dependents (i.e., person who received half or more support), and (2) close family
members a persons parents (including adoptive parents and step-parents), dependents (i.e.,
person who received half or more support), nondependent children (including step-children), and
brothers and sisters (excluding grandchildren, grand-parents, parents-in-law, and the spouses of each
of these).
Finally, a CPA is not permitted to have any loan to or from audit clients; however, home mortgages
and most secured loans from financial institution clients are permitted if made under normal lending
procedures and negotiated prior to audit engagement. The phrase "financial institution client" is
defined in the Interpretation as an entity that, as part of its normal business operations, makes loans
to the general public. The phrase normal lending procedures implies that the terms of the loans
should be made without any favoritism to the CPAs.
It should be noted that PCAOB Rules consider a CPA not independent of an audit client if any audit
partner received compensation based on the partner securing with the client billable work for
services other than audit or attestation.
A CPA is not permitted to have any joint or closely held business investment, i.e., joint investor or
investee relationship, with the client. For example, a CPA owns stock in a non-audit client, ABC
Co., and XYZ Co., which is an audit client, also owns stock in ABC Co. Interpretations of the joint
investor or investee relationship when an audit client is either an investor or investee of a non-audit
client in which a CPA has investment are as follows:
(1) A client invested in a non-client the CPA is a joint investor with the client.
If the clients investment in the non-client is material, the CPA violates Rule 101 for having any
direct/material indirect investment in the non-client. However, if the clients investment in the nonclient is immaterial, the CPA violates Rule 101 only for material direct/indirect investment.
(2) A non-client invested in a client - the CPA is a joint investee with the client.
If the non-client investment in the client is material, the CPA violates Rule 101 for having any
direct/material indirect investment in the non-client. However, if the non-clients investment in the
client is immaterial, the CPA violates Rule 101 only when the CPAs investment in the non-client
allows the CPA to exercise significant influence over the non-client.
A rule of thumb for determining materiality in a joint investor-investee relationship is (1) A
CPAs investment is presumed to be material if it exceeds either 5% of the CPA's net worth or the
net worth of the CPA's firm, whichever is more restrictive. (2) A client/non-clients investment is
presumed to be material if it exceeds either 5% of the client/non-clients total assets or 5% of the
client/non-clients income before taxes, whichever is more restrictive.
Rule 101 permits a CPA to provide both auditing and accounting services for the same client if
several conditions are met:
(1) The auditor must not have any relationship with the client or any conflict of interest;
(2) The client must accept responsibility for the financial statements;
(3) The auditor must not assume the role of employee or management, and
(4) The auditor must perform the engagement in accordance with generally accepted auditing
standards.
However, in practice, a CPA must also be aware of the SEC's regulations (Securities Exchange Act
1934) which do not permit a CPA to perform auditing and accounting services for the same SEC
client. Therefore, in practice, a CPA may provide both accounting and auditing services to non-SEC
clients provided the foregoing four conditions are met.
A CPA may provide auditing and management advisory services to the same client if (1) the CPA
just advises client and does not assume a decision-making role in the client's management, (2) the
CPAs engagement in both services is fully disclosed to the Audit Committee. Advisory services
that would not entail a CPA assuming a decision-making role include conducting special studies and
investigations, making suggestions to management, pointing out the existence of weaknesses,
outlining various alternative corrective measures, and making recommendations.
It should be noted that PCAOB Rules indirectly prohibit auditing and management advisory
services to an audit client by prohibiting eight types of non-audit services to an audit client. These
are (1) bookkeeping services (2) information system design and implementation services (3)
appraisal, valuation, and actuarial services (4) internal audit services (5) management functions or
human resources (6) various investment services (7) legal services and (8) any other services that
the PCAOB determines, by regulation, to be impermissible such as certain tax services.
It should also be noted that PCAOB Rules require audit committee to pre-approve all audit and nonaudit services a CPA provides unless non-audit fees are less than 5% of total audit fees. Specifically,
preapproved non-audit services include tax services under PCAOBs Rule 3524, Audit Committee
Pre-approval of Certain Tax Services, and internal control services under Rule 3525, Audit
Interpretation
Brief Comments
Actual or threatened litigation
Unpaid fees
Committee Pre-approval of Non-audit services Related to Internal Control Over Financial

Reporting.
Accordingly, the PCAOB Rules that indirectly prohibit auditing and management advisory services
to an audit client do not apply if the auditing and other non-audit services provided to an audit client
are pre-approved by the audit committee. Moreover, this pre-approval requirement is waived if the
aggregate fee of all such non-audit services constitutes less than 5% of the total audit fee paid to the
auditor.
Lastly, an exception to the preapproved tax services is that the auditor is not independent of the
audit client if the preapproved tax services were to provide for persons in financial reporting
oversight roles (e.g., the CEO) under PCAOBs Rule 3523, Tax Services for Persons in Financial
Reporting Oversight Roles. However, an amendment to this Rule in 2008 clarifies that if the auditor
provides such tax services for persons in financial reporting oversight roles preceding the beginning
of the audit engagement, the auditor is independent.
See Table 3-5 for a comparison of PCAOB and AICPAs rules regarding management advisory
services.
The relationship between the auditor and the client is characterized by the auditor's objectivity in
attesting the client's financial statements on one hand and the client's willingness to full disclosure
on the other hand. Actual or threatened litigation against the auditor by the client or against the
client by the auditor places the auditor and the client in an adversary position, thereby raising the
questions about the client's willingness to disclose, about the auditor's objectivity and self-interest,
and therefore about auditor independence. Consequently, in all cases in which an auditor is involved
in actual or threatened litigation, he or she should carefully evaluate independence.
Independence is considered impaired if billed or unbilled audit fees remain unpaid for auditing
services provided to the client more than one year before the date of the report. Such unpaid fees are
deemed to be a loan from the auditor to the client and are therefore a violation of Rule 101. Unpaid
audit fees from a client in bankruptcy do not violate Rule 101.
It should be noted that PCAOB Rules require public companies to disclose audit fees, audit related,
tax, and all other services.
Table 3-4 A Summary of the Effect of Rule 101 on Family Members, Relatives, and Friends
Relative
Effect of Rule 101
Immediate Family Members

AICPA: Spouse, spousal equivalent, and
dependents (whether or not related).
PCAOB: Spouse, spousal equivalent (including
cohabitant), and dependents (i.e., persons who
received half or more support).
Close Family Relatives

AICPA: Parent, siblings, and non-dependent
children.
PCAOB: Parents (including adoptive parents and
step-parents), dependents (i.e., person who
received half or more support), nondependent
children (including step-children), and brothers
and sisters (excluding grandchildren, grandparents, parents-in-law, and the spouses of each of
these)
Immediate family members are under the same restrictions as is the CPA. Accordingly,
if a member violates a rule, interpretation, or ruling that applies to the CPA, the CPA is
not independent. For example, if an immediate family member the CPA owns some
stocks (i.e. direct financial interest/investment) in the CPAs audit client, the CPA is
not independent.
The CPA and CPA firm independence is impaired if an individual on the audit team has
a close family relatives who has 1. A key position with the audit client, or 2. A material
indirect financial interest in the audit client of which the CPA has knowledge.
Independence is only impaired when a reasonable person aware of all relevant facts
relating to a situation would conclude that there is an unacceptable threat to
independence. This evaluation is made based on the AICPA Conceptual Framework for
Independence Standards.
Other Relatives and Friends
Table 3-5 A Comparison of PCAOB and AICPAs Rules Regarding Management Advisory Services
PCAOBs Position
AICPAs Position
(1) Prohibits bookkeeping or other services related to the

accounting records or financial statements of the audit client.
Allowed, providing the auditors do not:

(a) Determine or change journal entries without client approval.
(b) Authorize or approve transactions.
(c) Prepare source documents.
(d) Make changes to source documents without client approval.
Auditors are allowed to:
(a) Implement a system not developed by the auditor (e.g., off-the shelf
accounting software packages).
(b) Assist in setting up chart of accounts and financial statement format.
(2) Prohibits financial

implementation.
information
systems
design
and
53
54
PCAOBs Position
(3) Prohibits appraisal, valuation, and actuarial services.
(4) Prohibits internal audit outsourcing services.
(5) Prohibits management functions or human resources.

(6) Prohibits various investment services such as broker or dealer,
investment adviser, or investment banking services.
(7) Prohibits legal services and expert services unrelated to the
audit.
(8) Prohibits any other services that the PCAOB determines, by
regulation, to be impermissible such as certain tax services, which
include tax planning for potentially abusive tax transactions and
providing individual tax services for client officers in financial
reporting oversight roles.
Note: PCAOB allows non-audit services (including tax services
and ICFR) providing:
a. the services are preapproved by the audit committee, and
b. the aggregate non-audit services fee is less than 5% of the total
audit services fee.
Note: PCAOB prohibits preapproved tax services that are to
provide for persons in financial reporting oversight roles.
However, an amendment to this Rule in 2008 clarifies that if the
auditor provides such tax services for persons in financial
reporting oversight roles preceding the beginning of the audit
engagement, the auditor is independent.
AICPAs Position
(c) Design, develop, install, or integrate an information system unrelated
to the financial statements or accounting records.
(d) Provide training to client employees on the information and control
system.
Allowed, providing the services do not:
(a) Relate to a material portion of the financial statements, and
(b) Involve a significant degree of subjectivity.
Allowed, providing the client understands its responsibility for internal
control and:
(a) Designates competent individual(s) within company to be responsible
for internal audit.
(b) Determines scope, risk, and frequency of internal audit activities.
(c) Evaluates findings and results.
(d) Evaluates adequacy of audit procedures performed.
Auditors may provide various types of advice but may not perform
management functions.
Certain investment services are allowed, including:
(a) Assisting in developing corporate finance strategies.
(b) Recommending allocation of funds to investments.
Legal services are not directly addressed; various other services are
allowed if auditors do not make management decisions.
No specific restrictions.
Figure 3-2 provides a summary of the interpretations of Rule 101 Independence.

Figure 3-2 Interpretations of Rule 101 Independence
Auditor
Auditing
Client
XYZ Co.
No direct investment (e.g., stocks)

Note: Include immediate family members
Materiality not relevant
Be an accountant of the client?

AICPA Yes, if fulfills 4 requirements
PCAOB No, under the Securities Exchange
Act
Be an officer or employee of the client?
No, except honorary position/trustee for not-for
profit organization
Note: PCAOB No hiring of auditor 1 year
precedes the audit engagement
No indirect investment (e.g., mutual funds)

Exception: Immaterial based on personal
net worth
Client
Note: Include close family relatives
Invested
PCAOB No compensation for audit partner
securing non-auditing services
5 years engagement partner rotation
(7 years in Rule 101)
Non-client
Invested
Management Consulting services?

AICPA Yes, but not to make decision for the
client and full disclosure to the
audit committee
PCAOB Indirectly prohibits
Exception: Preapproved by audit committee and
< 5% of audit fee
Exception: Preapproved tax services to persons in
financial reporting roles preceding the
audit engagement.
No loan to or from the client

Exception: Home mortgages and secured loans
Note: No favoritism
Client is in loan business
Loan negotiated prior to audit engagement
Unpaid audit fee > 1 year is a loan
Investing
Non-client
ABC Co.
Joint Investor Client
Joint Investee Client
If Clients investment
If Non-clients investment
Material
Auditor
violation for
Any direct/material indirect
investment in Non-client
Not Material
Auditor
violation for
Material direct/indirect
Material
Auditor
violation for
Any direct/material indirect
Not Material
Auditor
violation for
Investment in Non-client
that has significant influence
55
56
Rule 102 - Integrity and Objectivity

In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall
not knowingly misrepresent facts or subordinate his or her judgment to others.
Under Rule 102, a CPA shall not knowingly misrepresent facts. An Interpretation of Rule 102 states that a CPA who
knowingly makes - or directs another to make - false or misleading entries in an entity's financial records is
considered to be knowingly misrepresent facts. Another interpretation of Rule 102 states that a CPA can be a client's
advocate in tax and management services but not in auditing service. Moreover, in auditing services an auditor shall
not subordinate his or her judgment to the client's best interest.
Rule 201 - General Standards

A member shall comply with the following standards and with any interpretations thereof by bodies designed by Council.
A. Professional Competence. Undertake only those professional services that the member or the member's firm can reasonably expect to be
completed with professional competence.
B. Due Professional Care. Exercise due professional care in the performance of professional services.
C. Planning and Supervision. Adequately plan and supervise the performance of professional services.
D. Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for conclusions or recommendations in relation to any
professional services performed.
Rule 201 reinforces the importance of compliance with the Generally Accepted Auditing Standards for all CPAs in
auditing services. The requirements for professional competence and due professional care relate to the first and
third of the General Standards of the Generally Accepted Auditing Standards, while the requirements for planning
and supervision, and sufficient relevant data relate to the first and third of the Standards of Field Work of the
Generally Accepted Auditing Standards.
Rule 202 - Compliance with Standards
A member who performs auditing, review, compilation, management consulting, tax, or other professional services shall comply with standards
promulgated bodies designated by Council.
Rule 202 broadens CPAs' responsibilities to comply with all professional standards beyond that associated with
auditing services in Rule 201. Under Rule 202, CPAs must comply with all relevant professional standards in all
types of CPA services.
Rule 203 - Accounting Principles
A member shall not (1) express an opinion or state affirmatively that the financial statements or other financial data of any entity are presented in
conformity with generally accepted accounting principles or (2) state that he or she is not aware of any material modificatio ns that should be
made to such statements or data in order for them to be in conformity with generally accepted accounting principles, if such statements or data
contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material
effect on the statements or data taken as a whole. If, however, the statements or data contain such a departure and the member can demonstrate
that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule
by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a
misleading statement.
An auditor shall not express unqualified opinion if a client's financial statements depart from GAAP. This means
that departures from FASB Statements of Financial Accounting Standards, GASB Statements of Government
Accounting Standards, Opinion of the Accounting Principles Board, and Accounting Research Bulletins are all
prohibited under Rule 203. An interpretation of Rule 203 recognizes the difficulty for authoritative accounting
bodies to anticipate all of the circumstances to which accounting principles might apply. Accordingly, a CPA may
allow a client's financial statements to depart from GAAP due to unusual circumstances, for example, new
legislation and the evolution of a new form of business transaction.
Rule 301 - Confidential Client Information

A member in public practice shall not disclose any confidential client information without the specific consent of the client.
This rule shall not be construed (1) to relieve a member of the member's professional obligations under rules 202 and 203, (2 ) to affect in any
way the member's obligation to comply with a validly issued and enforceable subpoena or summons, (3) to prohibit review of a member's
professional practice under AICPA or state CPA society authorization, or (4) to preclude a member from initiating a compliant with or
responding to any inquiry made by a recognized investigative or disciplinary body.
Members of a recognized investigative or disciplinary body and professional practice reviewers shall not use to their own advantage or disclose
any member's confidential client information that comes to their attention in carrying out their official responsibilities. However, this prohibition
shall not restrict the exchange of information with a recognized investigative or disciplinary body or affect, in any way, compliance with a validly
issued and enforceable subpoena or summons.
Rule 301 prohibits an auditor from disclosing any confidential client information, e.g. officers' salaries, unreleased
advertisements, production cost information, tax returns etc. For the CPA to have the client in trust, the auditor must
assure the client that matters discussed will be held in confidence.
Closely related to the ethical concept of confidential client information is the legal concept of privileged
communication. In contrast to attorney and physician, information communicated between a CPA and a client is not
privileged under federal law. Therefore, the information can be requested as evidence by a court of law. Although,
auditor-client confidential information is not privileged in federal jurisdiction, the information may be privileged in
the status of some states. Rule 301 states four important exceptions:
1. A CPA's adherence to GAAS overrides confidentiality (e.g. subsequent discovery of facts by the auditor after the
audit report has been issued).
2. The confidentiality rule does not apply when subpoenas or summonses enforceable by order of the court exist.
3. A CPA shall provide audit working papers requested by the Professional Ethics Executive Committee (PEEC) of
AICPA or state CPA society (or association) for peer review (or quality review) programs. In doing so, the CPA is
indirectly disclosing confidential client information. In addition, the CPA may release the working papers for peer
reviews without the client's consent; presumably it would be a time burden to all concerned if permission from each
client is needed for every peer review. It should be noted that AU 210), Terms of Engagement, requires a successor
(incoming) auditor to request the client's consent in order to gain access to a predecessor (outgoing) auditor's
working papers. Moreover, the successor auditor should also request the client to authorize (i.e., consent) the
predecessor to release working papers to the successor auditor. Finally, in the case that a CPA sells the practice to
another CPA, the buyer auditor must request the client to authorize the seller auditor to release audit working papers
to the buyer auditor.
4. A CPA is permitted to disclose confidential client information in the event of initiating a complaint with or
responding to any inquiry made by a recognized investigative or disciplinary body such as the Joint Trial Board or
the Public Company Accounting Oversight Board.
Figure 3-3 provides a summary of the interpretations of Rule 301 Confidential Client Information.
Figure 3-3 Interpretations of Rule 301 Confidential Client Information
Auditor
Working
Papers
Auditing
Client
XYZ Co.
No disclosure of confidential client information to anyone without the consent of the client
Exceptions: Shipment of audit working papers under Peer Review Program (no client consent is needed)
Successor/buyer auditor to request the clients consent for predecessor/seller auditor to
release audit working papers
Working papers subpoenaed under law suits
AUs overwrites CPC (e.g., reporting of known fraud under AUs)
Working papers examined by the Professional Ethics Executive Committee (PEEC)
Note: PCAOB has no specific rule on auditor and confidential information.

SEC requires the auditor to communicate confidential information on illegal acts.
57
58
SEC on Confidential Information

An amendment to the Securities Exchange Act of 1934, the Private Securities Reform Act of 1995, includes a
provision for whistleblowing by the auditor on confidential information. This law applies when the auditor obtained
confidential information (e.g., obtained from an employee whistle blower) that the client has committed an illegal
act and 1. It has a material effect on the financial statements. 2. Senior management and the board of directors have
not taken appropriate remedial action. 3. The failure to take remedial action is reasonably expected to warrant a
departure from standard unqualified audit report, or resignation by the auditor. In these circumstances, the auditor
must, as soon as practical, communicate their conclusions based on the confidential information directly to the
clients board of directors. Within one day, the management of the client must send a notification to the SEC of
having received such a communication from the auditor, and a copy of the notification should be sent to the auditor.
If the auditor does not receive the copy within the one-day period, they have one day to directly communicate the
matter to the SEC. The auditors responsibilities for illegal acts are further discussed in Chapter 6. Chapter 23
further discusses the auditors responsibilities for illegal acts under the Single Audit Act.
Currently, the PCOAB has no specific rule concerning confidential client information and the auditor.
Although Section 806 of the Sarbanes-Oxley Act of 2002 provides civil and criminal protections to employees of the
audit client who whistleblow confidential information, such protections do not extend to the auditor.
Rule 302 Contingent Fees
A member in public practice shall not
(1) Perform for a contingent fee any professional services for, or receive such a fee from a client for whom the member or the members firm
performs
(a) an audit or review of financial statements; or
(b) a compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use the financial
statement and the members compilation report does not disclose a lack of independence; or
(c) an examination of prospective financial information; or
(2) Prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client.
The prohibition in (1) above applies during the period in which the member or members firm is engaged to perform any of the services listed
above and the period covered by any historical financial statements involved in any such listed services.
Except as stated in the next sentence, a contingent fee is a fee established for the performance of any service pursuant to a n arrangement in
which no fee will be charged unless a specific finding or result is attained, or in which the amount of the fee is otherwise dependent upon the
finding or result of such service. Solely for purpose of this rule, fees are not regarded as being contingent if fixed by courts or other public
authorities, or, in tax matters, if determined based on the results of judicial proceedings or the findings of governmental agencies.
A members fee may vary depending, for example, on the complexity of the services rendered.
In 1990, the AICPA and the Federal Trade Commission reached an agreement that would eliminate the restriction
on contingent fees for non-attestation services, unless a CPA was also performing attestation for the same client. The
agreement also continues to prohibit tax return preparation on a contingent fee basis. An example of a prohibited
contingent fee for attestation service is when a CPAs audit is free (i.e., no audit fee is charged) contingent upon an
unqualified audit report is issued to the client. An example of a prohibited contingent fee for tax return preparation is
when a CPAs tax return preparation is free (i.e., no preparation fee is charged) contingent upon a tax refund is
obtained for the client. Under the agreement, an example of a prohibited contingent fee when a CPA performs both
attestation and non-attestation services for the same client is when the CPA charges a client consulting service fees
on a percentage of a bond issue while the CPA also performs audit service for the same client. Another example is
when the CPA charges fees as an expert witness based on the amount awarded to the plaintiff (client) while the CPA
also performs audit service for the same client. In addition, the agreement does not prohibit a CPA from charging an
audit fee based on (contingent upon) the complexity or number of hours or days needed to complete the audit
service.
An exception to the rule is when courts or regulatory agencies fix the contingent fee. An example is when a
court-appointed liquidator in the case of client liquidation fixes an audit fee. Another example is when the IRS fixes
the contingent fee for an auditor who represents an audit client in an examination (i.e., a federal tax probe) of the
clients federal tax return by an IRS agent. However, this particular example is no longer valid (meaning it is no
longer an exception to the rule) under the SECs Financial Reporting Release No. 65 in 2004.
In 2004, the SECs Financial Reporting Release No. 65 prohibits the use of contingent fees for tax
preparation services when a CPA performs both attestation and non-attestation services for the same client. The
release also states it is not a contingent fee if it is fixed by courts or other public authorities, or, in tax matters, if
determined based on the results of judicial proceedings or the findings of governmental agencies. Under this
definition, the AICPA has argued that a tax preparation services fee is not "contingent" because it is "considered
determined based on the findings of government agencies if the member can demonstrate a reasonable expectation,
at the time of a fee arrangement, of substantive consideration of an agency with respect to the member's client."
However, the SEC rejects this argument and clarifies that, "the release makes clear that the exception would apply
only when the determination of the fee is taken out of the hands of the accounting firm and its auditor client and is
made by a body that will act in the public interest, with the result that the accounting firm and client are less likely to
share a mutual financial interest in the outcome of the firm's advice or service," and because "the fact that a
government agency might challenge the amount of the client's tax savings and thereby altering the amount of the fee
paid to the firm heightens, not lessens, the mutuality of interest between the firm and client. Accordingly, such fees
impair an auditor's independence." In sum, the AICPAs exception to its Rule 302 on contingent fee does not apply
for tax preparation services fee that is fixed by the courts or regulatory agencies.
Currently, PCOABs Independent Rule 3521 makes it very clear that a CPA firm is not independent of its
audit client if the firm provides any service or product to the audit client for a contingent fee or a commission. See
Figure 3-4 for an overview of Rule 302 Contingent Fees.
Figure 3-4 An Overview of Rule 302 Contingent Fees
Attestation Services
and
Non-attestation Services
Client
XYZ Co.
Prohibit contingent fee for auditing

Exception: Allow contingent fee fixed by courts or
regulatory agencies for auditing
Allow audit fee contingent on hours and
complexity of audit
Prohibit contingent fee for tax services and other
non-attestation services
Exception: Allow contingent fee fixed by courts or
regulatory agencies for non-attestation
services (but not for tax services)
Auditor
Note: PCAOB Rule 3521 prohibits contingent fees for attestation & non-attestation services to the same client.
Non-attestation Services only
Client
XYZ Co.
Allow contingent fee for tax services

Allow contingent fee fixed by courts or regulatory
agencies for tax services and other non-attestation
services
Note: PCAOB Rule 3521 allows contingent fees for non-attestation services only to the client.
Rule 501 - Acts Discreditable

A member shall not commit an act discreditable to the profession.
The term "discreditable" is not defined in the Rule. Eight Interpretations of Rule 501 define acts that would be
considered to be discreditable:
1. A CPA retains client records after the client has demanded those records, especially in a situation where the client
has not paid the CPA's audit fee. Audit fee outstanding for more than a year becomes a loan to the client, which is
prohibited by Rule 101 Independence. Note that a CPAs working papers, including analyses, schedules, and records
prepared by the client at the request of the CPA, are not client records and need not be made available to the client.
Note also that analyses, schedules, and records prepared by the CPA for the client, such as tax returns, are client
records and need not be made available to the client. An exception exists in case the client experiences a loss of
records due to a natural disaster or an act of war. In those situations, the auditor should make such records available
to the client.
2. Discrimination by a CPA on the basis of race, color, sex, age, or national origin in hiring, promotion, salary, or
other employment practices constitutes an act discreditable to the profession.
59
60
3. A CPA fails to follow standards and/or procedures in auditing governmental agencies unless the CPA discloses in
the report the fact that such standards were not followed and reasons thereof.
4. Failure to follow the requirements of government bodies, commissions, or other regulatory agencies in
performing attest or similar services.
5. Negligence in the preparation of financial statements or records.
6. Failing to file tax returns or remit payroll and other taxes collected for others (e.g., employee taxes withheld).
7. Making, or permitting others to make, false and misleading entries in records and financial statements.
8. Soliciting or disclosing CPA Examination questions and answers from the closed CPA Examination.
One of the AICPA's bylaws states that a CPA's membership will be terminated if he/she commits a crime punishable
by imprisonment for more than a year. Therefore, the one year jail term may be a yardstick for deciding whether an
act is discreditable to the profession. Using this yardstick, unprofessional acts committed by a CPA such as
fraudulently prepared tax returns, criminal offenses, excessive drinking, and rowdy behavior would be considered as
discreditable acts if they resulted in more than a year's jail term.
Rule 502 - Advertising and Other Forms of Solicitation
A member in public practice shall not seek to obtain clients by advertising or other forms of solicitations in a manner that is false, misleading, or
deceptive. Solicitation by the use of coercion, overreaching, or harassing conduct is prohibited.
In the 1970s, the U.S. Justice Department and the Federal Trade Commission pressurized AICPA to relax
advertising rules for the purpose of opening up competition among CPAs. In 1978, Rule 502 allows advertisement
and solicitation that are not false, misleading, or deceptive. The Rule also states that the CPAs shall not use
coercion, over-reaching, or harassment in conducting their advertisement and solicitation.
An Interpretation of Rule 502 identifies four instances of false, misleading, or deceptive advertisement that a CPA
must avoid:
1. Advertisement that creates false expectations of favorable results.
2. Advertisement that implies an ability to influence any court, tribunal, or regulatory body.
3. Advertisement that states a specific service will be performed for a stated fee or estimated fee when it is likely
that the fee will be increased substantially.
4. Advertisement that contains and has other representation that would cause a reasonable person to misunderstand
or be deceived.
Rule 503 Commissions and Referral Fees
1. Prohibited commissions. A member in public practice shall not for a commission recommend or refer to a client any product or service, or for
a commission recommend or refer any product or service to be supplied by a client, or receive a commission, when the member or the
member's firm also perform for that client:
a. An audit or review of a financial statement.
b. A compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use th e financial
statement and the member's compilation report does not disclose a lack of independence.
c. An examination of prospective financial information.
This prohibition applies during the period in which the member is engaged to perform any of the services listed above and the period covered by
any historical financial statements involved in such listed services.
2. Disclosure of permitted commission. A member in public practice who is not prohibited by this rule from performing services for or receiving a
commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the me mber
recommends or refers a product or service to which the commission relates.
3. Referral fees. Any member who accepts a referral fee for recommending or referring any service of a CPA to any person or entity or who pays
a referral fee to obtain a client shall disclose such acceptance or payment to the client.
Rule 503 prohibits a CPA from receiving or paying a commission for service or product referrals to or from a client
when the CPA is performing an attestation service for the same client. This is to prevent potential conflicts of
interest. However, Rule 503 allows such a commission for any non-attestation service client provided disclosure is
made to the client. Part 3 of Rule 503 permits referral fees. However, the CPA must disclose such fees to the client.
Figure 3-5 provides a summary of the interpretations of Rule 503 Commissions and Referral Fees.
Figure 3-5 Interpretations of Rule 503 Commissions and Referral Fees
Commissions received
Violation
e.g., Supplier
Goods
(e.g., computers)
Auditor
Auditing
Client
XYZ Co
Services
(e.g., legal work)
Referral fees received

No violation
e.g., CPA of a
Law firm
Rule 505 - Form of Organization and Name

A member may practice public accounting in a form of organization permitted by state law or regulation whose characteristics conform to
resolutions of Council.
A member shall not practice public accounting under a firm name that is misleading. Names of one or more past owners may be included in the
firm name of a successor organization. Also, an owner surviving the death or withdrawal of all other owners may continue to practice under such
name which includes the name of past owners for up to two years after becoming a sole practitioner.
A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its owners are members of
the institute.
An audit firm shall practice only in the form of a proprietorship, a partnership, or a professional corporation. A
professional corporation represents a corporation in form, but a partnership in substance, that is, it has no limited
liability. A professional corporation provides a tax advantage to the individual CPAs by avoiding double taxation
(i.e., corporate taxes to the professional corporation and individual taxes to the CPA shareholders). In 1991, the
AICPA permits an audit firm to practice in the form of a limited liability partnership (LLP), which limits an
individual partners liability to his/her investment in the firm, except in litigation, where a litigant can make claims
against a partners personal assets for liability linked directly to his/her own negligent act (e.g., a partner-in-charge
of an audit client issued a wrong audit opinion for that client).
Under Rule 505, the name of a CPA firm can be fictitious or indicate a specialization, provided that the
firm name or specialization is not deceptive or misleading. For example, "International Tax Specialists" is
acceptable if the CPAs indeed specialized in International Tax Services. However, "International Tax Free
Specialists" is unacceptable because the word "Free" may be misleading.
Rule 505 states that a successor partnership or professional corporation may continue to include the names
of one or more past partners or shareholders in its firm name. However, a sole successor of a partnership or
corporation may do the same for up to two years after becoming a sole practitioner. Moreover, all partners or
shareholders of a CPA firm must be members of AICPA if the firm wants to carry the designation "Members of the
AICPA".
Enforcers of the CPC
The AICPA has two key avenues by which members can be disciplined for violating the CPC. For violations that are
not sufficient to warrant formal actions, the Professional Ethics Executive Committee (PEEC) can direct a member
to take remedial or corrective actions. The committee can also refer a member to the Joint Trial Board. Furthermore,
the State Board of Accountancy may revoke a CPAs license for very serious violations of the CPC.
61
62
In general, there are three levels of enforcement and disciplinary action as follows:
1. Less serious violations are handled by the PEEC of the AICPA and/or state society/association. Disciplinary
actions are usually in the form of corrective actions e.g., to attend a number of continuing education hours.
2. More serious violations are handled by the Joint Trial Board. Disciplinary actions include suspension or expulsion
of membership from AICPA and the name of the offending CPA published in the CPA Newsletter. It should be
noted that expulsion of membership does not stop one from practicing as an accountant.
3. Very serious violations are handled by the State Boards of Accountancy. Disciplinary actions include suspension
or revocation of a CPA certificate and/or the license to practice.
Figure 3-6 shows the enforcers of the CPC and their disciplinary action.
Figure 3-6 Enforcers of the CPC and Disciplinary Action
Enforcers of the CPC
AICPA
State Board of Accountancy
Professional Ethics Executive Committee
Joint Trial Board
Disciplinary action
Expulsion
Revoke CPA license
Enforcer of SECs Auditor Independent Rules

If the PCAOB determines that any registered CPA firm has engaged in practices in violation of the PCAOBs
Auditor Independent Rules, the Board may impose sanctions, including temporary suspension or permanent
revocation of registration or association of individuals with a registered firm, monetary penalties, censure, and
additional education or training.
3-1
Which of the following principles is not in the CPC?

a. To serve the public interests.
b. To exercise professional care.
c. To be a responsible profession.
d. To provide expert advice.
3-2
Which part(s) of the CPC is(are) enforceable?

a. Interpretations.
b. Ethical rulings.
c. Rules of conduct.
d. Principles.
3-3
Which of the following statements is a violation of the rule on independence in fact and independence in appearance?
a. A CPA acquired immaterial indirect investment in an audit client.
b. A CPA holds a honorary directorship in a not-forprofit religious organization.
c. A CPA secured a franchise loan from an audit client.
d. A CPA disengaged from an audit client.
3-4
A CPA will not be independence in fact and in appearance if s/he is

a. an honorary secretary of a not-for-profit client.
b. a trustee of a not-for-profit client's pension fund.
c. a part time accountant of an non-audit client.
d. an immaterial direct investor in an audit client.
3-5
The rule on confidential client information will be violated if a CPA

a. provides working papers to a succeeding auditor without the consent of an audit client.
b. provides working papers of an audit client to internal revenue service who requested them.
c. provides working papers of an audit client to a court of law which subpoenas them.
d. provides working papers of an audit client to an AICPA peer review program without the consent of the client.
3-6
A CPA will violate the rule on contingent fees if s/he

a. charges a fee according to what is stated in the engagement letter.
b. charges a fee that is the same as the previous year's audit fee.
c. charges a fee that is different from the previous year's audit fee.
d. charges a fee that is based on the type of audit opinion to be issued.
3-7
The CPC prohibits a CPA to

a. advertise for potential clients.
b. pay commission to others for client referrals when the CPA is auditing the same client.
c. charge a fee based on a particular outcome of the audit.
d. receive commission from others for client referrals when the CPA is auditing the same client.
3-8
Very serious violations of the CPC by a CPA are handled by

a. the National Joint Trial Board.
b. the National Ethics Committees.
c. the State Boards of Accountancy.
d. the National and State Ethics Committees.
3-9
The interpretations of the Rules of Conduct, Rule 101, define materiality for investor-investee relationships as:
a. 5% of audit clients total assets,
b. 5% of audit clients operating income before taxes.
c. either 5% of audit clients total assets or 5% of income before taxes, whichever is more restrictive.
d. 5% of audit clients net income after taxes.
63
64
3-10
Generally, loans between a CPA and an audit client are prohibited because they create a financial relationship. Which of
the following is not an exception to this rule?
a. Secured automobile loans.
b. Fully collateralized loans.
c. Home mortgages.
d. Unpaid credit card balances not exceeding $10,000.
3-11
Which of the following is not defined as an act discreditable in either the Rules or the Interpretations of the AICPAs Code
of Professional conduct?
a. A CPA firm issued a standard unqualified audit report after auditing a governmental agency, although GAAS was not
followed because the government required procedures different from GAAS.
b. A CPA firm discriminates in its hiring practices based on the age of the applicant.
c. A CPA retains a clients books and records to enforce past-due payment of the CPAs audit fee.
d. A CPA was arrested on his way home from the CPA firms holiday party. He was a passenger in a car driven by his wife
and she was charged with driving while intoxicated. He was also charged with lewd and indecent gestures towards an
officer of the law.
3-12
In which of the following instances would the independence of the CPA not be considered to be impaired? The CPA has
been retained as the auditor of a
a. charitable organization in which an employee of the CPA serves as treasurer.
b. municipality in which the CPA owns $250,000 of the $2,500,000 indebtedness of the municipality.
c. cooperative apartment house in which the CPA owns an apartment and is not part of the management.
d. company in which the CPAs investment club owns one-tenth interest.
3-13
In connection with a lawsuit, a third party attempts to gain access to the auditors working papers. The clients defense of
privileged communication will be successful only to the extent it is protected by the
a. auditors acquiescence in use of this defense.
b. common law.
c. AICPA Code of Professional Conduct, Rule 301 on client confidential information.
d. state law.
3-14
The AICPA Code of Professional Conduct requires compliance with accounting principles promulgated by the body
designated by AICPA Council to establish such principles. The pronouncements comprehended by the code include all of
the following except
a. AICPA Accounting Research Bulletins.
b. AICPA Accounting Research Studies.
c. opinions issued by the Accounting Principles Board.
d. interpretations issued by the Financial Accounting Standards Board.
3-15
A CPA is allowed to accept a referral fee for recommending a client to another CPA if
a. the client approves of the transaction either before or after the event.
b. payment of the referral fee is disclosed to the client.
c. the client pre-approves the transaction.
d. None of the above because referrals are never acceptable.
3-16
Rule 505 of the AICPAs Code of Professional Conduct permits CPA firms to organize as
a. single proprietorships or partnerships only.
b. single proprietorships, partnerships, or professional corporations.
c. single proprietorships, partnerships, professional corporations or regular corporations if permitted by state law.
d. single proprietorships, partnerships, professional corporations if permitted by state law, or regular corporations.
3-17
The interpretations to the Rules of Conduct permit a CPA to do both bookkeeping and auditing for the same client if three
important requirements are satisfied. Which of the following is not one of those requirements?
a. The CPA must conform to generally accepted auditing standards.
b. The CPA must not assume the role of employee or of manager.
c. The client must accept full responsibility for the financial statements.
d. The client must file audited financial statements with the SEC.
3-18
The AICPAs Code of Professional Conduct states that a CPA should maintain integrity and objectivity. The Term
objectivity in the Code refers to a CPAs ability
a. to choose independently between alternate accounting principles and auditing standards.
b. to distinguish independently between accounting practices that are acceptable and those that are not.
c. to be unyielding in all matters dealing with auditing procedures.
d. to maintain an impartial attitude on all matters that come under the CPAs review.
3-19
Which of the following activities is not prohibited for the CPA firms attestation service clients?
a. Competitive bidding on audit jobs.
b. Contingent fees on audit jobs.
c. Commissions for obtaining client services on audit jobs.
d. None of the above.
3-20
A violation of the AICPAs Code of Professional Conduct would most likely have occurred when a CPA
a. make arrangements to charge a client audit fee based on the complexity of the clients accounting systems.
b. make arrangements with a bank to collect notes issued by a client in payment of fees due.
c. whose name is Choo formed a partnership with two other CPAs and uses Choo & Associates as the firm name.
d. issued an unqualified opinion on the 2001 financial statements when audit fees for the 2000 audit were unpaid.
3-21
A CPA is permitted to disclose confidential client information without the consent of the client to
I. Another CPA who has purchased the CPAs tax practice.
II. Another CPA if the information concerns suspected tax return irregularities.
III. A state CPA societys quality control review board for the purpose of a peer review program.
a. I and III
b. II and III
c. II
d. III
3-22
In which of the following situations would a CPAs independence be considered to be impaired?

I. The CPA maintains a checking account that is fully insured by a government deposit insurance agency at an audit
clients financial institution.
II. The CPA has a financial interest in an audit client, but the interest is maintained in a blind trust.
III. The CPA owns a commercial building and leases it to an audit client. The rental income is material to the CPA.
a. I, II, and III.
b. I and III
c. II and III
d. I and II
3-23
A CPA purchased stock in a client and placed it in a trust as an educational fund for the CPAs dependent child. The trust
securities were not material to the CPA but were material to the childs personal net worth. Would the independence of
the CPA be considered impaired with respect to the client?
a. Yes, because the stock would be considered a direct financial interest and, consequently, materiality is not an issue.
b. Yes, because the stock would be considered an indirect financial interest that is material to the CPAs child.
c. No, because the CPA would not be considered to have a direct financial interest in the client.
d. No, because the CPA would not be considered to have a material indirect financial interest in the client.
3-24
Which of the following would probably not be considered an act discreditable to the profession:
a. Failing to file the CPAs own tax return.
b. Soliciting CPA Examination questions and answers.
c. Numerous moving traffic violations.
d. Refusing to hire Asian-Americans in an accounting practice.
3-25
According to the CPC, which of the following acts is generally prohibited?

a. Purchasing a product from a third party and reselling it to a client.
b. Writing a financial management newsletter promoted and sold by a publishing company.
c. Accepting a commission for recommending a product to an audit client.
d. Accepting engagements obtained through the efforts of third parties.
65
66
3-26
Which of the following is required for a CPA firm to designate itself as Members of the American Institute of Certified
Public Accountants on its letterhead?
a. All partners of the CPA firm must be member of AICPA.
b. The partners whose names appear in the firm name must be members.
c. At least one of the partners must be a member.
d. The firm must be a dues-paying member.
3-27
The concept of materiality would be least important to an auditor when considering the
a. adequacy of disclosure of a clients illegal act.
b. discovery of weaknesses in a clients internal control.
c. effects of a direct financial interest in the client on the CPAs independence.
d. decision whether to use positive or negative confirmations of accounts receivable.
3-28
A violation of the CPC most likely would have occurred when a CPA
a. expressed an unqualified opinion on the current years financial statements when audit fees for the prior years audit
were unpaid.
b. recommended a controllers position description with candidate specifications to an audit client.
c. purchased a CPA firms practice of monthly write-ups for a percentage of fees to be received over a 3-year period.
d. made arrangements with a financial institution to collect notes issued by a client in payment of audit fees due for the
current years audit.
3-29
According to the CPC, which of the following circumstances will prevent a CPA performing audit engagements from being
independent?
a. Obtaining a collateralized home loan from a financial institution client.
b. Litigation with a client relating to billing for consulting services for which the amount is immaterial.
c. Employment of the CPAs spouse as a clients internal auditor.
d. Acting as an honorary trustee for a not-for-profit.
3-30
According to the CPC, which of the following events may justify a departure from a Statement of Financial Accounting
Standards?
a.
b.
c.
d.
3-31
New Legislation
No
Yes
Yes
No
Evolution of a New Form of Business Transaction

Yes
No
Yes
No
According to the CPC and prior to the SECs Financial Reporting Release No.65, which of the following acts is not generally
prohibited?
a. Issuing a modified report explaining a failure to follow a governmental regulatory agencys standards when conducting
an attest service for a client.
b. Revealing confidential client information during a peer review of a professional practice by a team from the state CPA
society.
c. Accepting a contingent fee for representing a client in an examination of the clients federal tax return by an IRS agent.
d. Retaining client records after an engagement is terminated prior to completion and the client has demanded their return.
3-32
With respect to client records in a CPAs possession, the CPC provides that (Hint: Consider Rule 501)
a. an auditor may retain client records if fees due with respect to a completed engagement have not been paid.
b. worksheets in lieu of general ledger belong to the auditor and need not be furnished to the client upon request.
c. extensive analyses of legal expenses prepared by the client at the auditors request are working papers that belong to the
auditor and need not be furnished to the client upon request.
d. the auditor who returns client records must comply with any subsequent requests to again provide such information.
3-33
Which of the following is a violation of the SECs auditor independence rule on non-audit services?
a. A CPA firm provides certain non-audit services that they are pre-approved by the audit committee.
b. A CPA firm provides certain non-audit services that are not pre-approved by the audit committee but the aggregate fee
of all such non-audit services constitutes less than 5% of the total audit fee paid to the CPA firm.
c. A CPA firm provides tax services to an audit client that are not pre-approved by the audit committee.
d. The audit committee disclose to investors in periodic reports its decision to pre-approved non-audit services.
3-34
Which of the following is not a general principle used by the Public Company Accounting Oversight Board (PCAOB) in
evaluating the effect of other services on auditor independence?
a. The fee for the additional services must be less than the audit fee.
b. An auditor cannot function in the role of management.
c. An auditor cannot audit his or her own work.
d. An auditor cannot serve in an advocacy role for the client.
3-35
In which of the following situations would a CPA be considered not independent with respect to an audit client under the
independence Rules of the Sarbanes-Oxley Act?
a. The CPA firm provides tax planning services to the audit client that were pre-approved by the audit committee.
b. The audit client hires a partner of a CPA firm as its CFO who left the CPA firm one month earlier, and who was in
charge of the most recent audit of that audit client.
c. The audit partner-in-charge of an audit client has served in that capacity for the past four years.
d. The CPA firm provides general business consulting services that were pre-approved by the audit committee.
3-36
In which of the following situations would a CPA be in violation of the AICPA Code of Professional Conduct on commissions and
referral fees?
a. A CPA discloses to a non-attestation service client that he has received a commission from one of the
suppliers of that client.
b. A CPA discloses to an attestation service client that he has received a referral fee from one of the
lawyers of that client.
c. A CPA discloses to an attestation service client that he has received a commission from one of the
suppliers of that client.
d. A CPA discloses to a non-attestation service client that he has received a referral fee from one of the lawyers of that
client.
3-37
Contrast the requirements of AICPAs Independent Rule 101 and PCAOBs Auditor Independent Rules, which of the
following is a correct statement?
a. SEC requires the lead partner to rotate off the audit every seven years, whereas AICPA requires a rotation every five
years.
b. AICPA does not prohibits providing audit and management services to the same client, whereas SEC directly prohibits
providing audit and management services to the same client.
c. PCAOB allows a public company to employ a member of its external audit team one year after the audit engagement,
whereas AICPA allows a public company to employ a member of its external audit team one year preceding the audit
engagement.
d. PCAOB requires audit committee to pre-approve non-audit services unless the non-audit service fees are less than 5
percent of the total fees. In contrast, AICPA contains no such requirement.
3-38
With regard to enforcement and disciplinary action, very serious violations of the ethical rules are ordinarily handled by
a. AICPAs Professional Ethics Executive Committee.
b. AICPAs joint trial board.
c. AICPAs quality control standards committee.
d. State Board of Accountancy.
3-39
Which of the following is not a correct statement regarding auditors independent?

a. An auditors spouse, spousal equivalent (i.e., cohabitant), and dependents are prohibited from having a direct financial
interest in the audit client.
b. An auditor is not independent of the audit client if any audit partner received compensation based on the partner securing
with the client billable work for services other than audit or attestation.
c. An auditor is not permitted to have a home mortgage loan from the audit client.
d. An auditor is prohibited from being employed by the audit client one year preceding the audit engagement.
3-40
Which of the following is an example of a familiarity threat to an auditors independence?

a. An auditor has a material joint venture with the audit client.
b. An audit has provided audit services to the same client for a prolonged period.
c. An auditor establishes and maintains internal controls for the audit client.
d. An auditor represents an audit client in U.S. tax court.
67
68
3-41
In which of the following situations would a CPA be in violation of the PCAOBs rules on providing auditing and management
advisory services to the same audit client?
a. The auditing and management advisory services provided to the same audit client are pre-approved by the audit
committee .
b. The aggregate fee of the auditing and management advisory services constitutes less than 5% of the total audit fee paid
to the CPA. .
c. The auditing and management advisory services are provided to the same audit client that is a non-public company.
d. The auditing and management advisory services provided to the same audit client are not pre-approved by the audit
committee.
3-42
The PCAOBs Auditor Independence Rule defines a CPAs nondependent step-child as

a. a close family relative.
b. another relative.
c. an immediate family member.
d. neither an immediate family member nor a close family relative.
3-43
With regard to an auditor providing auditing and tax services to the same audit client, there would be a violation of the
PCAOBs Auditor Independence Rules if
a. The total tax services fee is less than 5% of the total audit fee.
b. The tax services are provided for the clients officers in financial reporting oversight roles after the audit engagement has
begun.
c. The tax services are preapproved by the audit committee.
d. The tax services are provided for the clients officers not in financial reporting oversight roles.
3-44
Which of the following is not a correct statement concerning both the PCAOB and AICPAs independence rules?
a. PCAOB prohibits actuarial service whereas AICPA allows it provided the service does not relate to a material portion of
the financial statements.
b. PCAOB prohibits implementing a financial information system whereas AICPA allows it provided the system is not
developed by the auditor.
c. PCAOB prohibits bookkeeping services whereas AICPA allows it provided the auditor does not authorizes or approves
transactions.
d. PCAOB prohibits internal audit outsourcing services whereas AICPA allows it provided the audit client is not
responsible for internal control.
3-45
Under the current Federal laws, which of the following does not apply to an auditor who has obtained certain confidential
information about an illegal act committed by the client?
a. The illegal act has a material effect on the financial statements and warranted a qualified audit report, the auditor must
communicate the act and confidential information to the clients board of directors.
b. Upon communicated of the illegal act and confidential information, the management must send a notification to the SEC
of having received such a communication from the auditor, and a copy of the notification to be sent to the auditor.
c. The SEC provides civil and criminal protections to employees of the audit client who whistleblow confidential
information and provides the same protections to auditor who possesses such confidential information from the
whistleblowers.
d. Upon communicated of the illegal act and confidential information, if the management did not send the auditor a copy of
the notification to the SEC of having received such a communication, the auditor must directly communicate the matter
to the SEC.
3-46
With regard to contingent fees, which of the following is not an appropriate interpretation of Rule 302 Contingent fees
when an auditor provides both attestation and non-attestation services to the same client?
a. It prohibits contingent fee for audit services provided to the client.
b. It prohibits contingent fee fixed by courts or regulatory agencies for audit services provided to the client.
c. It prohibits contingent fee for tax services and other non-attestation services provided to the client.
d. It prohibits contingent fee fixed by courts or regulatory agencies for tax services provided to the client.
Key to Multiple-Questions
3-1 d. 3-2 c. 3-3 c. 3-4 d. 3-5 a. 3-6 d. 3-7 c. 3-8 c. 3-9 c. 3-10 d. 3-11 d.
3-12 c. 3-13 b. 3-14 b. 3-15 b. 3-16 c. 3-17 d. 3-18 d. 3-19 a. 3-20 d. 3-21 d.
3-22 c. 3-23 a. 3-24 c. 3-25 c. 3-26 a. 3-27 c. 3-28 a. 3-29 c. 3-30 c. 3-31 c.
3-32 c. 3-33 c. 3-34 a. 3-35 b. 3-36 c. 3-37 d. 3-38 d. 3-39 c. 3-40 b. 3-41 d.
3-42 a. 3-43 b. 3-44 d. 3-45 c. 3-46 b.
69
70

Simulation Question 3-1 is an adaptation with permission from a case by Cullinan C.P. and G.B. Wright in Cases From The SEC Files, a
publication of the Pearson Education, Inc. in New Jersey. This simulation question is based upon a true set of facts from the SEC files.
SEC Findings
SEC Sanctions
SEC found PricewaterhouseCoopers (PwC) failed to comply with Rule2-01(b) of Regulation S-X, GAAS, SEC Independence Rules,
and AICPA Code of Professional Conduct which require, among other things, that public accounting firms and their partners and certain
professionals not have any direct or material indirect financial interest in their audit client. Details of the findings are as follows:
1. Professionals who owned securities of publicly held audit clients for which they provided professional services.
During the period 1996 through 1997, three Coopers & Lybrand (C&L) CPAs owned the securities of four publicly-held audit clients
for which they provided professional services. First, in December 1996, a senior tax associate of C&Ls Tampa, Florida, office (Tampa Tax
Associate) owned the securities of a company (Company A) for which he provided professional tax services relating to certain engagements
that were transferred from C&Ls Jacksonville, Florida, office. Second, during November 1996 through April 1997, the Tampa Tax Associate
also owned the securities of another company (Company B) for which he provided professional tax services relating to Company Bs initial
public offering and other tax projects. Third, during December 1996 through February 1997, the Tampa Tax Associate also owned the securities
of another company (Company C) for which he provided professional tax services relating to tax accrual in Company Cs 1996 financial
statements. In addition, during October 1997 through July 1998, a consultant in C&Ls Human Resource Advisory Group also owned securities
of Company C for which the consultant provided one hour of professional consulting services relating to a 401(K) plan offered by Company C.
Fourth, during October 1996 through February 1997, another senior tax associate of C&Ls Tampa office (Second Tampa Tax Associate)
owned the securities of a company (Company D) for which he provided professional tax services relating to pending IRS audits of Company
D.
2. Partners who owned securities of publicly held audit clients for which the partners provided no professional services and managers who owned
securities of publicly-held audit clients of their office for which the managers provided no professional services.
During the period 1996 through 1998, five C&L partners or their spouses owned securities of, or had another direct or material
indirect financial interest in, 31 publicly held audit clients for which the partners provided no professional services. In addition, three C&L
managers or their spouses owned securities of, or had another direct or material indirect financial interest in, three publicly-held audit clients of
their office for which the managers provided no professional services.
3. Investments by C&Ls retirement plan in securities of publicly-held audit clients of C&L and PwC.
During the period of 1996 through 1998, C&Ls retirement plan owned securities of 45 publicly held audit clients in three types of
instances. First, during the period 1977 through 1988, an independent fund manager that was not a C&L employee and that was retained to
manage certain of C&Ls pension fund assets made 15 purchases of the securities of 11 different publicly held audit clients of C&L. C&L
annually provided its fund manager with a list of its audit clients (independent list), the securities of which were not to be purchased. However,
C&Ls procedure of monitoring the fund managers compliance with C&Ls prohibition consisted of only a periodic comparison by personnel in
its pension department of the fund holdings to C&Ls independent list. Second, during the period of 1966 through 1998, the same fund manager
made three purchases of the securities of three different publicly held audit clients of C&L. The fund manager made these purchases prior to
being provided by C&L with an updated independent list which identified these three clients. Third, from July 1, 1998, the date of the Price
Waterhouse (PW) and C&L merger, through November 1998, C&Ls retirement plan held the securities of 32 PwC publicly held audit clients
that had been clients of PW before the merger. Former C&L pension personnel, who became employees of PwC, failed to provide three different
fund managers with a list of PWs clients.
(a)
(b)
(c)
(d)
(e)
(f)
SEC accepts PwCs offer of Settlement and orders that:

PwC is censured.
PwC takes measures to provide reasonable assurance that it will comply with SECs Regulation S-X and Independent Rules to be
independent, in fact and appearance, of their audit clients.
PwC takes measures to provide reasonable assurance that it will comply with AICPAs GAAS and Code of professional Conduct
requiring CPA firms not have any direct or material indirect financial interest in their audit clients.
Prior to accepting a new audit engagement, PwC checks its Securities Held List to determine whether any partner owns the securities
of that prospective audit client.
Annual reports to be filed by all PwC partners and professional staff indicating whether, over the prior year, they had acquired, or
were committed to acquire, any direct financial interest or any material indirect financial interest in any securities on its Restricted
Entity List.
All PwC partners and professional staff complete a course of professional education and training on independence issues.
Required
1. Cite and discuss the specific part(s) of (i) Regulation S-X, (ii) GAAS, (iii) SEC Independence Rules, and (iv) AICPA Code of Professional
Conduct that PwC failed to comply with professional independence. You should access Data File 3-1 in iLearn, which contains the SarbanesOxley Act of 2002. You should also search any relevant websites for more information. For example, search
http://www.aspenpublishers.com/SECRULES/Regsx.pdf for Regulation S-X.

Simulation Question 3-2 is an adaptation with permission from a case by Knapp, M. C. and C.A. Knapp in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts that was
drawn from United States of America V. Charles I. Covey, No. 00-1768, United States Court of Appeals for the Eighth Circuit, 232 F.3d 641,
2000 U.S.
A Prospective Client
An Unusual Proposal
Peter Kanah spent the early years of his professional career in a large city working on the auditing staff of a major accounting firm,
and then serving as an assistant controller for a municipal hospital. In 1995, Kanah and his wife decided they wanted a different lifestyle for
themselves and their three young children. After several months of searching for a new job, Kanah decided to accept an offer made to him by a
CPA with whom he had become acquainted at local professional meetings. Kanah agreed to purchase the CPAs accounting practice that was
located in a small suburb approximately 30 miles from the downtown business district where Kanah had worked for more than a decade. The
purchase agreement required the former sole practitioner to remain with the firm during a three-year transitional period to minimize client
turnover. In 1998, when Kanah assumed complete ownership of the firm, he had six full-time employees, including a receptionist and five
accountants, three of whom were CPAs. Tax, compilation, and bookkeeping services accounted for the bulk of Kanahs revenues.
Computer manufacturers, e-commerce start-ups, and other high-tech businesses dominated the greater metropolitan area in which
Kanahs firm was located. As a result, the economy of that area was hit hard by the recession that rocked the nations high-tech sector shortly
after the turn of century. In a span of 18 months, Kanah lost nearly one-third of his clients, forcing him to lay off two of his professional
employees. Making matter worse, over that same time frame, Kanah lost more than 80 percent of his personal savings. He had invested those
funds in the stocks of major e-commerce firms whose prices tanked in late 2000 and early 2001.
On a late Friday afternoon in June 2001, while Kanah sat at his desk contemplating his seemingly bleak future, his receptionist brought a
potential client to his door. Hello, Mr. Kanah. I am Robin Ornan. Ornan was a tall man with a sturdy physique and a firm handshake. He was
wearing a starched white shirt, blue jeans, and a frayed baseball cap. Immediately catching Kanah;s attention were large, diamond-encrusted rings
in the shape of a horseshoe that Ornan wore on the pinkie finger of each hand.
What can I do for you, Mr. Ornan?
Im looking for some accounting help.
Well, you certainly came to the right place.
Ornan proceeded to tell Kanah that he had recently inherited a good deal of money from his grandmother and planned to set up a
business in his hometown that was some 60 miles away, on the other side of the metropolitan area. When Kanah seemed surprised that Ornan was
searching for an accounting firm a considerable distance from his proposed business, Ornan quickly added that the planned to visit several
accounting firms in the metropolitan area before choosing one.
Because he had worked several years for an electrical contractor, Ornan believed that he had sufficient experience and contacts in that
field to quickly develop a profitable electrical contracting business. Coleman Services was the name he intended to use for his new company.
Ornan has settled on the generic name Coleman was his grandmothers maiden name - because he hope to expand into other lines of business
in the future.
As soon as Ornan paused, an anxious Kanah seized the opportunity to sell his firm to the prospective a client. Kanah described the
types of services he could offer a new business, including taxation, bookkeeping, and general consulting services. He also stressed the importance
of a new entrepreneur having a close relationship with his accountant. Because of his firms small size, Kanah assured Ornan that he would
receive prompt and personalized service.
Ornan listened politely to Kanahs sales pitch, put the business card Kanah offered him in his shirt pocket, and then excused himself.
As Ornan walked out the door, Kanah decided that he would likely never see Ornan again. Since Ornan had failed to ask any questions about
Kanahs services or fees, he had obviously been unimpressed with the small accounting firm. Kanah realized that Ornan had likely sensed that he
was desperate to acquire new clients, which he was. A few minutes later, the disconsolate Kanah told his employees they begin their weekend
early there was little for them to do anyway.
When Peter Kanah walked into his office the following Monday morning, he had a voice message waiting for him. Robin Ornan has
selected his firm over several others. In the brief message, Ornan told Kanah that he would drop by the office that afternoon to get the ball
rolling.
During their conversation later that day, it soon became apparent to Kanah that Ornan had little understanding of what steps were
necessary to set up a new business. Most of the questions Kanah directed to Ornan produced either a blank stare or an indifferent shrug of the
shoulders. Finally, Kanah decided to take the initiative.
Robin, I think we should start by developing a business plan for you. Ornan seemed bored by the length explanation of the nature
and purpose of a business plan and only glanced momentarily at the example that Kanah spread out on his desk.
When Kanah attempted to goad him into talking about the specific services his firm would provide, the restless Ornan finally spoke.
We dont need to talk about that. What you really need to know is that I want to put together a business big enough to clear about $20,000 per
month.
Kanah was surprised by the nave nature of Ornans remark. Im not sure what you mean, Robin. Do you mean $20,000 of revenues
per month or $20,000 of profits per month or $20,000 of net cash flow per month?
I mean $20,000 of cash, cash money, each month. I expect to operate on a cash basis and I want to know how much business I have
to bring in every month to clear that much cash.
Even more confused now, Kanah responded, You mean you arent going to extend credit to your customers?
No. No credit. Just cash. Im going to make them pay hard, cold cash.
Now, Kanah was just as frustrated as Ornan, but for a different reason. Over the previous few minutes, Kanah had realized that this
promising new client was not so promising after all. Clearly, Ornan had no idea what was involved in operating a business, any type of business.
Are you sure that you have the background necessary to start a business, Robin?
Yep. All I know is that the key to having a successful business is having customers willing to pay cash. And I have a lot of customers
lined up who are willing to pay me cash.
71
72
Kanah put down his pen and leaned back in his chair for several moments before responding. Well, exactly what do you want me to
do to help you? Ill have to rely on you to tell me because I have to admit, Im a little confused at this point.
Okay, thats fair. Why dont we start like this? Finally, Ornan seemed interested in the proceedings. Over the next couple of days,
you can set up a business on paper that would produce $20,000 of cash, or what did you say, net cash flow per month. Why dont you fix up a
set of financial statements or whatever you call them for a company of that size that does electrical contracting work. And, I think you should put
together a list of documents that the company would need to have and the types of reports that it would have to file with the IRS and any other of
those government-type organizations.
Arent you going about this backward? Shouldnt we
Ornan cut off Kanah in midsentence. Now wait a minute. You asked me what I wanted, didnt you? Kanah reluctantly nodded,
which prompted Ornan to speak again. Somewhere, you can find information on a typical electrical contracting business. And, you already know
what types of documents and reports that a business like that would have to prepare every year. Soon as you get all of that information put
together, then we can go from there.
GO? Go where? a flustered Kanah asked.
Go about getting the business started, Ornan shot back quickly. Now, whats so hard about that? You said youre a CPA. I know
you can put together all of that stuff.
Well, youre right. I can do what you asked. I just hope that is what you really need.
Good, the suddenly upbeat Ornan replied. Now, what do you charge for your services?
Well, for this type of work I would have to charge $100 an hour. Kanah expected that the first mention of his houly fee would
stop Ornan in his tracks and possibly bring their awkward discussion to an abrupt conclusion.
Sound fair to me, Ornan replied nonchalantly. How about I start out by paying you $2,500 upfront. Its called a retainer, isnt it?
As Kanah sat dumbfounded and silent at his desk, Ornan stood and reached into his right front pocket and extracted a large roll of
crisp $100 bills. He then counted out 25 of the bills and laid them in a neat pile in front of Kanah. There you are. Ill be back on Friday
afternoon around 1:00 to get that report. Without offering to shake Kanahs hand, Ornan turned and left, leaving his newly hired accountant
gawking at the stack of money in front of him.
An Atypical Business
An Unexpected Outcome
The always prompt Ornan returned to Kanahs office at 1:00 PM on Friday. Thomas, do you have my report?
Yes, I do. Here you are.
Ornan spent several minutes thumbing through the 15-page report after Kanah had completed his explanation of the key items
included in it. He then shook his head and tossed the report on the corner of Kanahs desk. Whew, I didnt know that starting a business
involved this much stuff.
It gets more complicated all the time, Kanah responded.
After taking off his baseball cap and scratching his head for several moments, Ornan stood and closed the door to Kanahs office.
Ornan then sat down and learned forward as he began speaking in a forceful and unapologetic tone. Listen here, Peter. Im going to come clean
with you. Over the next several minutes, Ornan explained that the money he had inherited from his grandmother had been in the form of cash
cash that she had literally hidden under a mattress, buried in cans in her backyard, and stashed in remote corners of remote cubbyholes of her
large home. Dang it, she had told me where it was all hid. But, I may have forgotten some of the spots. I spent the better part of two days tearing
that old house apart. I just hope I got it all. After a brief pause, Ornan shook his head and smiled. That old lady was quite a hoot. Didnt trust
bankers a lick.
Kanah was too shocked to interrupt his new client or to provide any commentary on the sudden and unexpected revelation.
Anyway, why dont we just forget about you helping me set up the business. I think I can do that myself. And, I really dont need an
accountant. My brother has a friend who knows how to keep the books for a cash business. Ornan paused for a moment as if to allow Kanah to
recover. Are you with me now? Peter, you with me? Kanahs gape-mouthed expression didnt change, but when he blinked his eyes and took a
breath, Ornan continued. What I really need to do is run my money through a business. Any business. Heres my plan.
The plan was for Kanah to loan Ornan $120,000 on a one-year promissory note. Ornan would use the cash flow from his business
to make 12 monthly payments of $11,000, meaning that Kanah would earn approximately 10 percent interest on the loan. The loan agreement
would indicate that the assets of Ornans business would serve as the collateral for the loan. But, to persuade Kanah to go along with the plan,
Ornan would give him cash of $135,000 as the true collateral for the loan. Ehen the loan was paid off, Kanah would return only $120,000 of the
cash, he would keep the remaining $15,000 as a loan origination fee.
By the time Ornan had finished laying out his proposal, Kanhs head was spinning. Finally, he mustered enough breath to speak.
Robin, I cant go along with this
Cmon, Peter. Theres nothing wrong here. Uncle Sam will be taken care of since Ill be paying a lot of taxes on my money. And,
you are going to make out like a bandit. Youll get $12,000 in interest plus another $15,000. For what? For nothing. youre not taking any risk
whatsoever. If I dont pay off the loan, you keep the cash collateral. Again, Ornan waited to allow Kanahs brain to catch up. And then, after
one year, we can do it all over again. Youll be making nearly $30,000 a year for the next several years. I know you can use it. I know your
business isnt doing well. You basically admitted that the other day.
During the tedious pause that followed, Kanah stared at the wall to his left. He then leaned forward, propped his elbows on his desk,
and clasped his hands together as if he was seeking divine guidance. At that point, Ornan stood and took his wad of $100 bills out of his pocket .
He slowly deliberately counted out 50 of the bills. Here you are, Peter. Heres a bonus for doing the deal. Thats $5,000. Now. Do we have a
deal?
After studying the large stack of bills for several moments, Kanah extended his right to Ornan and meekly said,Deal.
Peter Kanah liquidated his remaining investments and borrowed $25,000 from his parents to finance the $120,000 loan to Robin
Ornan. True to his word, Ornan delivered a large bundle of $100 bills held together with rubber bands as collateral for the loan. For nine months,
Ornan made the monthly payments on the first day of each month. But, in the spring of 2002, two FBI agents arrived at Kanahs firm to tell him
that Ornan would not be making any further payments on the loan since he had been arrested for selling a variety of illegal drugs including
marijuana and methamphetamines. The agents then informed Kanah he was being charged with conspiracy to commit money laundering and
aiding and abetting money laundering. Kanah was then handcuffed, read his Miranda rights, and taken to the local county courthouse to be
arraigned.
The principal witness against Kanah during his criminal trial was Ornan. With the coaxing of federal prosecutors, Ornan recounted the
series of meeting himself and Kanah that had eventually led to the loan agreement between the two men. Under cross-examination by Kanahs
legal counsel, Ornan testified that he had never told Kanah the actual source of his cash inheritance. When given the opportunity to testify on
his own behalf, Kanah insisted repeatedly that he did not know or suspect that Ornan was attempting to launder money from an illicit drug
operation, but did admit that he had failed to report the receipt of more than $10,000 in cash to the IRS as required by a federal status. Kanahs
denials had little impact on the jury. Kanah was convicted on both federal charges files against him. He was sentenced to six years in federal
prison, fined $19,000, and was required to forfeit $70,000 of cash he had received from Ornan that had been confiscated by la w enforcement
authorities.
Required
1. Use the internet to search for information and answer the following parts:
a. Explain what does the phrase money laundering mean?
Note: A useful site is http://en.wikipedia.org/wiki/Money_laundering
b. Briefly describe six methods that are commonly used to money laundering.
Note: A useful site is http://money.howstuffworks.com/money-laundering1.htm
c. With regard to the particular money laundering method used by Robin Ornan, briefly explain:
i. How would the Bank Secrecy Act of 1970 prevent/detect the money laundering by Robin Ornan.
ii. How would the Bank Secrecy Act of 1970 not prevent/detect the money laundering by Robin Ornan.
Note: A useful site is http://www.irs.gov/businesses/small/article/0,,id=152532,00.html
d. With regard to the criminal charges against Robin Ornan and Peter Kanah, briefly explain the criminal penalties that can be imposed on
individuals and organizations that are convicted of money laundering under the Money Laundering Control Act of 1986.
Note: A useful site is http://www.ffiec.gov/bsa_aml_infobase/documents/regulations/ML_Control_1986.pdf
2. Assume you were Peter Kanah. How would you have responded differently to the loan proposal laid out by Robin Ornan?
Note: You must response appropriately as a professional CPA; not simply a yes or no answer.
3. Robin Ornan goaded Peter Kanah into becoming an active participant in his money laundering scheme. Discuss three general strategies that
individual CPAs can use to prevent themselves from stepping onto a slippery slope that eventually result in them becoming involved in
unethical and possibly illegal conduct. For example, you may discuss the self-awareness of greed as one possible general strategy.
Note: A useful site is http://www.philforhumanity.com/Money_Can_Not_Buy_Happiness.html

Simulation Question 3-3 is an adaptation with permission from a case by Grambling, A. A. and V. Karapanos in the Issues in Accounting
Education, a publication of the American Accounting Association in Sarasota, Florida.
The SEC Regulation S-X Rule 2-01 on Auditor Independence
On January 28, 2003, in response to SOX 2002, the SEC adopted amendments to strengthen requirements regarding auditor
independence. The current SEC independence requirements, which include the 2003 amendments, are found in Regulation S-X Rule 2-01. The
Rule applies to public company auditors and their close family members, public company auditing firms and their associated entities, and
publicly held companies and their affiliates. Rule 2-01 describes four overarching independence principles indicating that a relationship between
the accountant and the audit client should not:
1. Create a mutual or conflicting interest between the accountant and the audit client;
2. Place the accountant in the position of auditing his or her own work;
3. Result in the accountant acting as management or an employee of the audit client; or
4. Place the accountant in the position of being an advocate for the audit client.
Rule 2-01 prohibits specific relationships including financial relationships, employment relationships, business relationships,
relationships whereby the audit firm provides non-audit services to the audit client, and relationships involving contingent fees. Finally, Rule 2-01
includes requirements regarding partner rotation and audit committee administration of the engagement.
Required
Review Regulation S-X Rule 2-01 on Auditor Independence published by the University of Cincinnati College of Law at
http: //www.law.uc.edu /CCL/ regS-X/SX2-01.html
Based on your review of Regulation S-X Rule 2-01, answer the questions in each of the following two scenarios. Each scenario is to be
considered separately.
Scenario 1
Izumi, a public company, has a financial investment, 30 percent ownership, in Pearl, a private company. The investment in Pearl is not
material to Izumi. Axiom Auditors audits Izumi and also has a financial investment, 15 percent ownership, in the same private company, Pearl.
The investment in Pearl is not material to Axiom Auditors.
Both Axiom Auditors and Izumi have invested in Pearl for the purpose of benefiting from the stock appreciation of Pearl, are not in
business with Pearl, do not promote Pearl or its products, and do not receive any of Pearls operating revenues. You should access Data File 3-3
in iLearn for Figure 1, which depicts the relationships among the three parties in scenario 1.
73
74
1. Does the case represent an example of a violation of an SEC independence rule? If so, which rule and why? If not, why not?
Note: Specifically consider whether Axiom Auditors independence is impaired because of its investment in Pearl.
Scenario 2
Mills Corporation, a public company, purchased Clarke Company, another public company. Both companies are similar and operate in
the same industry. A new holding company, Marathon Corporation, was created and owns all the stock of Mills and Clarke. After the
merger, Marathons shares began public trading and shares of Mills and Clarke ceased trading.
Marathon has a newly formed board of directors. None of the original board members of Mills or Clarke are part of Marathons new
board. The management team from Mills will manage Marathon. After the merger, Mills constitutes 40 percent of the consolidated revenues and
assets of Marathon; Clarke constitutes 60 percent of the consolidated revenues and assets of Marathon.
Audit firm Favor and Hamilton had been the auditor of Mills for the last 15 years. Audit firm Kastor and Kastor had been the auditor
of Clarke for the last 15 years. Marathon wants to hire Kastor and Kastor as the auditor of the newly formed holding company, Marathon.
D. Drossin, an audit partner at Kastor and Kastor, has been the lead engagement partner of Clarke for the last 4 years. Drossin has a
great deal of experience in the industry, and Kastor and Kastor wants him as the lead audit partner on the Marathon engagement.
You should access Data File 3-3 in iLearn for Figure 2, which provides a diagram that depicts Scenario 2.
1. Would allowing Drossin to become the lead partner of Marathon Corporation result in a violation of the SEC independence rules? If so, which
rule and why? If not, why not?
2. If your answer to Question 1 indicates that it would not be a violation of the independence rules to allow Drossin to become the lead partner of
the Marathon audit, for how many years might Drossin be allowed to be the lead partner of the Marathon audit engagement?
3. The current SEC independence rules require partner rotation, but not audit firm rotation. In your opinion, should the SEC also require audit
firm rotation? Why yes or why not?
Note: Specifically consider the SEC independence rules on lead partner rotation.
Chapter 4
The Auditors Legal Environment
LO4-1 Understand the auditors litigious environment.
LO4-2 Explain the auditors liability to client under common law.
LO4-3 Explain the auditors liability to third parties under common law.
LO4-4 Differentiate between the auditors defense in client and third party law suits.
LO4-5 Explain the auditors civil liability under the statutory law.
LO4-6 Differentiate between the auditors defense in common and statutory law suits.
LO4-7 Explain the auditors criminal liability under the statutory law.
LO4-8 Discuss the Private Securities Litigation Reform Act of 1995 and its subsequent
and future legal development.
75
76
Chapter 4 The Auditors Legal Environment

In the current legal environment, auditors may be sued under the common law and statutory law. Figure 4-1
provides an overview of the applicable law and legal concept.
Figure 4-1 Applicable Law and Legal Concept
3. Public Law Suits
-Under Statutory law
-File civil/criminal action
-Specific SA1933, SEA1934,
-SOX2002 etc. for violating
Federal laws
Stockholders &
Other 3rd parties
2. 3rd parties Law Suits

-Under Common Law
-File civil action
-Specific Tort law for
professional negligence
Client
XYZ Co.
1. Client Law Suits

-Under Common Law
-File civil action
-Specific Contract law
for breach of contract
SEC
Auditor
Engagement letter
(privity of contract)
Table 4-1 provides a summary of the applicable law and legal concept.
Table 4-1 Applicable Law and Legal Concept
Common Law
Statutory Law
Common law is unwritten law that evolves from legal precedent, that
is, in deciding a case, the court looks to judgments in prior court cases.
Over time, the principles of common law are determined by the social
needs of the community.
Common law is state dependent. However, a court in one state may
look to cases decided in another state but is not obligated to follow
such cases. Lower courts in a state are obligated to follow the legal
precedents set by the higher state courts. However, the highest state
court is not bound by its own legal precedents.
A client or a third party may file a civil action against an auditor under
the Common Law of Contract (or Contract Law) or the Common Law
of Tort (or Tort Law):
Statutory law is written law that is established by Congress at the

federal level or by state legislative bodies at the state level. Federal
and state courts are bound by federal and state status, unless the statute
violates the federal or state constitution. A third party may file a civil
action against an auditor under the statutory law. In addition, federal
or state government may file a criminal action against an auditor under
the statutory law. A comparison of civil with criminal action is as
follows:
Contract Law
A civil action in contract is based on the privity of contract, that is, a
contractual relationship that exists between two or more contracting
parties. For example, an auditor is liable to a client for breach of
contract when s/he does not deliver the audit report by the agreed-upon
date.
When a breach of contract occurs, the plaintiff usually seeks one or
more of the following remedies:
(1) Specific performance of the contract by the defendant.
(2) Direct monetary damages for losses incurred due to the breach.
(3) Incidental and consequential damages that are an indirect result of
nonperformance.
Tort Law
A civil action in tort is based on one of the followings:
(1) Ordinary negligence
Characteristic
Who brings the
action?
Civil action
The plaintiff
Criminal action
The government
Trial by whom?
Trial by jury
Trial by jury
What kind of
Burden of proof?
Preponderance
of the evidence
Beyond a
reasonable doubt
How does jury

vote?
Judgment for
plaintiff requires
specific jury vote,
e.g., 9/12 jurors
Conviction
requires
unanimous jury
vote
What type of
Monetary damages,
sanctions/penalties? equity remedies,
e.g., injunction,
specific performance
Imprisonment,
capital
punishment, fine,
probation
Common Law
Statutory Law
Failure to exercise a degree of care that an ordinary prudent person (a

reasonable person) would exercise under similar circumstances.
Failure to perform an audit in accordance with generally accepted
auditing standards might be interpreted as ordinary negligence. In
auditing, ordinary negligence may be viewed as "failure to exercise
due professional care".
(2) Gross negligence
Failure to exercise even a slight care in the circumstances. Substantial
failure to perform an audit in accordance with generally accepted
auditing standards might be interpreted as gross negligence. Reckless
behavior towards ones professional responsibilities is a form of gross
negligence.
(3) Fraud
Intentional deception, such as the misrepresentation, concealment, or
nondisclosure of a material fact, that results in injury to another
person. For example, an auditor intentionally misrepresents his/her
audit report.
Auditors Liability to Client under Common Law

In auditing, a CPA typically enters a direct relationship with the client by agreeing to perform an independent audit
service for the client. The agreed-upon independent audit service to be performed by the auditor is detailed in an
engagement letter and signed by both the auditor and the client. Accordingly, a contractual relationship or privity of
contract exists between the two parties. Given this contractual relationship, the auditor is liable to the client for
breach of contract when he/she: 1. Issues a standard unqualified audit report when the audit engagement has not
been conducted in accordance with GAAS. 2. Does not deliver the audit report by the agreed-upon date. 3. Violates
the client's confidential relationship. Key cases involving an auditor's liability to client (client law suits) are
summarized in Table 4-2 and Table 4-3.
Table 4-2 1136 Tenants Corporation Case (1976)
1136 Tenants Corporation Case (1976)
Facts:
A CPA was orally engaged to perform accounting and auditing services for the 1136 Tenants Corporation. The CPA misunderstood the contract
thinking that he was engaged to prepare accounting records only. Therefore, the CPA only prepared financial statements and related tax returns
for the client.
In the course of preparing the accounts for the client, the CPA came across some missing invoices which showed over $40,000 of disbursements
that did not have supporting documents. However, the CPA, thinking that he was not engaged in auditing, did not follow-up the missing invoices
and did not inform the plaintiff of the missing invoices.
As it turned out, the management of the cooperative apartment embezzled significant funds of over $110,000. The tenants of the cooperative
apartment sued the CPA for breach of contract and negligence for failure to detect the fraud.
Outcome:
The court concluded that the CPA was liable because regardless of the type of services performed by the CPA (even if he misunderstood them),
the standard of due professional care required him to follow-up the fraud and to inform the client of known wrongdoing.
Lesson:
The AICPA issues a letter to strongly recommend a written contract (i.e., an engagement letter) to be signed by the auditor and the client that
clearly defines the intention and scope of each audit engagement.
Table 4-3 Cenco Incorporated Case (1982)

Cenco Incorporated V. Seidman & Seidman (1982)
Facts:
A massive fraud was committed by the former top management of Cenco Incorporated by inflating inventory values to $25M. The new
management of Cenco sued the auditors, Seidman & Seidman, for breach of contract. They claimed that the auditors failed to detect the fraud
committed by the former top management in accordance with GAAS.
Outcome:
The Seventh Circuit Court of Appeals in Chicago concluded that "auditors' aren't detectives hired to ferret out fraud" and although the auditors
were responsible to follow-up any indications of fraud, in this case, the former management made fraud difficult to detect by turning the
company "into an engine of theft against outsiders." The auditors were not negligent in the face of a well-orchestrated management fraud.
Lesson:
The AICPA issues AU 316 Consideration of Fraud in a Financial Statement Audit that clarifies and reinforces the auditor's responsibility for the
detection of fraud in accordance with the four fundamental principles underlying an audit (AICPA).
77
78
Auditors Liability to Third Parties under Common Law

Under common law, a third party is defined as an individual who is not in privity with the parties to a contract.
There are two classes of third parties:
1. A primary beneficiary. Anyone specifically identified to the auditor prior to the audit who is to be the primary
beneficiary of the auditor's report. For example, a client informs the auditor prior to the audit that the audit report is
to be used to obtain a loan from a specified bank; the specified bank becomes a primary beneficiary.
2. Other beneficiary. Anyone not specifically identified to the auditor prior to the audit who may rely on the
auditor's report, such as creditors and potential investors. A key case that establishes auditor's liability to a primary
beneficiary is summarized in Table 4-4.
Table 4-4 Ultramares Corporation Case
Ultramares Corporation V. Touche (1931)
Facts :
The auditor, Touche, discovered that its client, Fred Stern & Co, overstated assets and stockholders equity by $700,000 through fictitious
transactions. However, Touche failed to report the fictitious transactions in the audit report.
Relying on Touche's audited financial statements, Ultramares lent Stern money that Stern was unable to repay because it was actually insolvent.
Ultramares sued Touche for negligence and fraud.
Outcome:
The court ruled that a privity of contract did not extend to a third party unless the third party is a primary beneficiary. In this case, the court found
that Touche was guilty of ordinary negligence but not gross negligence or fraud; and Touche was not liable to Ultramares for ordinary negligence
because Ultramares was not a primary beneficiary.
Lesson:
This case establishes the Ultramares doctrine by which auditors are not liable to a third party for negligence in the absence of a privity of
contract. In addition, under the Ultramares doctrine, auditors are not liable for ordinary negligence but may be liable for gross negligence or fraud
if the third party is a primary beneficiary.
The Ultramares doctrine remained unchallenged for many years, and it is still followed today in jurisdictions of
some states. However, there has been a trend to broaden the auditor's liability in the case of other beneficiaries based
on Section 552 of the Restatement (2nd) of Torts. Under this Restatement (2nd) of Torts, the other beneficiaries are
separated into two categories:
1. A foreseen party. A user of a reasonably limited class or group of users of financial statements who have relied on
the auditor's work; for example, if the client informed the auditor that the audit report is to be used to obtain a bank
loan from a specified bank, all banks are foreseen parties but trade suppliers would not be part of the foreseen group.
One identifiable (specific) user from a limited class or group of users must be known to the auditors, and the class or
group of users to which he/she belonged must be reasonably limited. Furthermore, the foreseen party concept
applies to past foreseen parties; it does not apply to a present or future foreseen parties. A key case that extends the
auditor's liability to foreseen third parties is summarized in Table 4-5.
Table 4-5 Rusch Factors Inc. Case
Rusch Factors Inc V. Levin (1968)
Facts:
Rusch Factor, a New York banker, asked the auditor to audit the financial statement of a Rhode Island corporation seeking a loan. Based on the
auditor's unqualified opinion on the financial statements, Rusch Factor lent $300,000 to the corporation which subsequently went into
receivership. Rusch Factor sued the auditor for negligence and intentional misrepresentation.
Outcome:
The court held that the auditor was liable for ordinary negligence in the case of a foreseen third party. The court ruled that the auditor should be
liable "in negligence for careless financial misrepresentation relied upon by actually foreseen and limited class of people."
Lesson:
The auditing profession is exposed to a broadened interpretation of the Utramares doctrine whereby foreseen third parties can successfully sue
the auditors for ordinary negligence.
2. A foreseeable party. A user whom the auditor either knew or should have known would rely on the audit report in
making business and investment decisions. A foreseeable party extends the auditor's liability to any unspecified
party, such as a creditor, stockholder, and investor, who relies on the auditor's report and suffers a loss as a
consequence. Furthermore, the foreseeable party concept applies to all past, present or future foreseeable parties. A
key case that extends the auditor's liability to foreseeable third parties is summarized in Table 4-6.
Table 4-6 Rosenblum Case
Rosenblum V. Adler (1983)
Facts:
Rosenblum acquired common stock of Giant Stores Corporation. The stock subsequently proved to be worthless after Giant's audited financial
statements were found to be fraudulent. Rosenblum sued Alder (a partner of Touche) for negligence and that the auditor's negligence was a
proximate cause to their loss.
Outcome:
The court found the auditor liable in gross negligence for any third party whom he either knew or should have known (i.e., a reasonably
foreseeable third party) would rely on his report in making investment decision.
Lesson:
The auditing profession is exposed to an even more broadened interpretation of the Utramares doctrine whereby foreseeable third parties can
successfully sue the auditors for gross negligence and fraud.
Throughout the 80s, the Rosenblum case typifies the application of the foreseeable party concept to the auditors
liability in the United States. However, in 1985, in a landmark case in New York, Credit Alliance Corp V Arthur
Andersen & Co., the New York Court of Appeals reversed a lower courts decision that prevented the defendant
auditor from using lack of privity of contract as a defense. In doing so, the appellate court seemed to move back to
the basic concept of privity established in the Ultramares doctrine. To date, four states Arkansas, Illinois, Kansas,
and Utah have adopted legislation that follows the Credit Alliance approach in making an auditor liable for
ordinary negligence only to those persons whom the auditor acknowledged in writing were known to be relying on
the audit report. A summary of the Credit Alliance case is provided in Table 4-7. Moreover, starting in the 90s,
California courts also seem to move away from the foreseeable party concept back to the Ultramares doctrine. A
key case to illustrate this legal movement in California is Bily V Arthur Young (1990) shown in Table 4-8.
Table 4-7 Credit Alliance Corp. Case
Credit Alliance Corp. V Arthur Andersen & Co. (1986)
Facts:
Credit Alliance Corp., a lending institution in New York, brought suit against Arthur Andersen & Co., who was the auditor of one of its
borrowers. Credit Alliance Corp. alleged that it relied on the audited financial statements of the borrower, who was in default, in granting the
loan. Thus, Arthur Andersen & Co was liable to Credit Alliance Corp., who was a foreseeable third party to the auditor.
Legal Issue:
The New York appellate court rejected the foreseeable party concept and moved back to the Ultramares doctrine by establishing three criteria for
determining whether a plaintiff can bring a claim against an auditor for ordinary negligence: (1) the plaintiff did in fact rely on the auditors
report, (2) the auditor knew that the plaintiff intended to rely on the audit report, and (3) the auditor, through some actions on his or her own part,
evidenced understanding of the plaintiffs intended reliance. Since this ruling, the AICPA has been promoting the passage of legislation
embodying the Credit Alliance approach in all jurisdictions.
Table 4-8 Bily Case

Bily V. Arthur Young (1990)
Facts:
Osborne Computer Corporation obtained a $2.3 million loan from Security Pacific National Bank (later merged with the Bank of America) in
1983. To provide for the loan, several warrant investors executed irrevocable letters of credit in favor of Security Pacific, which guaranteed
payment if Osborne did not repay the loan. Also, several stock investors purchased sizable blocks of Osborne stock. Both the warrant investors
and stock investors relied on Arthur Young's unqualified audit opinions of Osborne's financial statements. Osborne went into bankruptcy in 1983.
The warrant investors were called upon to repay the bank loan and the stock investors lost their investment. The investors sued Arthur Young for
negligence.
Legal issue:
The California Court of Appeals applied the foreseeability test for holding Arthur Young liable to foreseeable third parties. The Jury found
Arthur Young liable and awarded the plaintiffs over $3 million in damages. However, in 1992, the California Supreme Court reversed the Court
of Appeals decision against Arthur Young by moving back to the Ultramares doctrine. In its decision, the Supreme Court stated that an auditor
owes no general duty of care regarding the conduct of an audit to persons other than the client, and reasoned that the potential liability to
auditors under the foreseeable party concept would be distinctly out of proportion to fault.
A diagrammatic summary of the legal concepts in third parties law suits is shown in Figure 4-2.
79
80
Figure 4-2 Legal Concepts in Third Parties Law Suits
3rd parties
Ultramares Case
Established Ultramares Doctrine that
no contract between auditor and 3rd
parties, therefore, no liabilities
Reinstatement (2nd) of Torts
Foreseen 3rd parties
Foreseeable 3rd parties
Rusch Factors Case

Established auditor liabilities when
one identifiable (specific) user from
a limited class or group of users
is known to the auditor
Rosenblum Case
Established auditor liabilities when
any unidentifiable (non-specific)
user whom the auditor knew
or should have known
The auditors have four possible defenses in client law suits and three possible defenses in third party law suits. A
brief description of these defenses is provided in Table 4-9.
Table 4-9 Auditors Defenses
Lack of duty
Nonnegligent performance
Auditors Defense in Client Law Suits
An auditor can argue that the duty in question is not explicitly stated
in the audit engagement letter. In this case, the scope and
responsibilities detailed in the audit engagement letter are critical for
a successful defense.
An auditor can argue that the audit is performed in according to

GAAS. In particular, the audit gives no complete assurance that
material errors or irregularities will be detected. According to AU
240 Consideration of Fraud in a Financial Statement Audit , the
auditor is responsible for designing the audit to provide "reasonable
assurance of detecting errors and fraud that are material to the
financial statements". In addition, it states, "Because of the
characteristics of frauds, particularly those involving forgery and
collusion, a properly designed and executed audit may not detect a
material fraud." The auditor's working papers are critical in this
defense. Furthermore, the auditor hopes to convince the court that
s/he has only a secondary responsibility to detect and report errors
and frauds. The auditor's prime responsibility is to form an opinion
about the fair presentation of the client's financial statements.
Lack of privity of contract
Nonnegligent performance
Auditors Defense in 3rd Parties Law Suits
A lack of privity of contract defense is in effect invoking the

Ultramares doctrine as a defense. Application of the Ultramares
doctrine by the judicial jurisdiction varies across states. Therefore, a
successful defense will depend very much on a particular state's
judicial jurisdiction. Also, note that a lack of duty defense in suits by
clients is in essence a lack of privity of contract defense in suits by
third parties.
Although nonnegligent performance is a defense available to the
auditor in third party law suits, it is often difficult to convince a jury
of laypeople that the professional auditor is nonnegligent in an audit
simply by following the GAAS. Also, note that a contributory
negligent defense in suits by clients is generally not available to the
auditors in suits by third parties because the latter is not in a position
to contribute to the misstatement of the financial statements.
Contributory negligence (best defense)
Absence of causal connection
Auditors Defense in Client Law Suits
An auditor can argue that the client's management contributes to its

own loss by its own negligence, e.g., the management has withheld
critical accounting information from the auditor during the audit. In
such a case, there is no basis for recovery because the negligence of
one party nullifies the negligence of the other party. It should be
noted that in most states, contributory negligence is a defense for
the auditor only when the negligence directly contributes to the
auditor's failure to detect misstated financial statements, e.g., Cenco
Case.
Contributory negligence
None-proximate cause (best defense)
Auditors Defense in 3rd Parties Law Suits
A contributory negligent defense is generally not available to the

auditors in suits by third parties
An auditor can argue that there is a lack of a close causal connection

between the auditor's breach of contract and the resultant damages
suffered by the client, e.g., the loss of a client's major supplier is not
directly related to the fact the auditor has not issued his/her audit
report on time.
Even though an auditor might have been negligent in performing an

audit, the auditor will not be liable for the client's loss if the auditor's
negligence was not the proximate cause of the loss. Under Tort law,
a negligent party is not necessarily liable for all damages set in
motion by his/her negligent act. The law establishes a point along
the damage chain after which the negligent party is no longer
responsible for the consequences of his/her negligent act. This
limitation on liability is referred to as the proximate cause. A noneproximate cause defense is perhaps the best defense available to the
auditors in third party law suits. Also, note that a defense of an
absence of causal connection in client law suits is in essence a
defense of none-proximate cause in third party law suits.
Auditors Liability for Civil Action under Statutory Law

Federal or state legislative bodies establish statutory law. Congress enacts federal statutes. The two most important
federal statutes affecting auditors are the Securities Act of 1933 and the Securities Exchange Act of 1934 that
regulate the issuing and trading of securities within a state. A brief description of the auditors liability under these
two federal statutes is given in Table 4-10.
Table 4-10 Auditors Liability under the Securities Act of 1933 and Securities Exchange Act of 1934
Securities Act of 1933
Securities Exchange Act of 1934
The Securities Act of 1933 was enacted by Congress and administered

by SEC. It is designed to regulate new securities offered by a
company. Under this Act, a company intending to issue new securities
must file a registration statement and prospectus with the SEC.
Accompanying the registration statement is the audited financial
statements.
Auditors are usually sued under Section 11 of the 1933 Act, which
states, in part "In case any part of the registration statement, when such
part becomes effective, contained an untrue statement of a material fact
or omitted to state a material fact, the auditors are liable to any third
parties (purchasers) for losses resulting from the auditors' ordinary
negligence, gross negligence or fraud relating to material false or
misleading financial statements contained in the registration
statement. In addition, the auditor (the defendant) has the burden of
proof that there is non-negligent (i.e., there is due diligence) and there
is non-reliance by the plaintiff on (i.e., no loss to the plaintiff resulted
from) the false or misleading registration statement. However, it
should be noted that the plaintiff (purchaser) must bring a law suit
within 1 year of the discovery of the misstatement or omission and
within 3 years after the security was offered to the public (i.e., the
statutes of limitations applies here). Finally, the auditors liability
extends to the effective date of the registration statement.
The Securities Exchange Act of 1934 was enacted by Congress and

administered by SEC. It is designed to regulate the public trading of
securities on a national exchange or over the counter. The Act requires
companies to file quarterly reports (Form 10-Q which include
unaudited financial statements) and annual reports (Form 10-K which
include audited financial statements) with SEC.
Auditors are usually sued under Section 10 (b) and Rule 10b- 5 of the
1934 Act. Rule 10b-5 states, in part that it is unlawful for any person,
directly or indirectly, to
(1) employ any device, scheme, or artifact to defraud,
(2) make any untrue statement of material fact or omit to state a
material fact, and
(3) engage in any act, practice, or course of business that operates, or
would operate, as a fraud or deceit on any person in connection with
the purchase or sale of any security.
Under Rule 10b-5 of the 1934 Act, auditors are not liable to any seller
or buyer (investor) of the securities for ordinary negligence but for
losses resulting from the auditor's reckless behavior (a form of gross
negligence) if the element of scienter (i.e. an intent to manipulate,
deceive, or defraud the third parties) can be proven.
Under Rule 10b-5 of the 1934 Act, the investor (the plaintiff) has the
burden of proof that (1) there is reliance on the misstatement or
omission; (2) the transaction involved interstate commerce, the mail,
or a national securities exchange; (3) there is the element of scienter,
and (4) there is a loss resulted from the scienter element.
A key case on auditors liability for civil action under the Securities Act of 1933 is shown in Table 4-11.
Table 4-11 Escott case
81
82
Escott V. Bar Chris (1968)

Facts:
Bar Chris filed a registration statement in 1961 for the issuance of new debentures. In connection with the audit of Bar Chris, the auditor (Peat,
Marwick and Mitchell, now KPMG Peat Marwick) needed to perform an S-1 review of events subsequent to balance date for the SEC. The
purpose of the review was to ascertain whether, subsequent to the balance sheet date, any material changes had occurred that needed to be
disclosed to prevent the balance sheet from being misleading. Seventeen months after the registration Bar Chris filed for bankruptcy. The
purchasers of the debentures filed suit against the auditor under Section 11 of the 1933 Act.
Outcome:
The court concluded that the PMM's review program was in accordance to GAAS, but PMM was found liable because the senior who performed
the S-1 review did not establish due diligence (i.e. the standard of reasonable care of a prudent man in the management of his own property)
required under the 1933 Act.
Lesson:
The AICPA issues AU 560 Subsequent Events and Subsequently Discovered Facts. This auditing standard helps auditors to avoid being sued
under Section 11 of the 1933 Act.
A key case on auditors liability for civil action under the Securities Exchange Act of 1934 is shown in Tables 4-12.
Table 4-12 Hochfelder Case
Ernst & Ernst V. Hochfelder (1976)
Facts:
Ernst and Ernst (now Ernst and Young), the auditors of First Securities Co., a small brokerage firm, were sued by the investors (Hochfelder) in
nonexistent escrow accounts allegedly kept by the president, Lester Nay. To prevent detection, all investors were instructed to make their checks
payable to Nay and to mail them directly to him at First Securities. Nay imposed a "mail rule" that such mails were to be opened by him. The
funds were not recorded on First Securities' book. Instead, he misappropriated the funds. The fraud was uncovered in Nay's suicide note. The
investors sued Ernst & Ernst under Rule 10b-5 of the 1934 Act for negligence in their audit because they have not detected and reported the "mail
rule".
Outcome:
The supreme court ruled that the auditors were not liable under Rule 10b-5 for reckless behavior (a form of gross negligence) in the absence of
scienter (i.e. the auditors had no intent to deceive, manipulate or defraud the investors).
Lesson:
Auditors should not commit the element of scienter if they were to avoid being charged for violation of Rule 10b-5 under the 1934 Act. In
addition, although the auditors are not liable for ordinary negligence under the 1934 Act, they may be liable for recklessness (a form of gross
negligence) and fraud if the element of scienter exists under those circumstances.
The Hochfelder case (1976) clearly indicates that an auditor is liable for recklessness (a form of gross negligence)
only if scienter is present. However, in subsequent cases, there is a movement away from the presence of scienter.
Two key subsequent cases show that an auditor is liable for recklessness even though scienter is absent. Tables 4-13
and 4-14 show these two cases.
Table 4-13 Mclean Case
Mclean V. Alexander (1979)
Facts:
An investor purchased all the stock in a company based on the company's strong sales figure. However, the sales figure was based, in part, on 16
accounts receivable that were not true sales. The auditors did not conduct a thorough investigation of the accounts receivable. A thorough
investigation of the accounts receivable would require the auditor to perform accounts receivable confirmation and to follow-up non-responses.
Outcome:
The lower court held that the auditors were liable for reckless behavior (i.e. gross negligence under Rule 10b-5) in performing the audit even
though the element of scienter was absent. Although the lower court's decision on reckless behavior was subsequently overturned by the court of
appeals, this case indicates that the court (in this case the lower court) would hold auditor liable in the absence of scienter.
Lesson:
Auditors should not conduct their audit in a reckless manner because they might be charged for gross negligence under the 1934 Act even though
they have no intention to deceive, manipulate or defraud the buyers or sellers of securities.
Table 4-14 Howard Sirota case

Howard Sirota V. Solitron Devices, Inc. (1982)
Facts:
Solitron overstated its earnings by more than 30% by overstating its inventory account for the purpose of inflating its stock price issued on the
American Stock Exchange. The scheme has apparently helped Solitron's management in acquiring new companies. The investors sued the
Howard Sirota V. Solitron Devices, Inc. (1982)

auditor for reckless behavior in their audit of Solitron Devices, Inc.
Outcome:
The lower court did not find the auditors guilty of reckless behavior because the case of reckless behavior required proof that the auditors had
knowledge of the fraud by the management. The court of appeals established that the auditors knew about the fraud and that they failed to follow
it up. The auditors were therefore found guilty of reckless behavior under rule 10b-5.
Lesson:
An auditor is acting in a reckless manner if s/he knows about fraud and fails to follow it up. The auditor will be held liable for gross negligence
under the 1934 Act even though the element of scienter is absent.
An auditors defense under the Securities Act 1933 and Securities Exchange Act 1934 is shown in Table 4-15.
Table 4-15 Auditors Defense under the Securities Act 1933 and Securities Exchange Act 1934
Defense under the Securities Act 1933
Defense under the Securities Exchange Act 1934
The "lack of privity of contract" defense in common law suits by third

parties is not available to the auditors under the 1933 Act because the
privity of contract concept is not relevant under this Act. However, the
"nonnegligent performance" and the "none-proximate cause" defenses
in common law suits are available to the auditors.
When an auditor uses nonnegligent performance as a defense, he/she
must prove that he/she has made a reasonable investigation and
accordingly had reasonable ground to believe that there were no
material false or misleading financial statements contained in the
registration statement. The test of reasonable investigation under the
1933 Act is due diligence, that is, the standard of reasonable care of a
prudent man in the management of his own property. The auditor's
defense is referred to as the due diligence defense. However, in
contrast to common law cases, in which the plaintiff has to prove that
the auditor was negligent, the auditor has to prove that he/she
performed the audit work with due diligence.
When an auditor uses the none-proximate cause as a defense, the
auditor (the defendant) must establish that the third parties loss
resulted in whole or in part from causes other than the false or
misleading financial statements contained in the registration statement.
The same two defenses available to auditors in suits by third parties

under the 1933 Act are also available for suits under the 1934 Act.
These are the "nonnegligent performance" and the "none-proximate
cause" defenses.
When an auditor uses "nonnegligent performance" as a defense under
the 1934 Act, s/he must prove the absence of reckless behavior. The
test of reckless behavior under the 1934 act requires the auditor to
prove that he/she performed in good faith and had no knowledge that
the financial statements were false or misleading, that is, there is no
element of scienter. This means that the minimum basis for liability is
similar to gross negligence in common law.
When an auditor uses the "none-proximate cause" as a defense under
the 1934 Act, the third parties (the plaintiff) must prove reliance on the
false or misleading financial statements and damages resulting from
such reliance.
A summary of auditors liability in relation to negligence is provided in Table 4-16.

Table 4-16 Auditors Liability in Relation to Negligence
Source of Law
Tort Law Ultramares doctrine

Tort Law Foreseen 3rd parties
Tort Law Foreseeable 3rd parties
The Securities Act of 1933
The Securities Exchange Act of 1934
Ordinary Negligence
(or Due Diligence)
Auditor Liable For

Gross Negligence
(or Reckless Behavior)
Fraud
No
Yes
No
Yes
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
A summary of auditors defenses in common law and statutory law suits is provided in Table 4-17
Table 4-17 Auditors Defense in Common Law and Statutory Law Suits
Source of Law
Plaintiff
Contract Law
Client
Tort Law
Third Party:
1. Primary beneficiary
2. Other beneficiary:
a. Foreseen (past)
b. Foreseeable (past, present and future)
Auditors (defendants) Defense

1. Lack of duty
2. Nonnegligent performance
3. Contributory negligence
4. Absence of causal connection
1. Lack of Privity
3. None-proximate cause
Burden of Proof
Plaintiff
Plaintiff
83
84
Source of Law
Plaintiff
The Securities Act 1933
Any person acquiring new securities
The Securities Exchanges

Act 1934
Any person buying or selling securities
Auditors (defendants) Defense

Burden of Proof
Defendant (Auditor)
Plaintiff
Auditors Liability for Criminal Action under State and Federal Statutes
The Securities Act 1933, the Securities Exchange Act 1934, the Racketeer Influenced and Corrupt Organization Act
(RICO), as well as several other federal statutes such as the Federal Mail Fraud Statutes and the Federal False
Statements Status, are federal laws that make it a criminal offense for an auditor to defraud another person through
knowingly being involved with false financial statements (i.e., guilty of knowing complicity).
Auditors may be sued under Section 24 of the 1933 Act which makes it a criminal offense for any person
to:
1. Willfully make any untrue statement of material fact in a registration statement filed with the SEC,
2. Omit any material fact necessary to ensure that the statements made in the registration statements are not
misleading, or
3. Willfully violate any other provision of the Securities Act of 1933 or rule or regulation adopted there under.
Auditors may also be sued under Section 32(a) of the 1934 Act which makes it a criminal offense for any person
willfully and knowingly to make or cause to be made any false or misleading statement in any application, report, or
other document required to be filed with the SEC pursuant to the Securities Exchange Act of 1934 or any rule or
regulation adopted there under.
Criminal Action under the Securities Act 1933 and Securities Exchanges Act 1934
There have been relatively few criminal actions involving auditors in securities-related litigation; a majority of cases
have been for civil actions. A leading criminal case that involves auditors is U.S. v Simon 1969 (or Continental
Vending Machine Case). Table 4-18 provides a brief description of this case.
Table 4-18 U.S V Simmon (Continental Vending Machine Case)
U.S V Simmon (1969) (or Continental Vending Machine Case)
Facts:
The case involved loans made by Continental Vending to its affiliated company, Valley Commercial Corporation, which subsequently lent the
money to the president of Continental, Harold Roth. Roth pledged collateral, about 80 percent of which was Continental stock. Although the
accounts receivable from Valley was recorded by Continental, it was not collectible because Roth was unable to pay Valley, and the market value
of Roth's collateral was less than the amount owed.
Roth subsequently declared bankruptcy. The government sued the auditors. The action was brought under Section 32 of the Securities Exchange
Act 1934 alleging that a footnote in Continental's financial statements did not adequately disclose the fact that Roth diverted corporate funds
from Continental for private use through its affiliated Valley corporation.
Two audit partners and an audit manager were prosecuted for allegedly participating in the conspiracy to defraud Continental's stockholders. The
auditors argued that they had followed GAAP in the disclosure of the footnote and thus free of criminal liability.
Outcome:
The auditors were found guilty. The court held that "Generally accepted accounting principles instruct an accountant what to do in the usual case
when he has no reason to doubt that the affairs of the corporation are being honestly conducted. Once he has reason to believe that this basic
assumption is false, an entirely different situation confronts him." The auditors were fined $17,000 and their licenses to practice as CPAs were
revoked. However, they were pardoned by President Nixon in 1972.
Lesson:
The AICPA provides guidance on procedures that should be considered by an auditor when s/he is performing an audit involving related party
transactions in AU 550 Related Parties.
The auditors learned that demonstrating compliance with GAAP was not a successful defense in the case of a criminal charge of willfully and
knowingly making a false statement. Therefore, auditors must make sure that the financial statements adequately disclose known and material
management frauds.
Other key cases on an auditors liability for criminal action are presented in Tables 4-19 and 4-20 below.
Table 4-19 U.S V Weiner (Equity Funding Case)
U.S V Weiner (1975) (or Equity Funding Case)
Facts:
U.S V Weiner (1975) (or Equity Funding Case)

With the help of a computer, the top management of the Equity Funding Corporation created fictitious insurance policies and overstated its net
income and assets by over $100 million. Moreover, the management misstated the financial statements by recording fictitious commission
income, borrowing funds without recording the corresponding liability, and creating the fictitious insurance policies.
The auditors, an audit partner and two audit managers, were sued for failure to detect that $2.1 billion of the Equity Funding Corporation's $3.2
billion of assets were based on bogus insurance policies generated by the top management with the help of the computer.
Outcome:
The management fraud was so glaring that the court decided that the auditor must have been aware of the fraud and therefore guilty of knowing
complicity. Indeed, a special AICPA committee found that "the fraud was not based on a sophisticated application of data processing
technology." The committee concluded, "that customary audit procedures properly applied would have provided a reasonable degree of assurance
that the existence of fraud at Equity Funding would be detected."
Lesson:
The AICPA re-examines the auditor's assumption about top management honesty and issues AU 240 Consideration of Fraud in a Financial
Statement Audit. The standard states that "An audit of financial statements in accordance with generally accepted auditing standards should be
planned and performed with an attitude of professional skepticism. The auditor neither assumes that management is dishonest nor assumes
unquestioned honesty." In addition, the auditor learned that the best defense to a potential criminal charge is not to risk performing a sloppy
audit.
Table 4-20 U.S V Natelli (National Student Marketing Corporation Case)

U.S V Natelli (1975) (or National Student Marketing Corporation Case)
Facts:
Natelli, an auditor of Peat, Marwick, Mitchell & Co, was in charge of the 1968 audit of the National Student Marketing Corporation. The
company sold marketing programs (advertising contracts) to companies for promotional campaigns on college campuses.
The company uses a percentage-of-completion method to recognize revenues. This resulted in some $1.7 million uncollectible accounts
receivable on the books of the company, representing unconfirmed commitments from customers. Subsequently, approximately $1 million of the
uncollectible accounts receivable were written off. However, the auditor neither disclosed the material effect of the uncollectible accounts
receivables nor acknowledged the prior mistake made in recognizing uncollectible accounts receivable.
Outcome:
The circumstances and actions of the auditor were construed by the court to be a willful violation of the Securities Exchange Act of 1934 and
resulted in criminal liability.
Lesson:
Criminal liability can be imposed under Section 32 of the Securities Exchange Act 1934 when an auditor willfully and knowingly conceals
material prior errors.
The auditors learnt that they couldnt defense successfully by a plea of ignorance when they have shut their eyes to what was plainly to be seen.
Criminal Action under the Racketeer Influenced and Corrupt Organization Act 1970 (RICO)
The Racketeer Influenced and Corrupt Organization Act 1970 (RICO) was originally drafted as part of the 1970
Organized Crime Control Act to curtail the inroads of organized crime into legitimate business. The Act permits a
person victimized by a pattern of racketeering activity to sue for treble damages and attorneys fees. The RICO
states that a pattern of racketeering activity means at least two acts of racketeering activity within a two-year period.
Despite its focus on organized crime, the provisions of the RICO have been extended to losses suffered from
fraudulent securities offerings and failures of legitimate businesses.
Auditors have often been named as codefendants on the basis that their involvement with the issuance of
materially false financial statements for a minimum of two years out of a ten-year period constitutes a pattern of
racketeering activity. A key case, ESM Government Securities V Alexander Grant & Co (1986) that illustrates
criminal action against the auditors under the RICO is summarized in Table 4-21.
Throughout the 80s, the case law applying the RICO to the auditors was mixed. Some courts make it clear
that the RICO applies to an extensive participation by the auditors in the audit clients racketeering activities beyond
an annual audit, while other courts held that the issuance of a materially false audit report would constitute an act of
racketeering activity. Legislation has been considered by Congress to clarify the applicability of the RICO to the
auditors; but there was no action from Congress. Meanwhile, in 1993, The U.S. Supreme Court heard another RICO
case involving auditors, known as Reves V Ernst & Young (1993) that essentially clarified the applicability of the
RICO to the auditors. In this case, which involved investor losses related to a farmers cooperative that went
bankrupt, the Court ruled that requires some participation (of the auditor) in the operation or management of the
enterprise (audit client) itself. It further ruled that the auditors issuance of unqualified audit reports for two
consecutive years on the farmers cooperative did not meet the participation test. In short, the Court ruled that
external auditors who do not help run corrupt business cannot be sued under the provisions of the RICO. Many legal
observers hope this decision will mark an end to a majority of RICO actions against auditors.
85
86
Table 4-21 ESM Government Securities Case

ESM Government Securities V Alexander Grant & Co (1986) (or ESM case)
Facts:
The management of ESM devised a scheme of fictitious transactions to conceal operating losses from 1977 through to 1984. In 1978, the partner
from Alexander Grant & Co (now Grant Thornton & Co) who was in charge of the ESM audit was informed by the management that the
previous 1977 years audited financial statements contained a material misstatement that was not discovered by the auditor. Faced with potential
embarrassment and damage to his auditing career, the partner agreed to not disclose the fraud to give the management one year to work its way
out of the losses. The management failed to make up the losses, but the partner continued to cover up the fraudulent scheme until the company
collapsed in 1985.
Outcome:
The partner was convicted of criminal charges under the RICO for his role covering up the fraud and was sentenced to a 12-year prison term.
Lesson:
Several lessons can be learned from this case:
(1) The auditor can be found criminally guilty in the conduct of an audit even if the auditors background indicates integrity in their personal and
professional life. The criminal liability can extend to partners and staff.
(2) Independence in appearance and fact by all individual auditors on the engagement is essential, especially in a defense involving criminal
actions.
(3) Good documentation may be just as important in the auditors defense of criminal charges as in a civil suit.
(4) The potential consequences of the auditor knowingly committing a wrongful act are so severe that it is unlikely that the potential benefits
could ever justify the actions.
Private Securities Litigation Reform Act of 1995

In 1995, a federal law, the Private Securities Litigation Reform Act, was passed by Congress to curb frivolous
securities-related litigation and to reduce significantly potential damages in securities-related litigation against the
auditor. The key provisions of the Private Securities Litigation Reform Act of 1995 include:
Doctrine of proportionate liability instead of joint and several liability.
Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount of a
damage award from the defendants who have money or insurance. In reality, when a group of defendants (e.g.,
auditors, management, and an audit client) are found liable for damages, the auditors are the only parties with deep
pockets of money to pay damages. Thus, the auditors usually pay the entire amount even though they may be only
partially at fault. The Reform Act of 1995 seeks to replace joint and several liability with proportionate liability,
unless the violation is willful; that is, the auditors knowingly participated in a fraud, thereby remaining jointly and
severally liable for all the plaintiffs damages. Under proportionate liability, the auditors are only required to pay a
proportionate share of the courts damage award, depending upon the degree of fault determined by a judge and jury
(e.g., 20%, 30%, but not 100%). Specifically, civil lawsuits for damages under the Reform Act of 1995 now are
governed by the following proportionate liability terms:
1. The total responsibility for loss is divided among all parties responsible for the loss.
2. If other defendants are insolvent, a solvent defendants (e.g., auditors) liability is extended to 50% more than the
proportion found at the trial. For example, if an auditor is found 20% responsible for a loss and the audit client and
its managers are insolvent, the auditor will have to pay 30% (20% + of 20%) the loss, but not 100% as before.
3. An exception to compensate smaller investors is that all defendants remain jointly and severally liable to plaintiffs
who have net worth of less than $200,000 and lost 10% or more of the net worth in the case.
Cap on Actual Damages.
The Reform Act of 1995 also caps the actual damages under the securities acts based on an investor purchase
price of a security and the mean trading price during a 90-day period following the date on which information is
released that corrects the misstatement or omission in the financial statements. For example, assume that an investor
purchases a security at $40 per share. On the day of the release of the information that corrects the misstatement, the
closing price for the security falls to $20. During the following 90-day period the security returns to a closing price
of $30 per share with an average for the period of $25 per share. Actual damages would be capped at $15 ($40-$25)
per share.
Responsibility to Report Illegal Act.
The Private Securities Litigation Reform Act of 1995 imposed new reporting requirements on auditors who
detect or otherwise become aware of illegal acts by issuers of securities. If an auditor concludes that an illegal act
has a material effect on the financial statements, senior management has not taken appropriate action, and the illegal
act warrants a departure from a qualified audit report or a withdrawal from an engagement, the auditor should report
these conclusions directly to the board of directors. The board should then notify the SEC within one day. If the
board does not file a timely report with the SEC, the auditor should make a report to the SEC. The Reform Act of
1995 explicitly states that the auditor will not be held liable in a civil action for any finding, conclusions, or
statements made in such reports. Chapter 6 further discusses the reporting requirements on illegal acts.
Securities Litigation Uniform Standards Act of 1998
The proportionate liability doctrine in the Private Securities Litigation Reform Act of 1995 applies only to
lawsuits brought in federal courts under federal securities laws. Since the act applies only to lawsuits brought in
federal courts, clever lawyers took their cases to state courts that follow the joint and several liability doctrine.
This loophole was closed by Congress passing the Securities Litigation Uniform Standards Act of 1998. This
Uniform Standard Act of 1998 requires that class action lawsuits with 50 or more parties must be filed in the federal
courts.
Class Action Fairness Act of 2005
The Uniform Standard Act of 1998 requires that class action lawsuits with 50 or more parties must be filed in the
federal courts. Since smaller class actions lawsuits with less than 50 parties can still be pursued in state court, clever
lawyers took their cases to state court by filing multiple class actions lawsuits in state court with each lawsuit filed
on behalf of fewer than 50 parties. For example, in an attempt to circumvent the Uniform Standard Act of 1998,
attorneys brought a number of Enron-related lawsuits in Texas state court with each suit filed on behalf of less than
50 parties in Newby V Enron Corp. (2002). Consequently, Congress passed the Class Action Fairness Act of 2005 in
response to attorneys attempt to circumvent the Uniform Standard Act of 1998 by filing nationwide multiple class
actions lawsuits in various state courts. The Class Action Fairness Act of 2005 expands the federal jurisdiction to
include most multistate class actions lawsuits where there is more than $5 million in dispute. It appears that the
federal judges are more likely to dismiss dubious claims under the Act. Moreover, the Class Action Fairness Act of
2005 imposes increased judicial and regulatory scrutiny over the propriety of class action settlements because in
some past settlements the only parties that actually benefited were the attorneys.
Sarbanes-Oxley Act of 2002
In 2002, prompted by the Enron Corp. and Arthur Andersen case, Congress passed the Sarbanes-Oxley Act of 2002
to restore investor confidence in the securities markets and to deter future corporate frauds. The Act includes
sections that create the PCAOB, stricter independent rules, and increased internal controls reporting responsibilities.
The creation of the PCOAB is the most significant aspect of the Sarbanes-Oxley Act, which ends decades of selfregulation by the accounting profession.
Table 4-22 provides a brief summary of the Enron Corp. and Arthur Andersen case. In this case, Arthur
Andersen became the first major CPA firm ever convicted of a felony one count of obstruction of justice in the
Enron investigation. The indictment, which named only the firm and not any employees or partners, accused Arthur
Andersen of the wholesale destruction of documents relating to the Enron Corp. collapse. Ironically, in 2005, the
U.S. Supreme Court unanimously reversed Arthur Andersens conviction due to vague instructions provided to the
jury for determining whether Arthur Andersen obstructed justice. However, the Supreme Courts decision did little
to resuscitate Arthur Andersen because the 2002 conviction was a fatal blow to the CPA firm.
Table 4-22 Enron Corp. and Arthur Andersen Case
U.S. V. Enron Corp. and Arthur Andersen (2002)
Facts:
In 2001, after showing profit for the previous several years, Enron Corp. reported a third quarter loss of $618 million and a $1.2 billion reduction
in owners equity related to off-balance sheet partnerships. The news resulted in a sharp drop in Enrons stock price and a formal SEC
investigation. On November 8, 2001, Enron Corp. announced that it had overstated profits by $586 million, erasing almost all its profits from the
past five years, collapsing the stock price, and diminishing the confidence of its clients. Within a month of this announcement, Enron Corp. filed
for Chapter 11 bankruptcy.
The Enron collapse involved many players, including company executives, investment bankers, financial analysts, and accountants. Enrons
auditor Arthur Andersen, a Big Five CPA firm at the time, quickly became the source of government scrutiny. In 2002, the Justice Department
accused top Arthur Andersen officials of directing employees to alter and/or shred Enron Corp.- related documents after it knew about the SEC
investigation of Enron Corp. collapse. The accusation was centered on an e-mail message written by an Arthur Andersen attorney. In that e-mail
message the attorney advised an Arthur Andersen partner to revise a memo to omit certain information, including a comment that an Enron Corp.
press release that included an earnings announcement was misleading. Arthur Andersen argued that the firm was merely applying its document
87
88
U.S. V. Enron Corp. and Arthur Andersen (2002)

retention policy in destroying the documents.
The governments investigation of Enron Corp.s accounting practices revealed a number of accounting frauds, including misuse of specialpurpose entities (SPE) to sell off underperforming assets at a profit. Because of undisclosed Enron Corp. guarantees related to the transactions,
most of these sales were really schemes to overstate paper gains and understate liabilities. Meanwhile, the governments investigation of
Arthur Andersens document retention policy revealed a wholesale destruction of documents relating to its audit of Enron Corp.
Outcome:
In 2002 Andrew Fastow, Enrons former CFO and principal player in the companys accounting schemes, pleaded guilty to two counts of
conspiracy, and was sentenced to serve the maximum 10-year sentence.
In 2006 former Enron chairman Kenneth Lay and former president Jeffery Skilling were convicted on numerous federal fraud and conspiracy
charges. Shortly after the conviction, Lay died of a massive heart attack and his conviction was vacated. Skilling was sentenced to 24 years in
prison.
In 2002, Arthur Andersen was found guilty of one count of obstruction of justice in the Enron Corp. investigation. However, in 2005, the U.S.
Supreme Court unanimously overturned the felony conviction handed down against Arthur Andersen in 2002 due to vague instructions provided
to the jury for determining whether Arthur Andersen obstructed justice. The Supreme Courts decision to overturn Arthur Andersens felony
conviction was little consolation to the more than 20,000 partners and employees who lost their jobs when the CPA firm was forced out of
business by the felony conviction.
Lesson:
In the wake of Arthur Andersons felony conviction, the Sarbanes-Oxley Act and the PCAOB Auditing Standard No.3 (AS 3) Audit
Documentation require that all audit documentations that form the basis of the audit or review are required to be retained for seven years from
the date of completion of the engagement, unless a longer period of time is required by law. For example, in cases involving pending or
threatened lawsuit, investigation, or subpoena. Prior to the Act and AS 3, CPA firms typically would not include in their working papers
documentation that was inconsistent with the final conclusion of the audit team, nor would they include all internal correspondence leading up to
a final decision. The Act and AS 3 now require that any document created, sent, or received, including documents that are inconsistent with a
final conclusion, be included in the audit files. This includes any correspondence between engagement teams and national technical accounting or
auditing experts in a CPA firms national office. In addition, this type of correspondence is required to be retained to facilitate any subsequent
investigations, proceedings, and litigation.
Many lessons in creative accounting can be gleaned from this case, including:
(1) More than $8 billion in loans was misclassified as trades of energy futures. The borrowed funds were labeled cash flows from trading
activities; the related liabilities were labeled price risk management liabilities and buried in an enormous derivatives trading budget that ran in the
hundreds of billions of dollars. Readers of the financial statements had no way to know that Enron Corp. was borrowing such large amounts of
money simply for basic operating funds.
(2) Enron Corp. abused mark-to-market (MTM) accounting. MTM is typically used in the financial securities industry to include in income
unrealized gains and losses in security positions. In other words, income is recognized when increases in value occur in a companys securities
assets, and a loss is recognized when decreases in value occur. This does not follow the accounting principle of matching in which gains and
losses are associated with the actual sales of a companys security assets. In any case, SEC gave Enron Corp. permission to use MTM accounting
for its natural gas trading business, but Enron Corp. abused the practice by applying it to business activities other than those relating to natural
gas securities. It immediately recognized as current income the amounts of estimated future income from contracts signed. It also recognized as
income increases in value from investments that were based on complex assumptions. For example, Enron Corp. used MTM to mark up the
value of its investment in Mariner Energy (a private oil and gas exploration company) from $185 million to $367 million, thus creating $182
million in revenue. Enron Corp. later admitted that the markup had been greatly overstated.
(3) Enron Corp. used special-purpose entities (SPEs) to hide enormous MTM losses by creating hedge agreements with the SPEs that were
supposed to cover Enron Corp.s MTM losses. The problem was that the SPEs were funded with revenue from sales of Enrons stock, so they
were unable to cover MTM losses when Enron Corp.s stock price declined. Eventually, Enron Corp.s stock prices dropped, and the SPEs
became insolvent.
(4) Enron Corp. sold future income streams at their present value to generate cash and reported these proceeds as revenue. The problem was that
Enron Corp. guaranteed the future income streams, thus creating accounting sales without real economic substance. Some of the guarantees were
part of secret side agreements.
Future Legal Development

The threat of legal liability serves to prevent or limit inappropriate behavior, such as negligent, on the part of
auditors. However, auditors cannot be expected to absolutely ensure the accuracy of either financial statements or
the financial health of a business entity. Thus, the auditing profession has an interest in minimizing auditors
exposure to legal liability. It is increasingly exploring the possibility of utilizing alternative dispute resolution
procedures (i.e., arbitration and mediation) as a means of reducing litigation costs. Using arbitration and mediation
to settle disputes does not remove legal liability (except perhaps punitive damages), but it may significantly reduce
the administrative and legal support costs of litigation. For example, in 2005, Sun Microsystems Inc. disclosed in its
proxy statement that the companys engagement letter agreement with Ernst & Young LLP was subject to
alternative dispute resolution procedures and an exclusion of punitive damages. A strict reading of this engagement
letter agreement suggests that Sun Microsystems Inc. is barred from bringing suit against Ernst & Young and would
need to seek redress through mediation and arbitration; furthermore, it suggest that Ernst & Young would be liable
only for compensatory (not the often more costly punitive) damages. Although the effectiveness of this engagement
letter agreement in limiting auditors liability has not been legally tested, some negative publicity over these
agreements has resulted in Ernst & Youngs deciding no longer to include language related to exclusion of punitive
damages in its engagement letters. However, it continues to include the language related to alternative dispute
resolution.
Audited financial statements are now being provided using XBRL (eXtended Business Reporting
Language). In 2009, the SEC issued rules requiring public companies to provide financial information in a form that
can be easily downloaded directly into interactive spreadsheets to make it easier for investors to analyze and to assist
in automating regulatory filings. The SEC mandated that this form of financial information to be posted to a
companys website. Under the current SEC rules and professional auditing standards, auditors are not required to
perform procedures or provide assurance on XBRL-tagged data in the context of audited financial statements.
Accordingly, the auditors report on the financial statements does not cover the process by which XBRL-tagged data
that results from this process, or any representation of XBRL-tagged data. However, auditors may choose to engage
in XBRL-related assurance engagements (services) such as 1. Agree-upon procedures engagements on XBRLtagged data to assist management in its evaluation of the XBRL-tagged data and the audit committee in its oversight
role. 2. Assurance engagements on the controls related to the XBRL-tagging process and examinations of the
accuracy of the XBRL-tagged data itself. 3. Assurance engagements on financial information as presented in
particular pre-defined instance documents.
89
90
Multiple-Choice Question
4-1
The auditor's failure to exercise minimum care in an audit is the definition of

a. fraud.
b. gross negligence.
c. ordinary negligence.
d. due diligence.
4-2
A major outcome of the 1136 Tenants Corporation Case (1976) was that
a. the auditor had no responsibility in detecting frauds.
b. the auditor owed no contractual obligation to the client because it was not a written contract.
c. the auditor was aware of frauds and failed to follow-up the frauds.
d. the auditor misunderstood the terms of the contract.
4-3
The Ultramares doctrine establishes that the auditor is

a. liable to clients for gross negligence.
b. liable to third parties for ordinary negligence.
c. liable to primary beneficiaries for gross negligence.
d. liable to foreseeable third parties.
4-4
The concept of foreseeable third parties establishes that the auditor is liable to third parties whom
a. the auditor is able to establish a privity of contract.
b. the auditor has foreseen as a group of users who will rely on the audit report.
c. the auditor has committed ordinary negligence.
d. the auditor foresees a group of users who will likely rely on the audit report.
4-5
Which of the following legal cases established the fact that the auditor had conducted the audit with reckless behavior?
a. Howard Sirota V. Solitron Devices, Inc. (1982).
b. Rosenblum V. Adler (1963).
c. Continental Vending Machine case (1969)
d. Ultramares case (1931).
4-6
Under the Securities Act of 1933, the auditor's responsibility for the fairness of the client's financial statements covers up to
a. the date the client's financial statements.
b. the effective date of the client's registration statement.
c. the date of the audit report.
d. the date of the client's director report.
4-7
Under the Securities Exchange Act of 1934, most civil suits against the auditor relate to
a. Section 10 (b) of the Act.
b. Rule 10b-5 of the Act.
c. Section 10(b) and Rule 10b-5 of the Act.
d. Section 10 of the Act.
4-8
A leading case of criminal action against the auditor is

a. the Equity Funding case
b. the National Student Marketing case.
c. the Continental Vending Machine case.
d. the Bar Chris case.
4-9
Which of the following legal cases established a general awareness of the auditor's exposure to criminal prosecution?
a. Escott V. Bar Chris (1968).
b. Rosenblum V. Adler (1983).
c. Continental vending machine case (1969).
d. Rusch Factors V. Levin (1968).
4-10
The U.S. Supreme Court ruled in 1976 in Hochfelder V. Ernst & Ernst that before CPAs could be held liable for Rule 10b5 of the Securities Exchange Act of 1934, what would be required to be shown to the court was the auditors
a. Ordinary negligence.
c. knowledge and intent to deceive.
d. recklessness.
4-11
The similarity which exists in both the United States V. Natelli case, aka National Student Marketing case of 1975, and the
ESM Government Securities V. Alexander Grant & Co. case of 1986 is that in each case
a. a partner in a national CPA firm served prison time.
b. the partners were punished for the shoddy work of their subordinates.
c. a presidential pardon kept them from serving time in prison and allowed them to retain their CPA licenses.
d. the auditors were not convicted for failing to discover the problem in year 1, but for failing to disclose the problem when
it was discovered in year 2.
4-12
Which of the following auditors defenses, when used in a third-party lawsuit, usually means non-reliance on the financial
statements by the user?
a. Absence of causal connections.
b. Lack of duty.
c. Non-negligent performance.
d. Contributory negligence.
4-13
Which of the following statements about the Securities Act of 1933 is not true?
a. It concerns only the reporting requirements for companies issuing new securities.
b. The amount of the potential recovery is the original purchases price plus punitive damages.
c. It deals with the information in registration statements and prospectuses.
d. The only parties that can recover from auditors under the 1933 act are original purchasers of securities.
4-14
Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securitiesrelated litigation against the auditor?
a. Public Securities Damages and Settlements Act.
b. Racketeer Influenced and Corrupt Organization Act.
c. U.S. Securities Claims Reform Act.
d. Private Securities Litigation Reform Act.
4-15
Tort actions against CPAs are more common than breach of contract actions because
a. the burden of proof is on the auditor rather than on the person suing.
b. the amounts recoverable are normally larger.
c. the person suing need prove only negligence.
d. there are more torts than contracts
4-16
To be successful in a civil action under Section 11 of the Securities Act of 1933 concerning liability for a misleading registration
statement, the plaintiff must prove
a.
b.
c.
d.
Defendants Intent to Deceive

Yes
Yes
No
No
Plaintiffs Reliance on the Registration Statement

Yes
No
Yes
No
91
92
4-17
The Private Securities Litigation Reform Act 1995 resulted in a number of changes in statutory law that revised the SEC Acts of 1933
and 1934. Which of the following was not one of the major changes that resulted from the Reform Act of 1995?
a. The statute introduced proportionate liability for auditors who were not found to knowingly commit a violation of the
securities laws.
b. The statute imposed a responsibility to report illegal acts to the SEC.
c. The statute provided that auditors would not be held liable for civil actions for statements made in the reporting of illegal
acts to the SEC.
d. The statute created a cap on damages based on the personal net worth of the auditors.
4-18
One of the elements necessary to hold an auditor liable to a client is that the auditor
a. acted with scienter.
b. was a fiduciary of the client.
c. failed to exercise due care.
d. executed an engagement letter.
4-19
Under the provisions of the Securities Exchange Act of 1934, which of the following activities must be proven by a stock purchaser in
a suit against a CPA?
I. Intention by the CPA to manipulate, deceive, or defraud investors.
II. Gross negligence by the CPA.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
4-20
An auditor lost a civil lawsuit for damages under the Private Securities Litigation Reform Act of 1995. The court found total losses of
$5 million; the auditor was found 30% at fault, and the auditor was the only solvent defendant. The court would order the auditor to
pay
a. $5,000,000.
b. $2,250,000.
c. $1,500,000.
d. $0.
4-21
X Corp. approved a merger plan with Y Corp. One of the determining factors in approving the merger was the financial
statements of Y that were audited by A, a CPA. X has engaged A to audit Ys financial statements. While performing the audit, A
failed to discover certain fraud that later caused X to suffer substantial losses. For A to be liable under common-law negligence, X at a
minimum must prove that A
a. knew of fraud.
b. failed to exercise due care.
c. was grossly negligent.
d. acted with scienter.
4-22
If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties
who are unknown to the CPA (i.e., foreseeable 3rd parties) based on
a. privity of contract.
c. strict liability.
d. criminal deceit.
4-23
Under common law, which of the statements is generally correct regarding the liability of a CPA who negligently
expresses an opinion on audit of a clients financial statements? (Hint: Consider the key word negligently)
a. The CPA is liable only to those third parties who are in privity of contract with the CPA.
b. The CPA is liable only to the client.
c. The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
d. The CPA is liable to all possible foreseeable users of the CPAs opinion.
4-24
Under common law, which of the statements is generally correct regarding the liability of a CPA who fraudulently
expresses an opinion on audit of a clients financial statements? (Hint: Consider the key word fraudulently)
a. The CPA is liable only to third parties in privity of contract with the CPA.
b. The CPA is liable only to known users of the financial statements.
c. The CPA probably is liable to any person who suffered a loss as a result of the fraud.
d. The CPA probably is liable to the client even if the client was aware of the fraud and did not rely on the opinion.
4-25
The best description of whether a CPA has met the required standard of due professional care in conducting an audit of a
clients financial statements is
a. the clients expectations with regard to the accuracy of audited financial statements.
b. the accuracy of the financial statements and whether the statements conform to generally accepted accounting principles.
c. whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the
circumstances.
d. whether the audit was conducted to investigate and discover all acts of fraud.
4-26
When performing an audit, a CPA will most likely be considered negligent when the CPA fails to
a. detect all of a clients fraudulent activities.
b. sign a written audit engagement letter.
c. warn a client of known material internal control weaknesses.
d. warn a clients customers of embezzlement by the clients employees.
4-27
Which of the following facts must be proven for a plaintiff to prevail in a common-law ordinarily negligent action against an auditors
(defendants) misrepresentations?
a. The defendant made the misrepresentations with a reckless disregard for the truth.
b. The plaintiff justifiably relied on the misrepresentations.
c. The misrepresentations were in writing.
d. The misrepresentations concerned opinion.
4-28
A, a CPA, expressed an unqualified opinion on C Corp.s financial statements. Relying on these financial statements, B
Bank lent C $2 million. A was unaware that B would receive a copy of the financial statements or that C would use them to obtain a
loan. C defaulted on the loan. To succeed in a common-law civil action against A, B must prove, in addition to other elements that B
was
a. free from contributory negligence.
b. in privity of contract with A.
c. justified in relying on As financial statements.
d. in privity of contract with C.
4-29
C Corp. orally engaged A, a CPA, to audit its financial statements. Cs management informed A that it suspected the
accounts receivable were materially overstated. Though the financial statements A audited indeed included a materially overstated
accounts receivable, A expressed an unqualified opinion. C used the financial statements to obtain a loan to expand its operations. C
defaulted on the loan and incurred a substantial loss. If C sues A for negligence in failing to discover the overstatement, As best
defense will be that A did not
a. have privity of contract with C (i.e., lack of duty).
b. sign a written engagement letter.
c. cause Cs substantial loss (i.e., absence of causal connection).
d. violate GAAS in performing the audit (i.e., nonnegligent performance)
4-30
Y bought Z Corp. common stock in an offering registered under the Securities Act of 1933. A, a CPA, gave an unqualified
opinion on Zs financial statements that were included in the registration statement filed with the SEC. Y sued A under the provisions
of the 1933 act that deal with a false statement or an omission of fact required to be in the registration statement. Y must prove that
a. there was fraudulent activity by A.
b. there was a material misstatement in the financial statements.
c. Y relied on As opinion.
d. A was negligent.
93
94
4-31
Under Section 11 of the Security Act of 1933, a CPA usually will not be liable to the purchaser of securities
a. if the purchaser is contributory negligent.
b. if the CPA can prove due diligence.
c. unless the purchaser can prove privity with the CPA.
d. unless the purchaser can prove scienter on the part of the CPA.
4-32
C Corp. made a public offering subject to the Securities Act of 1933. In connection with the offering, A, a CPA, rendered
an unqualified opinion on Cs financial statements included in the SEC registration statement. P purchased 1000 of the offered shares.
P has brought a civil action against A under Section 11 of the Securities Act of 1933 for losses resulting from misstatements of facts in
the financial statements included in the registration statements. As weakest defense would be that
a. P knew of the misstatements when P purchased the stock.
b. Ps losses were not caused by the misstatements.
c. A was not in privity of contract with P
d. A conducted the audit in accordance with GAAS.
4-33
C Corp. engaged A, a CPA, to audit the financial statements to be included in a registration statement C was required to
file under the provision of the Securities Act of 1933. A, the CPA, failed to exercise due diligence and did not discover the omission
of a fact material to the statements. P, a purchaser of Cs securities, may recover from A under Section 11 of the Securities Act of
1933 only if the P
a. brings a civil action within 1 year of the discovery of the omission and within 3 years of the offering date.
b. proves that the registration statement was relied on to make the purchase.
c. proves that A was negligent.
d. establishes privity of contract with A.
4-34
Under Section 11 of the Securities Act of 1933, which of the following may a CPA use as a defense?
a.
b.
c.
d.
4-35
None-proximate clause
Yes
No
Yes
No
A, a CPA, audited the financial statements of C Corp. As a result of As negligence in conducting the audit, the financial
statements included material misstatements. A was unaware of this fact. The financial statements and As unqualified opinion were
included in a registration statement and prospectus for an original public offering of stock by C. P, a purchaser, purchased shares in
the offering. P received a copy of the prospectus prior to the purchase but did not read it. The shares declined in value as a result of the
misstatements in Cs financial statements becoming known. Under which of the following acts is P most likely to prevail in a lawsuit
against A? (Hint: Think about the scienter element)
a.
b.
c.
d.
4-36
Non-negligent Performance
Yes
Yes
No
No
Securities Exchange Act of 1934, Section 10(b), Rule 10b-5

Yes
Yes
No
No
Securities Act of 1933, Section 11

Yes
No
Yes
No
In a suit against an auditor under Section 10(b) and Rule 10b-5 of the Securities Act of 1934, an investor (buyer or seller of
securities) must prove all the following except that
a. the investor was an intended user of the financial statements that contained misstatement.
b. the investor relied on the financial statements that contained misstatement.
c. the transaction involved some form of interstate commerce.
d. the auditor committed scienter.
4-37
A, a CPA, issued an unqualified opinion on the financial statements of C Corp. These financial statements were included in
the Cs annual report, and Form 10K were filed with the SEC. As result, of As reckless disregard for GAAS, material misstatements
in the financial statements were not detected. Subsequently, P, an investor, purchased stock in C in the secondary market without ever
seeing Cs annual report or Form 10-K. Shortly thereafter, C became insolvent, and the price of the stock declined drastically. P sued
A for damages based on Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. As best defense is that
a. There has been no subsequent sale for which a loss can be computed.
b. P did not purchase the stock as part of an initial offering.
c. P did not rely on the financial statements or Form 10-K.
d. P was not in privity with A.
4-38
Under Section 10(b) of the Securities Exchange Act of 1934, a CPA may be liable if the CPA acted
a. without a written contract.
b. with independence.
c. without due diligence.
d. without good faith (i.e., act with scienter)
4-39
A, a CPA, was engaged to audit C Corp.s financial statements. During the audit, A discovered that Cs inventory
contained stolen goods. C was indicted and A was subpoenaed to testify at the criminal trial. C claimed accountant-client privilege to
prevent A from testifying. Which of the following statements is correct regarding Cs claim? (Hint: Criminal Law rather than
Common Law applies here)
a. C can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.
b. C can claim an accountant-client privilege only in federal courts.
c. The accountant-client privilege can be claimed only in civil suits.
d. The accountant-client privilege can be claimed only to limit testimony to audit subject matter.
4-40
The Sarbanes-Oxley Act and the PCAOB Auditing Standard 3 (AS 3) require that
I. all audit documentations that form the basis of the audit or review are required to be retained for seven years.
II. all audit documentations that are inconsistent with the final conclusion of the audit team are not to be retained for
seven years.
III. all correspondences between the engagement teams and the CPA firms national office relating to the audit are not to
be retained for seven years.
IV. all correspondences between the engagement teams and the CPA firms national office relating to the audit are to be
retained for seven years.
a. I and II.
b. II and IV.
c. I and III.
d. I and IV.
4-41
The auditing profession is increasingly exploring the possibility of utilizing alternative dispute resolution procedures (i.e.,
arbitration and mediation) as a means of reducing litigation costs. This future legal development does not
a. reduce the administrative and legal support costs of litigation.
b. minimize the auditors exposure to legal liability.
c. remove the auditors legal liability except perhaps punitive damages.
d. exclude the auditor from punitive damages.
4-42
As a result of Enron Corp. case (2002), attorneys can only file class action lawsuits involving more than $5 million in dispute in
federal courts under
a. Sarbanes-Oxley Act of 2002.
b. Private Securities Litigation Reform Act of 1995.
c. Securities Litigation Uniform Standards Act of 1998.
d. Class Action Fairness Act of 2005.
Key to Multiple-Choice Question

4-1 c. 4-2 c. 4-3 c. 4-4 d. 4-5 a. 4-6 b. 4-7 c. 4-8 c. 4-9 c. 4-10 c. 4-11 d.
4-12 a. 4-13 b. 4-14 d. 4-15 b. 4-16 d. 4-17 d. 4-18 c. 4-19c. 4-20 b. 4-21 b.
4-22 b. 4-23 c. 4-24 c. 4-25 c. 4-26 c. 4-27 b. 4-28 c. 4-29 d. 4-30 b. 4-31 b.
4-32 c. 4-33 a. 4-34 a. 4-35 c. 4-36 a. 4-37 c. 4-38 d. 4-39 a. 4-40 d. 4-41 c.
4-42 d.
95
96

Simulation Question 4-1 is an adaptation with permission from a case by Reisch, J. T. in the Issues in Accounting Education, a publication of the
American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
Introduction
BX Buys the Rights to Bolsan
BX Finds the Motherlode
In the spring of 1993, David Winston found himself thinking, What have I got to lose? He was contemplating spending the last
$10,000 of his companys cash to purchase the mineral rights to a piece of land in Indonesia. Winston had just received a call from an old friend,
John Feldman, who indicated that the land probably contained 2 to 3 million ounces of gold. A geologist by trade, Feldman had been exploring
the jungles of Southeast Asia for mineral deposits for the previous two decades and had discovered a large copper and gold deposit in New
Guinea. It was just one of many successful mines he had discovered in the region.
Winston had filed for personal bankruptcy earlier in the year and he was struggling to keep his small company afloat. The company,
Brodnax Minerals Co. (hereafter, BX), a Montana-based exploratory mining company, was founded by Winston in 1988. BX had struggled since
its inception, and at one point the financial lookout for BX looked so bleak that CEO Winston wrote to shareholders in the companys 1991
annual report, Yes, we are still in business!
Much of Winstons personnel financial problems stemmed from nearly $60,000 in credit-card debt he had accumulated and an earlier
court order for Winston to repay over $40,000 to a brokerage firm for a mishandled stock transaction. A broker had mistakenly credited
Winstons account with shares Winston had already sold. When the brokerage firm notified Winston of its mistake, he refused to refund the
money gained when he resold the shares. In a statement about the transaction, Winston later explained, You have to have your priorities. I was
constantly putting out fires running an exploratory mining company and didnt have the time to worry about things like bank statements.
Winston had been a stockbroker himself for over 20 years before he ventured in 1988 into the world of the exploratory mining
industry. However, he had a vision of striking it rich with a big find, and perhaps most importantly, he had the ability to sell his dream to
investors.
Between 1989 and 1992, BXs stock price averaged $0.27 per share and fell to as low as $0.02 per share after the company failed to
find minerals on its most promising claim. But there was a reversal of fortune in 1993 when Winston received the fateful call from John Feldman.
Winston and Feldman met initially in 1987 at a mining convention when Winston first became interested in the exploration business.
Winston was impressed by Feldmans successful finds and his enthusiasm for exploring. In fact, Feldmans enthusiasm earmarked him in the
mining industry as having big arms, meaning he had the tendency to show the upside potential of a project by stretching his arms farther and
farther apart as he described the project.
Feldman persuaded Winston to take a look at the Indonesian property when he called Winston on a spring day in 1993. Using most of
BXs remaining cash, Winston flew to Jakarta to meet Feldman. The pair spent nearly two weeks trekking through the rain forest before Winston
pair flew home, convinced there was a gold mine in the Indonesian jungle.
Prior to Winstons trip, Feldman had explored the area for an Australian company, Queensland Gold. Queensland had hired Feldman
and another geologist, Michael DeAngelo, to assess the region for potential minerals. Feldman and DeAngelo estimated that the areas, known as
Bolsan, contained 2 to 3 million ounces of gold, despite their finding only trace amounts of gold in 19 core drillings. They were convinced there
was gold, based on favorable geological formations in the area, but that the holes were not drilled in the right places. Their report, however,
conflicted with the findings of a dozen other companies who found the remote area, a thick jungle populated by clamorous monkeys and a few
native tribesmen, to be economically unfeasible for mining. Despite the positive report from Feldman and DeAngelo, cash-strapped Queensland,
wanting to pull out of the region, put the mineral rights to Bolsan up for sale at a price of $180,000.
When Winston went back to Montana, he used his brokerage skills to laud the upside potential for striking it rich in Indonesia.
Winston quickly raised over $250,000 through the sale of stock and in the summer of 1993 used the proceeds to purchase the mineral rights to
Bolsan.
Soon after BX obtained the mineral rights to the Bolsan property, Feldman officially joined the company as Vice President of
Operations. Feldman also brought his exploring friend, Michael DeAngelo, abroad as the chief geologist. DeAngelo, who possessed a near-genius
IQ, had previously developed a novel theory about the formation of gold deposits. The theory, rejected by conventional geologists, suggests that
gold deposits are formed at fault line junctions by mineralized fluids transported to the earths surface during volcanic activity. DeAngelo
convinced Feldman that his theory had merit, and the two geologists, using the theory as a basis for their exploratory work, began to assess the
Bolsan region more closely in hopes of finding gold.
The first significant discovery of gold at Bolsan occurred in early 1994 when DeAngelo noted an outcrop of volcanic rocks with a
yellowish tint along a riverbank in the area. With news of the find, Winston enticed Paul Krause, a former executive of mining giant Barrent Gold
Corp., to join BXs board of directors. The addition of the well-respected Krause helped transform the image of BX from a fledging venture
company to a real player in the market. Krauses expertise in the industry gave investors a high comfort level in BXs operations. With Kraus on
board, Winston began to use his contacts in the brokerage business to obtain additional funding for BXs exploration in the Bolsan region. By
March 1994, Winston had arranged a $6 million private placement of preferred stock for BX. The inflow of cash enabled BX to continue its
drilling through 1994, and by years end, BX estimated the property contained just over three million ounces of gold.
It was not until January 1995, however, that BX geologists found what they were looking for a dome-like geological structure,
hidden under the entangled canopy of the rain forest, which lay at the crossroads of fault lines. The area was mapped and the geological
abnormalities were confirmed by satellite imagery. When Feldman reported the findings to BXs Montana headquarters, he told Winston, I think
weve got a monster by the tail.
BX continued to drill in the region and the findings were very promising. In October 1995, BX estimated the Bolsan mine contained
30 million ounces of gold, making it one of the worlds largest gold mines. As drilling in the region increased, so did the estimates of gold. In
February 1996, Feldman announced that 40 million ounces of gold had been estimated by an independent firm, Kearn Labs Ltd. This wellrespected firm processed the core samples, but did not do its own drilling.
In July 1996, BX announced that the estimate had risen to nearly 47 million ounces, planning it slightly behind the worlds largest
gold mine, which contained 51 million ounces. Before the end of that year, the Bolsan mine was thought to have been the worlds largest gold
mine at an estimated 57 million ounces. Investors wanted in on the gigantic deposit and BX needed cash to expand its drilling in the area. On
March 4, 1997, the company raised nearly $30 million in an equity offering.
The estimates continued to climb as the drilling continued. On March 17, 1997, BX announced that its estimated gold reserves were
71 million ounces, and the following day, Feldman told investors he was extremely confident in predicting that the mine would eventually
yield over 200 million ounces of gold.
The stock market responded to the announcements, and BXs stock price soared. Prior to the acquisition of the mineral rights in
Indonesia, BX shares traded for pennies. They traded for less than $0.25 in 1991, rose to over $1 in late 1993, and were trading at $3 by the end
of 1994. As word of the gold find spread through the stock market during 1995, the stock reached $15 per share in August and rose to over $50 in
October upon the announcement that Bolsan contained 30 million ounces of gold. By February 1996, shares were trading for over $200. The
following month, BX announced a 10-for 1 stock split. Shares of BX reached their peak in September 1996 at $28.13, the equivalent of over $281
in pew-split terms. Shortly thereafter, and until March 1997, the stock price of BX had settled to around $20. The decrease in price was primarily
attributable to uncertain political risk in Indonesia.
Political Instability in Indonesia
The Golden Glitter is Gone
Its Really a Salt Mine
Nearly every major business deal in Indonesia can be linked to a few politicians who control the central government. The mining
industry is no exception. With billions of dollars at stake in the mine, these politicians wanted to lay claim to some or all of the gold in Bolsan.
As an exploration company, BX had no expertise in actually extracting minerals. The company had to obtain a major mining partner
or sell its claim to the highest bidder since it did not have the capability of operating the worlds largest gold mine The Indonesian government
wanted the mining operations to begin as soon as possible and began to put pressure on BX in the fall of 1996 to find a partner or sell out. In fact,
the government already had a proposal in mind for BX, which it had been working covertly on for months. The Indonesian government was
aggressively pursuing an alliance between Barrent Gold and BX. Barrent, one of the worlds largest mining entities, had been operating mines in
Indonesia for some 20 years; ties between Barrent and the Indonesia government were strong.
In November 1996, the Indonesian government simply declared that Barrent would have a 75 percent interest in Bolsan while BX
would have the remaining 25 percent. The government also indicated that it would appreciate a 10 percent interest in the site, although it did
not indicate from which party that share would come. In addition, the government threatened to revoke mining permits for the Bolsan property
until the ownership dispute was resolved. However, the subtle threats made by the Indonesian government were never enforced because several
key political advisers argued that the arrangement would act as a catalyst to erode foreign investment in Indonesia. Thus, the deal between
Barrent and BX never proceeded.
Barrent was not the only mining company interested in Bolsan. In January 1997, Vancoucer-based Placid Mines Inc. offered to
acquire BX in a stock swap valued at $4.5 billion. While the offer was good, Placid did not have the necessary political ties to the Indonesian
government to consummate the merger; however, a Houston based company, Freemont Copper & Gold Inc., did.
Freemont has operated the largest copper and gold mine in Indonesia since 1972 and employed nearly 17,000 Indonesians. On
March21, 1997, a deal was struck between BX and Freemont that was immediately approved by the Indonesian government. Under terms of the
agreement, Freemont received a 15 percent stake in Bolsan, became sole operator of the mine, and committed to providing $1.6 billion in
financing for the operation, all subject to due diligence testing of the gold reserves. BX maintained a 45 percent stake in Bolsan. The Indonesian
government secured a 10 percent interest, with the remaining 30 percent interest split between Indonesian companies controlled by influential
government officials.
The agreement with Freemont reduced BXs stake in Bolsan to only 45 percent, with BX receiving no tangible compensation for
giving up 55 percent of the mine. However, Winston defended the deal, saying, Brondnax ends up getting 45 percent of a potential 200 million
ounces of gold without spending another dime, and the property will be managed by a first-class operator. Many Indonesian businessmen
indicated the lack of compensation for its reduced claim was the only means by which BX could clear the way to begin mining.
Shortly after agreeing in principle to operate the Bolsan mine, Freemont geologists were sent to Indonesia to begin their due diligence
testing. This included taking independent samples from the site as well as reviewing BXs existing sampling data. The seven test holes drilled by
Freemont indicated an insignificant amount of gold, although the geologists were aware that discrepancies often exist when a limited number of
core samples, only a few inches wide, are drilled. Concerned over their findings, Freemont officials arranged a meeting with DeAngelo and the
other BXs geologists to reconcile the differences in the sample results.
On April 18, 1997, DeAngelo boarded a helicopter at Bolsan that was to take him to Jakarta to meet with Freemont officials. However
en route to the meeting, DeAngelo was killed when he took a mysterious plunge of some 800 feet into the jungle below. Although a suicide note
was found indicating that DeAngelo could no longer bear the anguish of a debilitating liver disease and malaria, his family and friends suspect he
was pushed from the helicopter.
The death of DeAngelo started rumors about the Bolsan site. When many speculated that the amount of gold might have been
overstated, the market began to react. The share price immediately slid some $5, to just below $15. But the slide was halted by remarks made by
Feldman, who angrily dismissed notions that the size of the deposit was misstated and said he was 110 percent confident the gold was there.
Freemonts geologists tried to obtain sample data recorded by BX to continue their due diligence testing, but the BX geologists at
Bolsan could not provide much information about their samples. Freemont learned that a fire had broken out a t the Bolsan mining compound on
January 11, 1997, which destroyed several buildings, as well as thousands of pages of BXs sample logs and other key data. These items were
critical for comparing the assay (analysis of ore) results to scientific descriptions of the cores and the locations from which the samples were
taken. In addition to the fire, Freemont also learned about the unusual manner in which the cleanup took place. Rather than looking for the
remains of records or other salvageable items, DeAngelo ordered a bulldozer to plow the site immediately after the fire was put out.
The dam broke on April 25, 1997, when Freemont announced that its preliminary findings indicated there were only traces of gold in
its samples, and that an independent mining laboratory, Strickland, would issue a final report a few weeks later. Freemonts statement sent BX
shares on a steep downward ride. The value of the stock plunged nearly 84 percent, from about $13 to $2 per share, erasing an equity value of
$2.4 billion in a single day.
The results of Strictlands testing confirmed the doubts about the lack of gold at the Bolsan site. On June 5, 1997, Strickland said it
found only trace amounts of gold at Bolsan and that there was virtually no possibility of an economic gold deposit at the site. In its report,
Strickland noted, the magnitude of the tampering with core samples taken at Bolsan, and the resulting falsification of assay values, is of a scale
that, to our knowledge, is without precedent in the history of mining.
97
98
In laymans terms, the core samples taken from the property had been salted or adulterated; that is, the drilled cores were laced with
particles of gold from other sources. Both Winston and Feldman vehemently denied any involvement in the elaborate scheme to taint the core
samples and placed the blame on DeAngelo. The mystery of how the Bolsan samples were salted and who was responsible is still a puzzle. But
several pieces of the puzzle have come to light.
The standard industry practice to prevent tampering with samples is to have geologists log the samples, place them in numbered
plastic bags, seal the bags, and dispatch the samples immediately to an independent laboratory for assaying. BX, however, did not follow this
practice. The owner of a trucking company that transported BXs samples to Kearn, the independent lab, indicated that samples were warehoused
by BX for a few days to month before being sent to the lab. Before being transported, witnesses said, the samples were opened and mixed with
powders by BX geologists under the supervision of DeAngelo. In addition, no samples were sent to the lab unless they were personally checked
by DeAngelo. This questionable handling of the samples suggests evidence of the salting operation used to inflate the gold claims. Moreover,
Strickland found the gold particles in BX samples to be rounded, a common characteristic of gold found in riverbeds, rather than flaky, a physical
trait of gold embedded deep within the earth.
The day the Strickland report was released, the remaining values of the BX shares plunged another 97 percent, to close at $0.08 per
share. Some 58 million shares were traded that day as skittish investors stampeded for the closest exit. The following day, BX shares were
delisted by NASDAQ because the company no longer met certain listing requirements.
Shedding Light on the Saga
Shareholders File Lawsuits
In the summer of 1996 (when the value of BX shares was skyrocketing), the officers of the company quietly began exercising options
they owned. The exercise of the stock options increased the companys equity by over $18 million, and gains realized by Winston and Feldman
from immediately reselling their new shares were substantial approximately $125 million between the two. DeAngelo also took in nearly $5
million form the exercise of options. Although disclosures of the transactions were made as required by the SEC, the information did not
adversely impact the markets value of BX.
In the eight years since its inception, BX had never earned a dime from operations, although it did earn interest income on its cash
holdings. As of December 31, 1996, BX had approximately $44 million in total assets, comprising mostly cash and fixed assets. You should
access Data File 4-1 in iLearn for Table 1, which shows selected financial information of BX for 1995 and 1996. The gold claims were not
included on the balance sheet because the deposits were not yet considered probable; that is, even though preliminary drillings indicated the
existence of gold, the sampling data were not specific enough to adequately estimate the quantity and grade of the ore. Under GAAP, only proven
and probable reserves that meet certain measurement criteria are recorded as assets (SFAS No.89). The company also had approximately $2
million in payables and $42 million in equity on its balance sheet. As of December 31, 1996, the markets value of the company was nearly $4.5
billion; thus, the stock market clearly valued the large gold deposit, even though it was never included on the balance sheet.
The auditors report, dated January 24, 1997 and included in the 1996 BX annual report issued on February 12, 1997, contained a
standard unqualified opinion for the two-year comparative financial statements. You should access Data File 4-1 in iLearn for Table 2, which
shows the independent auditors (Healy & Wallace LLP) unqualified report. No mention of the gold was explicitly included in the footnote
disclosures, although the accounting treatment for the mining property was described in the following note on the companys operations:
The Company is engaged in the acquisition, exploration and development of mining properties. The mining properties are recorded at
cost. Acquisition, exploration, and related overhead expenditures are deferred and will be amortized over the estimated life of the property. The
estimated life of the property depends on whether the property contains economically recoverable reserves that can be brought into production.
The total amount recorded for mineral properties and deferred exploration expenditures represents costs incurred to date and does not reflect
present or future values. If properties are determined to be commercially unfeasible, related costs will be expensed in the year that determination
is made.
In addition to audited financial statements, BX included a managements discussion and analysis (MD&A) section in its 1996 annual
report. You should access Data File 4-1 in iLearn for Table 3, which shows excerpts from the MD & A section.
BX filed for bankruptcy on June 9, 1997, shortly after the Strickland report was issued. Although the company had net assets of over
$70 million (including the $30 million raised in March by the equity issuance) at the time of the bankruptcy filing, it sought protection from an
onslaught of legal suits that were launched as a result of purported fraud. In addition to class-action lawsuits against BX and its officers and
directors, shareholders of BX also filed suits against Kearn Labs, the independent assaying firm, various investment advisors, and BXs external
auditor, Healy & Wallace LLP.
Healy & Wallace LLP (hereafter, H&W) was included as a defendant in the lawsuits because shareholders believed the firm breached
its duty to exercise due professional care and failed to uncover the fraud. Shareholders allege that H&W should have noticed that information
contained in the MD&A section of the 1996 annual report was misleading, given the fact that H&W had copies of private quarterly reports issued
by Kearn Labs to BX. Those reports explicitly stated that the core samples the lab tested were provided to it by BX and that the labs estimates
were not conclusive enough to consider the deposit to be a probable mineral reserve. In addition, shareholders contend that if H&W had a
sufficient understanding of BXs internal controls, the fraud would have been detected much earlier.
In response to the suits alleging negligence, H&W announced it would vigorously defend itself and claimed that it followed generally
accepted auditing standards (GAAS) while conducting its audit. In addition, the accounting firm maintained that the financial statements
contained no material misstatements and were fairly presented in conformity with generally accepted accounting principles (GAAP).
H&W is a large, well-respected regional firm with several audit clients in the mining industry, including the sixteenth largest
American mining company. That particular audit client also has mines located in foreign countries; thus dealing with the international operations
of a company is not new to the firm. Like many public accounting firms, H&W has, on occasion, been named as a defendant in litigation against
clients and third parties. The firm has never had a judgment against it for negligence. Although during the last decade they have settled out of
court two times.
The firm was familiar with BXs operations since H&W had audited the company each year since 1993, and a standard unqualified
opinion had been expressed in each of those years. The engagement partner indicated that the control risk had always been assessed at the
maximum because it was more economical to expand the scope of substantive tests given the nature of the accounts contained on BX financial
statements than to rely on the companys internal controls. There also had never been any unresolved disputes between the auditors and
management, and by all accounts the substantive audit procedures performed by H&W on the 1996 BX engagement were carried out with a high
level of quality.
You should access Data File 4-1 in iLearn for Table 4, which shows a timeline of significant developments involving BX,
including events that transpired in 1996 and 1997.
Required
Assume you are part of the legal teams involved in the class-action lawsuit brought by BX shareholders against H&W, the external auditor. Using
the format below, answer the following questions from both the shareholders (the plaintiffs) and the auditors (the defendants) point of view.
Some viewpoints from both sides are provided to help you complete the rest.
1. Is H&W liable to BXs shareholders for issuing an inappropriate audit report?
The Plaintiff (Shareholders)
1. Some information included in the MD&A section was presented not
in conformity with GAAS because the gold was probable and should
be noted as an explanatory paragraph to the audit report.
2.
3.
4.
The Defendant (Auditors)

1. Information in BXs annual report was presented in conformity with
GAAP because the gold was properly excluded from the balance sheet
since it was not probable.
2.
3.
4.
2. Is H&W liable to BXs shareholders for improperly accepting the BX client?

1. If the defendant had performed thorough background checks on
management, it would have discovered that management lacked
integrity, for example, Winstons mishandling of a stock transaction.
2.
3.
4.

1. Just because Winston filed for personal bankruptcy does not mean
he lacked integrity.
2.
3.
4.
3. Is H&W liable to BXs shareholders for not detecting the BXs fraud?
1. The defendant overlooked obvious red flags such as the mysterious
fire in January 1997 that destroyed sample records.
2.
3.
4.

1. The red flag concerning the fire that destroyed the 1997 sample
records did not have a material impact on the financial statements
because the gold was excluded from the financials.
2.
3.
4.

This simulation question is based upon a true set of facts; however, the names and places have been changed. The simulation Question is
developed by F. Choo in Financial and Integrated Audits, a publication of CSU AcademicPub, California.
In 2008, San Francisco Chronicle reported that a San Mateo Court was in the process of ruling on whether the public accounting firm
of Rod Ferria & Associate, CPAs, LLP (hereafter, RFA), should be required to pay all or part of $20 million in damages relating to Jazer Co. for
failing to detect a scheme to defraud the company. Jazer Co., an SEC registrant, charged that RFA was negligent in failing to discover fraud
committed by the companys controller and wanted RFA to foot the bill for all $20 million in claims by and against the company. The company
claimed that if it had known about the fraud, it could have stopped it and recovered financially. Bank of American, the bank involved in the case
claimed that it granted a loan of $5 million based on misstated financial statements. The stockholders claimed that they purchased $5 million
Jazer Co.s stock on the American Stock Exchange at an inflated price due to the misstated financial statements. They acknowledged that while
stock had been outstanding and traded for many years prior to the fraud, they made their investment decisions relying upon the misstated
financial statements.
RFAs general counsel said, We anxiously await a decision that will show that CPAs are not guarantors for everything that goes on in
the company. Jazer Co.s lawyer said that she anxiously awaited a decision because it will clearly show that CPAs are liable for finding fraud.
The $20 million lawsuit was as follows:
Jazer Co.
Bank of America .
Stockholders
Required
Claim Against Auditor

$10 million
$ 5 million
$ 5 million
Claim Against Auditor and Jazer Co.

None
$ 5 million
$ 5 million
99
100
1. Assume that the case is brought under common law; that the San Mateo court follows the foreseeable concept but may move back to the
Ultramares concept in a third-party lawsuit, and that RFA can be charged under different types of negligence in performing the audit, answer
the following questions:
a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments.
c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
2. Assume that the case is brought under the Securities Exchange Act of 1934, and that FRA can be charged under different types of negligence
in performing the audit, answer the following questions:
3. Assume that the case is brought under the Securities Act of 1933; that the stock involved are new stock issued to the public for the first time,
and that the financial statements involved had been included in a registration statement for the securities, answer the following questions:
4. Assume that the case is brought under the Private Securities Litigation Reform Act of 1995, and that according to the Joint and Several
Liability doctrine, Jazer Co. is liable for 50% and RFA is liable for 50% of a $10 million damage awarded to the Bank of America and the
stockholders, answer the following questions:
a. If the co-defendant, Jazer Co., were insolvent, how much the remaining co-defendant, RFA, has to pay for the $10 million damage awarded to
the Bank of America and the Stockholders?
b. If the stockholders initially purchased Jazer Co.s $5 million stock at $100 per share and that the average closing price of the stock was $20 per
share during the 90-day period following the date of a press release about the misstated financial statements, how much damage per share could
the stockholders claim against the auditor, RFA?

Simulation Question 4-3 is an adaptation with permission from a case by McKnight, C. A., T. S. Manly, and P. S. Carr in the Issues in
Accounting Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true
set of facts; however, the names and places have been changed.
Li and Associates, CPAs, LLP
Two Clients of Li and Associates, CPAs, LLP
Jeanne Thomsons Employment and Education History
In 1979, Jet Li graduated from college with an accounting degree. After seven years at an international accounting firm, Jet decided to
start his own CPA firm, Li and Associates, CPAs, LLP (hereafter, L & A). This firm, located in San Francisco, caters to local clients; specifically,
Jet and his staff of four professionals specialize in non-public companies. The majority of the services provided by L & A are tax planning and
preparation; however, the firm also performs bookkeeping services, audits (mainly for client debt compliance purposes), and other attestation
services. L & A has been a profitable and successful business for Jet. Tax returns are rarely questioned by the IRS, and banks and other lenders
trust the attestation services provided by L & A. Clients have come to expect quality work from L & A, and they receive this quality.
Ali Automotive
Ali Automotive is the most profitable car dealership in San Francisco. The company, which sells approximately 100 new cars each
month, has been a business leader in the city for 30 years. Ali Automotive sells about 20 percent more used cars than new ones each month. In
addition to the margins made on car sales, Ali Automotive earns additional revenues through its finance and service departments. These revenues
for service and parts average $200,000 each month. The dealership has a strong financial history and expects moderate growth in the future.
Mohammad Ali leads this family-run automotive dealership. Outgoing and personable, he brings strong sales and customer service to
this business, which he took over when his father retired ten years ago. Ali family members are responsible for all aspects of the business except
the accounting department. Ali knew accounting was difficult and wanted a CPA firm to perform bookkeeping services and tax preparation. L &
A has been Ali Automotives accountant for ten years. Ali has been very pleased with the CPA firms work. He was especially impressed with
Karen Green, an L & A employee in charge of the bookkeeping services provided to Ali over the past two years. He trusted her completely and,
although he did not understand accounting, felt she did an excellent job.
Kim Jewelers
Kim Jewelers is another important client of L & A. Founded and operated by renowned artist and silversmith Jung Kim, Kim
Jewelers sells Jung Kims unique and highly demanded creations. As Kims reputation grew, he knew he needed a good partner to run the
business side of the company. Therefore, he enlisted an M.B.A. to manage the production and finance departments, so he could concentrate on
Kim Jewelers creative development. Based on his education and experience with manufacturing companies, the new partner quickly identified
the need for internal controls at Kim Jewelers. Since the raw materials and finished goods inventory consisted of small but valuable pieces, he
implemented a number of physical controls such as locks on the cases and security cameras. He also added other extensive controls, including
policy and procedures manuals and training for the employees, formal accounting and finance documents, and an extensive computer system with
limited access. Although a total separation of duties is not present at Kim Jewelers due to its small staff, both Jung Kim and his partner actively
monitor the companys daily activities. Each year, L & A reviews Kim Jewelers annual and quarterly results and prepares its taxes. The L & A
employees assigned to Kim Jewelers consider it an easy engagement, because Kim Jewelers presents impeccable, nearly error-free records.
After working as a retail sales associate for ten years, Jeanne Thomson returned to college to complete her accounting degree. She put
in many hours at her sales job, but had not received the compensation or respect she believed she deserved. She rarely missed work, was
punctual, and often exceeded her sales quota; however, she was never promoted or given a substantial raise. Therefore, Anna decided a college
degree was the key to her financial success.
Jeanne worked hard in college while continuing her sales job, looking after her two children, and supporting her husband who was
injured at his job. Jeanne was determined to make life better for herself and her family. During college, she was willing to get the job done in
her courses. Faculty members knew that Jeanne was bright, but her performance was often marginal. She often skipped class, but when she was
there, she was an active participant in discussions and seemed to grasp concepts well. She often missed daily assignments, but she would
compensate by earning higher scores on exams. Group assignments were particularly difficult for Jeanne, because they forced her to arrange
meeting times outside of class. Luckily for Jeanne, her classmates always covered her responsibilities when she could not do the work. Most of
them understood she could not work and complete all her homework assignments while watching her kids. They also enjoyed the baked goods
she brought to meetings. Every once in a while, some fellow students would give her a poor peer evaluation because she did not complete her
portion of the assignment; however, the good grades on the assignments outweighed the evaluations. She felt that most college students could not
comprehend her position because they did not have the same real-life responsibilities.
Jeanne completed her degree with 150 hours and a 3.00 GPA. She was thrilled; her family was very proud. Jeannes father-in-law, a
prominent attorney, was especially overjoyed. Despite his help, Jeannie and his son had struggled with their finances. He was so proud they had
started taking responsibility for themselves. After graduation, Jeanne began her job search immediately. She had many bills to pay, including
payments on a new convertible, a present she gave herself after graduation. She was glad to quit her sales position and hoped she would receive
the respect she felt she rightfully deserved as an accountant.
Jeanne Thomson Joins Li and Associates, CPAs, LLP
Jeanne Thomsons Performance at Li and Associates, CPAs, LLP
Busy season was about to begin, and one of L & As best employees, Karen Green, gave her two-week notice. Karen was a smart,
successful CPA who enjoyed the challenge and the camaraderie of working in an office. Although she did not need to work due to a large
inheritance, Kate often worked 50-plus hours a week during her five years with the firm. Jet Li was sad to see such a valuable employee leave the
firm.
Jeannes resume could not have come to Jet Li at a better time. Although Annas grades were not outstanding, Jet was impressed that
Jeannie did have a 3.00 GPA while working full-time and maintaining a family. Jeannie appeared able to multi-task, a skill demanded of Jet Lis
staff. Jet Li was also pleased that Jeanne came from a distinguished family in San Francisco; he didnt feel the need to check her references,
because the Thomson family was well known and respected. Therefore, he hired Jeanne immediately.
When Jeanne started working, she was immediately assigned to Ali Automotive to take Karen Greens place. This client was small
and required only one staff accountant. Jet Li not only introduced Jeanne to Mohammad Ali and the other Ali Automotive employees, but also
spent the first day with Jeanne on the job. Previously, he had spent three days training Karen Green at Ali Automotive, but since it was busy
season, he had to focus his attention on tax returns. He was thankful that Jeanne was a fast learner. Jeanne could not believe all of the information
needed just to perform bookkeeping services. Although she felt she learned a lot in her accounting courses, they were nothing like actual on-thejob experience. While Mohammad Ali did not expect a new graduate to take over Karen Greens job, he trusted Jet Lis judgment. After all,
Jeanne had worked hard for years before obtaining her degree, appeared eager to learn, and was eager to pass the CPA examination.
Jeanne worked for three years for L & A with Ali Automotive as one of her main responsibilities. She performed bookkeeping
services for Ali Automotive, visiting the automotive dealership once a week. She was fortunate that a lot of the work could be done from L & As
office. After the initial learning curve, Jeanne excelled in the eyes of Mohammad Ali. She always got her job done on time and in spotless order.
Her weekly job responsibilities included recording journal entries, preparing checks for bills to be paid by Ali, and making trips to the bank and
post office. Monthly, Anna prepared bank reconciliations and compiled financial statements for review by Ali. After approval, Jeanne forwarded
the financial statements to the bank, which were a requirement to keep Ali Automotives line of credit open. Within a few months, Mohammad
Ali completely trusted Jeanne, just as he had trusted Karen Green. He didnt need to review the financial statements, journal entries, or the
supporting documents for payments. He did not understand accounting, and he believed in Jeanne. In fact, he was about to approach Jeanne about
working for Ali Automotive full-time. She really seemed to be a part of the Ali family and dedicated to the job. When Ali employees put in extra
hours, Jeanne followed suit. Even during her vacations, Jeanne took time to help at the dealership. Jet Li was pleased with the high praise from
Mohammad Ali. He was relieved that he did not have to frequently review her work. Since the client was happy, he worked on other projects and
stayed out of Jeannes way.
Jeanne was also assigned to Kim Jewelers. This client required the work of two staff accountants and a senior. At first, Jeanne was
glad to have colleagues available to answer questions, share the work, and help her get started. She learned a lot from the senior accountant
during the first year, although it was odd to be supervised by someone younger than she was. Jeanne was impressed with the internal controls at
Kim Jewelers and often commented on the impressive hands-on management style in every aspect of the business. Jeanne liked working at Kim
Jewelers, but often suggested to her colleagues there that it was Ali Automotive where she was the most needed. To the detriment of her Kim
Jewelers audit team, Jeanne often delayed working on the engagement whenever Ali Automotive needed her. She was the only staff accountant
on the Ali Automotive job; it was her top priority.
After three years, Jet Li began to receive mixed reviews from clients for Jeanne Thomson. He was content with her praise from Ali
Automotive, but other clients, including Kim Jewelers, were less impressed. Jeanne seemed to perform at or below expectations for a third-year
staff on her other jobs. Her intelligence and confidence were evident, but her work and effort did not convey her abilities. In addition, she often
complained that her friends at large international accounting firms were making quite a bit more money than she was. On the positive side,
Jeanne recently passed the CPA examination. She was professional at work and in the community; her expansive wardrobe always reflected the
role of a professional, and her demeanor was a positive reflection on L & A. Jeanne also was making some new business contacts for L & A
through her membership at the country club and the gated neighborhood where she lived. In fact, she had brought in two new clients for the firm,
a feat that was unheard of for a staff accountant. Jeanne was well liked by her coworkers at L & A. She often had them over to her new home to
socialize after working hours. They enjoyed her company and were impressed that she was juggling her career and family. Since her husband was
still collecting disability, they assumed Jeannes father-in-law was footing the bill for some of their luxuries.
Unfortunately, Jeanne had a car wreck during busy season of her fourth year. Although she did not have any permanent injuries,
Jeanne had to stay in the hospital for three weeks. During that time, Jet Li covered her work responsibilities. During the second week of Jeannes
absence, Jet collected Alis mail from the post office and began preparing checks for payment. Jet was surprised to see a very large credit card
bill. Upon examination of the bill, Jet noticed large charges at a home improvement store. Was Ali Automotive expanding its business? Jet was
curious, and when he brought flowers to the hospital for Jeanne, he asked her about the charges. Jeanne could not answer Jets questions and
seemed rattled by the discussion. Jet contacted the credit card company to determine if the charges were valid. He discovered that the charges
101
102
were authorized by Jeanne Thomson. Further investigation revealed that the charges were for personal items for Jeanne. In response to these
charges, Jet meticulously examined the dealerships accounting records and found that Jeanne had been making personal charges and cash
withdrawals on Alis credit card for two and a half years. Jet swiftly contacted Alis credit card company to terminate a pending payment of
$200,000 that was fraudulently charged by Jeanne Thomson to Home Upgrade, a home improvement store. Consequently, Home Upgrade suited
L & A for professional negligence under a third party liability law suit. Lastly, Jet also investigated Jeannes work with her other clients,
including Kim Jewelers. He was relieved that he did not find any additional irregularities; nevertheless, he was overwhelmed and distraught over
Jeannes fraud at Ali Automotive.
Required
1. List and discuss three personal or situational factors that might have triggered Jeanne Thomson to commit fraud at Ali Automotive.
2. List and discuss three personal or situational factors that might not have triggered Jeanne Thomson to commit fraud at Kim Jewelers.
3. Assume that Ali Automobile files a civil common lawsuit against Li and Associates, CPAs, LLP for breach of contract and Jeanne Thomson
for fraud, answer the following questions:
a. Should L & A be found liable to Ali Automobile? Explain and cite prior legal case(s) to support your arguments.
b. Should Jeanne Thomson be found liable to Ali Automobile? Explain and cite prior legal case(s) to support your arguments.
4. Assume that Home Upgrade files a third-party joint liability common lawsuit against Li and Associates, CPAs, LLP and Ali Automobile; that
the San Francisco court follows the foreseeable concept but may move back to the Ultramares concept in a third-party lawsuit, and that L &
A can be charged under different types of negligence in performing professional services, answer the following questions:
a. Should L & A be found liable to Home Upgrade? Explain and cite prior legal case(s) to support your arguments.
b. Should Ali Automobile be found jointly liable to Home Upgrade? Explain and cite prior legal case(s) to support your arguments.
Chapter 5
Audit Plan Preplan and Documentation
LO5-1 Describe the four main considerations of preplan in a financial audit.
LO5-2 Describe the six main considerations of preplan in an integrated audit.
LO5-3 Explain the external auditors consideration of the internal auditors involvement
in preplanning an audit.
LO5-4 Compare and contrast the general documentation requirements between the
SECs SOX 2002 and AICPAs AU 230.
LO5-5 Compare and contrast the specific documentation requirements between
PCAOBs AS No.3 and AICPAs AU 240.
LO5-6 Identify the content of the auditors permanent and current files.
103
104
Chapter 5 Audit Plan Preplan and Documentation

Preplan in a Financial Audit
Preplan in a financial audit involves four main considerations as shown in Figure 5-1.
Figure 5-1 Main Considerations of Preplan in Financial and Integrated Audits
The Audit Process
Audit Plan
Preplan and
Documentation CH 5
Tests of Controls
Tests of Balances
Completing the Audit
Financial Audit
Audit Report
Integrated Audit
Objectives CH 6
1. Investigate the Client
Evidence CH 7
2. Understand the Clients
Business
Internal Control CH 8
3. Assign Staff to the
Engagement
Materiality and Risk CH 9
4. Sign the Engagement
Letter
Program and
Technology CH 10
5. Considers Matters Specific to
An Integrated Audit
6. Consider the Risk of Fraud

and Management Override
of Controls
Table 5-1 provides some comments on the four main considerations of preplan in a financial audit.
Table 5-1 Four Main Considerations of Preplan in a Financial Audit
Consideration
(1) Investigate the client
(2) Understand the clients business
(3) Assign staff to the engagement
Comments
For new client:
Prior to accepting a new client, AU 210 Terms of Engagement requires the successor auditor to
communicate, either orally or in writing, with the predecessor auditor. The initiative in
communication rests with the successor auditor. The inquiry of the predecessor auditor is important
because the predecessor auditor may be able to provide the successor auditor with information that
assists him/her in determining whether to accept the engagement.
The successor auditor should also request the client to authorize the predecessor auditor to allow a
review of the predecessor's working papers, including documentation of planning, internal control,
audit results, and other matters of continuing accounting and auditing significance, such as the
working paper analysis of balance sheet accounts, and those relating to contingencies. In addition, the
client's consent to the review is needed in accordance with Rule 301 of the Code of Professional
Conduct on confidential client information.
The auditor may hire a professional investigator to obtain information about the reputation and
background of the potential new clients management.
The auditor may also use the internet to search and learn more about the potential new client. Table
5-2 describes some useful sites for the electronic search.
The auditor should assess the legal and financial stability of the potential new clients and reject it if it
poses a high risk of litigation.
For old client:
The incumbent auditor should review prior experience with the existing client and decide whether to
continue auditing the client.
KPMG LLP has developed and implemented an innovative technology-enabled auditor decision aid,
known as KRisksm, for making acceptance and continuance risk assessments of both new and old
clients.
The auditor should obtain a knowledge of the nature of the client's business, its code of ethics,
organization, and its operating characteristics, such as the type of business, types of products and
services, capital structure, related parties, locations, and production, distribution and compensation
method. Some procedures to accomplish these are:
(a) A tour of the client's plant and offices.
(b) A review the client's legal documents, policies and the auditor's working papers from prior years.
Legal documents that the auditor should examine include corporate charter and bylaws, minutes of
corporate meetings, and contracts.
(c) Consult the AICPA Industry Audit Guide, industry publications, periodicals and financial
statements of other business entities in the industry to obtain knowledge of the business environment
in which the client operates, such as economic conditions, government regulations, and changes in
technology.
(d) Gain knowledge of the clients values and ethical standards through policy statements and code of
ethics. In response to the Sarbanes-Oxley Act of 2002, the SEC now requires each public company to
disclose whether it has adopted a code of ethics that applies to senior management, including the
CEO, CFO, and principal accounting officer or controller. A company that has not adopted such a
code must disclose this fact and explain why it has not done so. Accordingly, as a part of the
understanding of the clients business, the auditor should gain knowledge of the companys code of
ethics.
(e) Identify related parties of the client through inquiry of management, review of SEC filings, and
contacting the stock registrar to identify principal stockholders. A related party transaction is any
transaction between the client and a related party (Discussed in Chapter 20). Related party
transactions increase inherent risk of a client because they are not at arms length and may not be
valued at the same amount as they would have been if the transactions had been with an independent
third party. Accordingly, Sarbanes-Oxley Act of 2002 specifically prohibits related party transactions
that involve personal loans to executives. It is now unlawful for any public company to extend or
maintain credit, to arrange for the extension of credit, or to renew the extension of credit in the form
of personal loan to any director or executive officers. These restrictions do not apply to any loan,
such as a home loan or credit card agreement, made by a bank or other insured financial institution
under normal banking operation using market terms offered to the general public. In light of these
prohibitions, the auditor should now be alert of any such loans to directors or executives that are
illegal acts.
(f) Perform analytical procedures (Discussion in Chapter 7)
Considerations for assigning staff to the engagement are:
(a) In the case of a new client, the key members of the audit team are identified; this will allow the
prospective client to assess the credentials of the proposed audit team whose resumes are usually
enclosed with the pre-engagement proposal.
(b) In the case of an old client, ensure the continuity of the assigned audit staff to the client and
maintain the familiarity of the assigned audit staff with the client.
105
106
Consideration
(4) Sign the engagement letter
Comments
(c) In the case of a client with computerized accounting systems, and if specialized computer skills
are needed, the auditor should seek a professional possessing such skills, who may be an individual
with the audit firm or an outside professional.
(d) When outside expert help is needed, AU 620 Using the Work of a n Auditors Specialist requires
the auditor to satisfy himself/herself concerning the professional qualification and reputation of the
specialist, such as computer analysts, lawyer, and appraiser, by inquiry or other procedures, as
appropriate. There are more discussions on using the work of a specialist in Chapter 20.
(e) Recall in Chapter 2 that the partner-in-charge of an audit should be rotated at least every seven
years as per the Firms Division of the AICPA and every five years as per the Sarbanes-Oxley Act
2002.
Recall Table 2-10 in Chapter 2 that under Section 301 of the Sarbanes-Oxley Act, audit committees
(or those charged with governance) are now directly responsible for the appointment, compensation,
and oversight of the external auditor. Moreover, Section 202 of the Sarbanes-Oxley Act amends
Section 10A of the Securities Exchange Act of 1934 to require that the audit committee must also
pre-approve all audit and non-audit services provided by the external auditor. This means that the
auditor should now establish an understanding with the audit committee (or those charged with
governance) regarding services to be performed in the audit engagement. Since that understanding is
usually established through an engagement letter, the auditor should obtain signed engagement letters
directly from the audit committee (or those charged with governance).
An understanding with the client regarding an audit of the financial statements generally includes the
following matters:
(a) The objective of the audit is the expression of an opinion on the financial statements.
(b) Management is responsible for the entitys financial statements and the selection and application
of the accounting policies.
(c) Management is responsible for establishing and maintaining effective internal control over
financial reporting.
(d) Management is responsible for designing and implementing programs and controls to prevent and
detect fraud.
(e) Management is responsible for identifying and ensuring that the entity complies with the laws and
regulations applicable to its activities.
(f) Management is responsible for making all financial records and related information available to
the auditor.
(g) At the conclusion of the engagement, management will provide the auditor with a letter
(management representation letter) that confirms certain representations made during the audit.
(h) Management is responsible for adjusting the financial statements to correct material
misstatements and for affirming to the auditor in the management representation letter that the effects
of any uncorrected misstatements aggregated by the auditor during the current engagement and
pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the
financial statements taken as a whole.
(i) The auditor is responsible for conducting the audit in accordance with generally accepted auditing
standards. Those standards require that the auditor obtain reasonable rather than absolute assurance
about whether the financial statements are free of material misstatement, whether caused by error or
fraud. Accordingly, a material misstatement may remain undetected. Also, an audit is not designed to
detect error or fraud that is immaterial to the financial statements. If, for any reason, the auditor is
unable to complete the audit or is unable to form or has not formed an opinion, s/he may decline to
express an opinion or decline to issue a report as a result of the engagement.
(j) An audit includes obtaining an understanding of the entity and its environment, including its
internal control, sufficient to assess the risks of material misstatement of the financial statements and
to design the nature, timing, and extent of further audit procedures. An audit is not designed to
provide assurance on internal control or to identify significant deficiencies. However, the auditor is
responsible for ensuring that those charged with governance are aware of any significant deficiencies
that come to his/her attention. An understanding with the client also may include other matters, such
as the overall audit strategy; involvement of the internal auditor, if applicable (a more detailed
discussion of the internal auditors involvement is provided in a separate section below);
involvement of a predecessor auditor; fees and billing; any limitation of or other arrangements
regarding the liability of the auditor or the client, such as indemnification to the auditor for liability
arising from knowing misrepresentations to the auditor by management; condition under which
access to audit documentation may be granted to others; additional services to be provided relating to
regulatory requirements, and other services to be provided in connection with the engagement, for
example, non-attestation services, such as accounting assistance and preparation of tax returns subject
to the limitations CPC Rule 101.
After a decision is made to accept or continue an engagement, an engagement letter is drafted by the
auditor for the audit committees signature. Such an engagement letter is not required by the
professional standards. However, the AICPA recommends the preparation of an engagement letter for
every audit engagement in light of the potential risk of misunderstanding between the parties. Recall
1136 Tenant's Corp case in Chapter 4. An example of an engagement letter is shown in Figure 5-2.
After accepting the engagement, the senior auditor responsible for coordinating the field work usually
schedules a pre-audit conference with the audit team primarily to give guidance to the staff regarding
Consideration
Comments
both technical and personnel aspects of the audit.
Table 5-2 Auditors Electronic Search for Information about a Prospective Client
Electronic Search
Accounting and auditing standards
relevant to a prospective client.
Resources
This information may be searched and retrieved from :

FASB
FASB provides its standards on its web site, www.fasb.org. Also, FASBs Financial Accounting
Research System provides a CD ROM that contains Statements on Financial Accounting Standards,
Emerging Issues Task Force Abstracts, and FASB Implementation Guides.
AICPA
AICPAs reSOURCE ONLINE Accounting and Auditing Literature provides access to all AICPA
professional standards, audit and accounting guides, and technical practice aids over the Internet.
Financial information about companies
in a prospective clients industry.
This information may be searched and retrieved from:

Compustat and Disclosure SEC Database (Disclosure)
Subscribers to Compustat and Disclosure may search and retrieve financial data that have been
extracted from SEC filings and annual reports of public companies.
EDGAR (Electronic Data Gathering and Retrieval System)

Auditors may access EDGAR via the Internet to obtain the SEC filings of certain public companies,
including their financial statements.
Current development relevant to a
prospective client.
The Internet provides online access to newspaper and journal articles. Also, many companies and
industry associations have WWW home pages that describe current developments and statistics.
Some useful Internet resources are as follows:
Public Company Accounting Oversight Board (PCAOB), www.pcaobus.org
Securities and Exchange Commissions

Home page, www.sec.gov/
EDGAR page, www.sec.gov/edgarhp.htm
Securities Act of 1933, www. law.uc.edu/CCL/33Act/Index.html
Securities Exchange Act of 1934, www. law.uc.edu/CCL/34Act/Index.html
Accounting and Auditing Web Sites

American Institute of CPAs (AICPA), www.aicpa.org
Association of Certified Fraud Examiners (CFE), www.acfe.com
The Institute of Internal Auditors (IIA), www.theiia.org
Tax and Accounting, http://taxsites.com
Large Accounting Firms

PricewaterhouseCoopers, LLP, www.pwcglobal.com
Ernst & Young, LLP, www.ey.com
Deloitte & Touche, LLP, www.deloitte.com
KPMG, LLP, www.us.kpmg.com
Grant Thornton, LLP, www.gt.com
BDO Seidman, www.bdo.com
McGladrey & Pullen, LLP, www.rsmmcgladrey.com
107
108
Figure 5-2 Example of an Engagement Letter

M & M, CPAs, LLP
San Francisco, CA 94321
Jan 4, 20xx
Mr. A, Chair of Audit Committee

XYZ Company
San Francisco, CA 94321
Dear Mr. A, Chair of Audit Committee
This letter is to confirm our arrangement for our audit of XYZ Company for the year ended December 31, 20xx.
We will audit the consolidated balance sheet of XYZ Company and its subsidiaries, YZ Company and XY Company, as of December 31,
20xx, and the related consolidated statements of earnings, retained earnings, and cash flows for the year then ended. Our audit will be made
in accordance with the standards of the Public Company Accounting Oversight Board and in compliance with the Sarbanes-Oxley Act of
2002. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation.
We direct your attention to the fact that management is responsible for the fair presentation of financial statements and the establishment and
maintenance of adequate internal control in compliance with the Sarbanes-Oxley Act of 2002. The standards of the Public Company
Accounting Oversight Board require us to obtain reasonable assurance, but not absolute, assurance that the financial statements are free of
material misstatement. Accordingly, we cannot guaranty that our audit will detect all errors, fraud, and illegal acts that might be present. Our
findings regarding your internal control, including information regarding material weaknesses, will be reported to the audit committee in a
separate letter.
We will also perform a review, but not an audit, of the Company's financial statements for each of the first three quarters of the financial year
ended December 31, 20xx. Our review will be in accordance with standards established by the American Institute of Certified Public
Accountants as set forth in Statement on Auditing Standards AU 930, titled "Interim Financial Information".
Assistance to be provided by your accounting department personnel, including the preparation of the detailed trial balance and supporting
schedules, is described in a separate attachment.
Our examination is scheduled for performance and completion as follows:
Begin field work
Completion of field work
Delivery of audit report
May
31, 20xx
February 15, 20xx
March
1, 20xx
Our fee will be based on the time spent by various members of our staff at our regular rates, plus travel and other out-of-pocket costs
(photocopying, telephone, etc.). Invoices will be rendered every two weeks and are payable on presentation. We will notify you immediately
of any circumstances we encounter which could significantly affect our initial fee estimate of $160,000.
If the above arrangement is in accordance with your understanding, please sign and return to us the duplicate copy of this letter.
We are pleased to have this opportunity to serve you.
Very truly yours,
____________________
M & M, CPAs, LLP
Arrangement Accepted:
___________________________
Mr. A, Chair of Audit Committee
______________
Date
External Auditor Consideration of the Internal Auditors Involvement

AU 610 Using the Work of Internal Auditors requires the external auditor to consider the involvement of the internal
auditor at the preplan phase of an audit. The decision process the auditor follows is outlined in Figure 5-3. The
major issue for the external auditor is considering the competence and objectivity of the internal auditors and the
effect of their work on the audit. Factors that the auditor should consider include:
Competence
1. Educational level and professional experience.
2. Professional certification and continuing education.
3. Audit policies, procedures, and checklists.
4. Practices regarding their assignments.
5. The supervision and review of their audit activities.
6. The quality of their working paper documentation, reports, and recommendations.
7. Evaluation of their performance.
Objectivity
1. The organizational status of the internal auditors responsible for the internal audit function. For example, the
internal auditor reports to an officer of sufficient status to ensure that the audit coverage is broad and the
internal auditor has access to the board of directors or the audit committee.
2. Policies to maintain internal auditors objectivity about the areas audited. For example, internal auditors are
prohibited from auditing areas to which they have recently been assigned or are to work upon completion of
responsibilities in the internal audit function.
The internal auditors work may affect the nature, timing, and extent of the audit procedures performed by
the independent auditor. For example, as part of their regular work, internal auditors may review, assess, and
monitor controls of the clients the accounting system. Similarly, part of their work may include confirming
receivables or observing certain physical inventories. If the internal auditors are competent and objective, the
external auditor may use the internal auditors work in these areas to reduce the scope of audit work. The materiality
of the account balance or class of transactions and its related audit risk may also determine how much the external
auditor can rely on the internal auditors work. When internal auditors provide direct assistance, the external auditor
should supervise, review, evaluate, and test their work.
Preplan in an Integrated Audit
Preplan in an integrated audit is coordinated with the preplan in a financial audit. For both audits, the auditor
considers matters related to the clients industry, business, and regulatory environment and so on (see Figure 5-1 and
Table 5-1). In addition, the auditor considers preplan matters specific to an integrated audit that includes 1.
Knowledge of the entitys internal control over financial reporting (ICFR) obtained during other engagements. 2.
Matters affecting the industry in which the client operates, such as financial reporting practices, economic
conditions, laws and regulations, and technological changes. 3. Matters relating to the clients business, including its
organization, operating characteristics, and capital structure. 4. The extent of recent changes in the client, its
operations, or its ICFR. 5. Preliminary judgments about materiality, risk, and other factors relating the determination
of material weaknesses. 6. Control deficiencies previously communicated to the audit committee or management. 7.
Legal or regulatory matters of which the client is aware. 8. The type and extent of available evidence related to the
effectiveness of the clients ICFR. 9. Preliminary judgments about the effectiveness of ICFR. 10. Public information
about the client relevant to the evaluation of other likelihood of material financial statement misstatements and the
effectiveness of the clients ICFR. 11. Knowledge about risks related to the clients evaluated as part of the audits
client acceptance and retention evaluation. 12. The relative complexity of the clients operations.
The auditor also considers preplan matters specific to the risk of fraud and the risk of management override
of controls in an integrated audit such as: 1. Controls over significant, unusual transactions, particularly those that
result in late or unusual journal entries. 2. Controls over journal entries and adjustments made in the period-end
financial reporting process. 3. Controls over related-party transactions. 4. Controls related to significant management
estimates. 5. Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately
manage financial results.
Lastly, to effectively plan an integrated audit, PCAOBs AS 5 recommends 1. Scaling the audit which
means the auditor takes into consideration the size and complexity of the client, its business processes, and business
units that affect the way in which the client achieves effective internal control objectives. 2. Using the work of
others which means the auditor uses the work performed by, or receives direct assistance from, internal auditors
(consistent with AU 610), company personnel, and third parties working for management (e.g. valuation specialist
discussed in Chapter 19) or the audit committee.
109
110
Figure 5-3 The External Auditors Consideration of the Internal Auditors Work
1. Obtain an understanding of the internal audit function:
a. Gather information about its activities
b. Consider the relevance of the internal audit activities to the audit of the financial statements
No
Are internal audit

activities relevant
to the external audit?
Yes
No
Is it efficient to
consider the work of
internal auditors?
Yes
2. Assess the competence and objectivity of the internal auditors.

Yes
Are internal auditors
competent and objective?
No
Yes
3. Consider the effect of the internal auditors work on the audit:
a. Understanding internal control.
b. Risk assessment.
c. Test of controls and test of balances procedures.
4. Consider the extent of the effect of the internal auditors work.
5. Coordinate external audit work with internal auditors.
6. Evaluate and test the effectiveness of the internal auditors work
Does the auditor plan

to request direct assistance
from internal auditors?
Yes
7. Apply the procedures outlined in AU 610
Using the Work of Internal Auditors
END
No
Documentation in Financial and Integrated Audits

The audit preplan, the audit program, the tests performed, the collection and evaluation of evidence, and the
conclusions reached by the auditors are documented in the audit working papers in compliance with AICPAs AU
230 Audit Documentation in a financial audit and PCOABs Auditing Standard No.3 (AS 3) Audit Documentation in
an integrated audit. At the completion of audit, auditors at the supervisory level review these working papers
prepared by the audit staff.
The primary function of the working papers is to provide the principle support for the auditor's opinion and
to aid the auditor in the conduct and supervision of the audit. Moreover, the information contained in the working
papers is the auditor's primary means for proving due diligence under Section 11 of the Securities Act of 1933 and
Section 18 of the Securities Exchange Act of 1934.
Working papers are the property of the auditor. However, the auditor's right of ownership is subject to the
limitations of AICPA Rule of Conduct 301 on confidential client information. In a financial audit, completed
working papers are typically retained in the auditor's office for at least two years following an engagement, after
which the papers are moved to a remote location for storage, sometimes on microfilm form and sometimes on
computer disk. The retention period thereafter should be sufficient to meet the audit firm's needs and consistent with
applicable federal and state statutes of limitations. In an integrated audit, an applicable federal status is the Corporate
and Criminal Fraud Accountability Act of 2002 which requires the auditor to maintain working papers for seven
years. Moreover, under this Act, it is a felony for the auditor to knowingly destroy or create working papers to
impede, obstruct or influence any existing or contemplated federal investigation; an offense subject to financial fines
and imprisonment up to 10 years.
In February 2003, the SEC, under the Sarbanes-Oxley Act of 2002, issued a set of rules on the retention of
records for audits and reviews. The rules require the auditor to maintain the following documentation: 1. Working
papers or other documents that form the basis for the audit of the companys annual financial statements or review
of the companys quarterly financial statements. 2. Memos, correspondence, communications, other documents, and
records, including electronic record, that meet the following criteria: a. the materials are created, sent, or received in
connection with the audit or review, and b. the materials contain conclusions, opinions, analyses, or financial data
related to the audit or review. Accordingly, The SECs rule significantly increases the audit documentation that must
be retained. For example, auditors will now be required to retain email correspondence that contains information
meeting the above criteria. In addition, the SECs rule acknowledges that administrative records and other
documents not containing relevant financial data or the auditors conclusions, opinions, or analysis, do not meet the
retention criteria. For example, superseded drafts of memos, duplicates, previous copies of working papers that have
been corrected for typographical errors or errors due to training of new employees, or voice-mail messages do not
need to be retained.
Audit Documentation under AICPAs AU 230 in a Financial Audit
AICPAs AU 230 Audit Documentation states that the auditor should maintain working papers, the form and
content of which should be designed to meet the circumstances of a particular engagement. In addition, the
standard states that the quantity, type, and content of working papers will depend on: 1. The anticipated nature of the
auditors report. 2. The nature of the engagement. 3. The nature of the financial statements, schedules, or other
information reported. 4. The nature and condition of the clients records. 5. The assessed control risk. 6. The needs
for supervision and review of the audit work. Concerning the quantity of working papers, the standard further
stipulates that the working papers should be sufficient to show that the accounting records agree or reconcile with
the financial statements or other information reported on and that the applicable standards of field work have been
observed. Finally, concerning the content of working papers, the standard further stipulates that certain of the
auditors working papers may sometimes serve as a useful reference source for the client, but the working papers
should not be regarded as a part of, or a substitute for, the clients accounting records. Although the form and
content of working papers vary with the circumstances, they are typically divided into two categories of files:
permanent and current. Figure 5-4 shows the two categories of working papers files: permanent and current files.
Table 5-3 describes the content of the permanent and current files.
111
112
Figure 5-4 Two Categories of Working Papers
Working papers
Permanent files
Include:
Corresponding file
Tax file
Current files
Contain
Contain
1. Copies of articles of incorporation, bylaws,

bond indentures and contracts.
2. Analyses of previous years accounts.
3. Organization charts, flowcharts, and
internal control questionnaires.
4. Analytical procedure results of previous
years audit
Audit Program
Copy of financial statements
Working trial balance
Lead Schedule
Detailed supporting schedule
Table 5-3 Permanent and Current Files

File
Permanent Files
Description
Permanent files contain information that is of continuing interest and relevance to the auditor in performing in
performing recurring engagement on an audit client. The permanent files are typically separated into three bundles:
(1) Corresponding file:
It is also known as the administrative file. It contains all correspondence to, from, or on behalf of a client. For
example, the auditor's client advisory comments letter on insignificant control deficiencies. Information contained in
this file is useful for planning the following year's audit.
(2) Permanent file:
This file contains information of continuing interest and relevance to an audit engagement. For example, the file may
include a client's articles and bylaws of incorporation, terms of capital stock and bond issues, chart of accounts,
organization charts, flow charts of internal control structure, schedule of amortization of long-term debt and
depreciation of assets, lease agreements, labor-management agreements, pension plan, copies of contracts, excerpts
from minutes, and analysis of business industry and economy. The permanent file should be updated during each
engagement.
(3) Tax file:
The tax file contains information relevant to a client's past, current, and future income tax obligations. For example,
the file may include a client's prior year state and federal income tax returns and schedule of significant temporary
differences between pretax accounting income and taxable income. This file serves as a basis for preparing current
File
Current Files
Description
year returns or for performing other tax-related services, such as representing the client in an IRS audit.
Current files are also known as the analysis files and they contain information relevant to a given audit client for a
particular year's audit. Working papers in the current files typically include the:
(1) Audit program. A detailed listing of all audit procedures to be performed during the engagement.
(2) Copy of financial statements. A draft copy of the current years financial statements.
(3) Working trial balance. A list of all the account balances from the general ledgers. It includes columns for
adjustment and reclassification. The working trial balance may be prepared by the client or the auditor. If the client
prepared a working trial balance, the auditor should verify the trial balance by footing the columns and tracing the
account balances to the general ledgers.
(4) Lead schedules. A lead schedule details each individual account balance within a major account category on the
financial statements, e.g., petty cash and cash at bank under cash account. The lead schedule also summarizes the audit
adjustments affecting the accounts.
(5) Detailed supporting schedules. A detailed supporting schedule documents specific audit procedures and tests
performed on individual account balances. The tests, the results, and the conclusions constitute the body of "sufficient
appropriate evidential matter" supporting the auditor's opinion on the financial statements. The detailed supporting
schedules typically include:
(a) An analysis schedule (e.g. allowance for doubtful debts)
(b) A reconciliation schedule (e.g. bank reconciliation)
(c) A reasonableness test schedule (e.g. provision for depreciation)
(d) Internal documents (e.g. memorandum)
(e) External documents (e.g. SEC Form 10-K)
(6) Audit adjustment and reclassification entries. Audit adjustments are journal entries proposed by the auditor to the
client. The purpose of the entries is to correct for material errors discovered during the audit (e.g. to write off obsolete
inventories that are not written off by the client). The "adjustments" column of the working trial balance lists the
journal entries. Audit reclassifications are items requested by the auditor to be reclassified to ensure proper
presentation of the financial statements. The "reclassifications" column of the working trial balance lists the audit
reclassifications (e.g. reclassification of material current installments of long-term liabilities as current liabilities).
Figure 5-5 shows an example of working paper organization. Figure 5-6 shows an example of working paper content.
Expanded Audit Documentation under AICPAs AU 240 in a Financial Audit

In 2002, the Auditing Standard Board issued AU 240 Consideration of Fraud in a Financial Statement Audit that
expands the auditors documentation requirements. AU 240 requires the auditor to discuss and identify fraud risk
factors at the planning phase of the financial statement audit. It also requires the auditor to perform additional testing
procedures on suspected fraud. Finally the auditor is required to discuss fraud with the management and audit
committee. All this work relating to the auditors consideration of fraud in a financial statement audit must be
documented in the working papers. Table 5-4 provides some brief comments of the expanded audit documentation
relating to the consideration of fraud in a financial statement audit.
Table 5-4 Expanded Documentation in Relation to the Consideration of Fraud
Expanded Documentation
Discussions among engagement

team members in planning the audit
regarding the susceptibility of the
clients financial statements to fraud.
Documentation should include (1) how
and when the discussion occurred, (2)
description of audit team members who
participated, and (3) subject matter
discussed.
Procedures performed to obtain

information necessary to identity and
assess
the
risks
of
material
misstatements due to fraud.
Specific
risks
of
material
misstatements due to fraud that were
identified, and a description of the
Brief Comments
The discussion should include:
(1) An exchange of ideas or brainstorming among the audit team members.
(2) A consideration of the known external and internal conditions that might (a) create
incentives/pressures for management and others to commit fraud, (b) provide the opportunity for
fraud to be penetrated, and (c) indicate a culture or environment that enables managements
attitude/rationalization to commit fraud.
(3) An emphasis on the need to maintain a questioning mind and to exercise professional
skepticism in gathering and evaluating evidence throughout the audit.
(4) Inputs from key team members from different locations and specialists assigned to the team.
These procedures include:
(1) Make inquiries of management and others about the risk of fraud. These inquiries include: (a)
Managements knowledge about suspected fraud. (b) Audit committees view about the risk of
fraud. (c) Internal auditors about their views about the risk of fraud. (d) Other employees
perspective regarding the risk of fraud.
(2) Consider the results of procedures relating to the acceptance and continuance of the audit
engagement (Discussion in Chapter 5).
(3) Consider the results of the analytical procedures performed in planning the audit (Discussion in
Chapter 7).
(4) Reviews of interim financial statements.
The identification of a risk of material misstatement due to fraud involves professional judgment
and includes the consideration of:
(1) The type of risk that may exist, i.e., whether it involves fraudulent financial reporting or
113
114
Expanded Documentation
auditors response to those risks.
The
results
of
additional
procedures performed to address the risk
of improper revenue recognition.
The
results
of
additional
of improper inventory quantities.
The
results
of
additional
of biased management estimates.
The
results
of
additional
of management override internal
controls.
The nature of the communication

about fraud made to management, the
audit committee, and those charged with
governance.
Brief Comments
misappropriation of assets.
(2) The significance of the risk, i.e., whether it is of a magnitude that could lead to material
misstatements.
(3) The likelihood of the risk, i.e., the likelihood that it will result in material misstatements.
(4) The pervasiveness of the risk, i.e., whether it affects the financial statements as a whole or is
restricted to certain accounts or class of transactions.
The auditors response to the risks of material misstatement involves professional skepticism in
gathering and evaluating audit evidence and involves the consideration of: (1) The overall effect
on how the audit is conducted, i.e., general considerations such as assignment of personnel and
supervision, managements selection and application of accounting principles, and predictability of
auditing procedures.
(2) Changing the nature, timing, and extent of auditing procedures (Discussion in Chapter 10).
(1) Perform substantive analytical procedures relating to revenue using disaggregated data, e.g.,
comparing revenue reported by mouth and by product line.
(2) Confirm with customers certain relevant contract terms and agreements, e.g., acceptance
criteria, delivery and payment terms, cancellation or refund provisions.
(3) Inquiry of the sales and marketing personnel or legal counsel regarding sales or shipments for
unusual terms associated with the transactions.
(4) Be present at one or more locations to observe goods being shipped at period end.
(5) Test controls on revenue transactions that are processed electronically for existence and
occurrence.
(1) Review inventory record to identify specific locations for inventory count observation on an
announced basis.
(2) Apply more rigorous procedures during the inventory count observation, e.g., examine the
purity, grade, or concentration of inventory in liquid form.
(3) Comparison of quantities for the current period with prior periods by class or category of
inventory to test the reasonableness of the quantities counted.
(1) Engage a specialist/expert or develop independent estimates for comparison to management
estimates, e.g., comparing the fair value of a derivative.
(2) Retrospective review of similar management estimates in prior periods for the reasonableness
of judgments and assumptions supporting management estimates.
The auditor should use professional judgment to determine additional procedures to examine
journal entries and other adjustments for evidence of management override of internal controls.
(1) Assess the risk of material misstatement associated with a specific class of journal entries.
(2) Assess the effectiveness of specific internal controls associated with a specific class of journal
entries.
(3) Gather both manual and electronic evidence for a specific class of journal entries.
(4) Identify unique characteristics of fraud associated with a specific class of journal entries such
as entries (a) made to seldom used accounts, (b) made by individuals who typically do not make
journal entries, (c) made pre- or post-period with little or no explanation, (d) made pre- or postperiod with no account number, and (e) made containing round numbers or a consistent ending
number.
(5) Examine other accounts affected by a specific class of journal entries at different locations.
(6) Examine journal entries or other adjustments processed outside the normal course of business,
e.g., entries used to record nonrecurring transactions, such as business combinations and
nonrecurring estimates, such as asset impairment.
The communication process includes:
(1) Fraud involving senior management should be reported directly to the audit committee.
(2) Fraud resulting from significant deficiencies in the design and operation of internal controls
should be reported to those charged with governance as material weakness AU 265
Communicating Internal Control Related Matters Identified in an Audit (Discussion in Chapter 8).
(3) Ordinarily, the auditor is not responsible to disclose fraud to outside parties except in the
following situations: (a) To comply with legal and regulatory requirements. (b) To a successor
auditor when the successor makes inquiries in accordance with AU 210 Terms of Engagement. (c)
In response to a subpoena. (d) To a funding agency or other specified agency in accordance with
requirements for the audits of entities that receive governmental financial assistance.
Specific Documentation Requirements under PCAOBs AS 3 in an Integrated Audit

PCOABs Auditing Standard No.3 (AS 3) Audit Documentation contains specific documentation requirements for
audits of public companies for significant findings or issues, actions taken to address them (including additional
evidence obtained), the basis for the conclusions reached. Examples of significant findings or issues that required
documentation under PCAOBs As 3 include:
1. Significant matters involving the selection, application, and consistency of accounting principles, including
related disclosures. For example, accounting for complex or unusual transactions, accounting estimates and
uncertainties related to management assumptions.
2. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures or
the existence of material misstatements or omissions in the financial statements or the existence of significant
deficiencies in internal control over financial reporting.
3. Audit adjustments and the ultimate resolution of these items.
4. Disagreement among members of the engagement team or with others consulted on the engagement about
conclusions reached on significant accounting or auditing matters.
5. Significant findings or issues identified during the review of quarterly financial information.
6. Circumstances that cause significant difficulty in applying auditing procedures.
7. Significant changes in the assessed level of audit risk for particular audit areas and the auditors response to those
changes.
8. Any other matters that could result in modification of the audit report.
In addition, the auditor must identify all significant findings or issues in an engagement completion memorandum.
This memo should be specific enough for a reviewer to gain a thorough understanding of the significant findings or
issues.
115
116
Figure 5-5 An Example of Working Paper Organization
Balance Sheet
12/31/0x
Cash
$15,000
Accounts Receivable 35,000
X
X
X
Working
Trial
Balance
Lead Schedule
ABC Company Ref: TB

DR
|
CR
Working Trial Balance |Adjust |Reclass | Adjusted Trial Balance
Cash
$15,000
X
X
X
ABC Company
Ref: A-lead
Cash Lead Schedule
Account No. W/P Ref
Adjusted Balance
101
A-1 Petty cash
$ 500
102
A-2 Cash-General 12,000
103
A-3 Cash-Payroll
2,500
$ 15,000 To: TB
======
ABC Company
Ref: A-2
Bank Reconciliation W/P Ref
Balance per bank
$ 14,000 A-2.1
Add: Deposits in transit
2,000
Less: Outstanding checks
4,000 A-2.2
Balance per book
$ 12,000 To:A-lead
======
Bank Confirmation
Detailed Supporting Schedules
Cash balance at bank
Ref: A-2.1
$ 14,000 To: A-2

======
Listing of Outstanding Checks

Check No.
688
689
X
X
X
Ref: A-2.2
Amount
$ 168
863
x
x
x
______
$ 4,000 To: A-2
======
Figure 5-6 An Example of Working Paper Content

ABC Company
Bank Reconciliation
12/31/20xx
Schedule: A-2
Client Date: 1/10/20xx
Reviewed by: FC
Date: 1/18/20xx
Prepared by:
Acct. 101 General account, Bank of America

$ 109,713 T
Balance per Bank

Add:
Deposit in transit
12/30
$ 10,017
12/31
11,100
#
#
A-2.1
21,117
Deduct:
Outstanding checks
# 8008 12/16
3,068
8013 12/16
9,763
8016 12/23
11,916
8028 12/23
14,717
8033 12/28
37,998
8036 12/30
10,000
^
^
^
^
^
^
(87,462)
Other reconciling items:

Bank error
Deposit for another bank customer credited
to General account by bank, in error
(15,200)
Balance per bank, adjusted
28,168
=====
A-3
TB
F
Balance per books before adjustments
32,584
A-1
(4,416)
C 3.1
A-1
Adjustments:
Unrecorded bank service charge

NSF check returned by bank, not collectible from customer
Balance per books, adjusted
216
4,200
A-1
28,168
=====
F
T = Traced and agreed to bank confirmation
# = Traced deposit to the December 200x cash receipts and to the
January 200x bank cutoff statement.
^ = Traced check to the December 200x cash disbursements and to the
January 200x bank cutoff statement.
X = Cross-footed
TB = Traced to 12/31 adjusted trial balance.
C = Cross-index to working paper 3.1
F = Footed
117
118
5-1
Which of the following procedures does not belong to the preplan phase of an audit engagement?
a. Establishing the management's assertion.
b. Establishing the client's reason for audit.
c. Establishing contact with the preceding auditor.
d. Establishing contract with the client.
5-2
What is the responsibility of a successor auditor with respect to communicating with the predecessor auditor in connection with a
prospective new audit client?
a. The successor auditor has no responsibility to contact the predecessor auditor.
b. The successor auditor should obtain permission form the prospective client to contact the predecessor auditor.
c. The successor auditor should contact the predecessor auditor regardless of whether the prospective client authorizes
contact.
d. The successor auditor need not contact the predecessor if the successor is aware of all available relevant facts.
5-3
The current file of the auditor's working papers should include

a. copies of client's contracts.
b. client's organization charts.
c. client's chart of accounts.
d. client's SEC Form 10-k.
5-4
The primary purpose of the auditor's working papers is to

a. support a client's financial statements.
b. support the adjustment and reclassification entries recommended by the auditor.
c. support the auditor's tests of controls and tests of balances.
d. support the auditor's opinion about the client's financial statements.
5-5
An audit working paper that shows the auditor's reasonableness test on a client's provision for depreciation is known as a(an)
a. adjustment and reclassification entries.
b. detailed supporting schedule.
c. lead schedule.
d. working trial balance.
5-6
Which of the following eliminates voluminous details from the auditors working trial balance by classifying and
summarizing similar or related items?
a. Account analyses.
b. Lead schedules.
c. Control accounts.
d. Supporting schedules.
5-7
An auditor who accepts an audit engagement and does not possess the industry expertise of the audit client should
a. engage financial experts familiar with the nature of the business entity.
b. refer a substantial portion of the audit to another CPA who will act as the principal auditor.
c. inform the clients management that an unqualified opinion cannot be issued.
d. obtain knowledge of matters that relate to the nature of the clients business.
5-8
The engagement letter

a. affects the CPA firms responsibility to external users of audited financial statements.
b. can be used to alter the auditors responsibility under generally accepted auditing standards.
c. can affect legal responsibilities to the client.
d. affects only an audit engagement, but does not affect review or compilation services.
5-9
After audit preplan, an engagement letter should be sent to the client. The letter usually would not include
a. a statement that management advisory services would be made available upon request.
b. a reference to the auditors responsibility for the detection of errors or frauds.
c. an estimation of the time to be spent on the audit work by audit staff and management.
d. a reference to managements responsibility for adequate internal controls.
5-10
Ordinarily, the working papers can be provided to someone else only with the express consent of the client. This is the case
even if
a. the papers are subpoenaed by a court.
b. the papers are used as a part of an AICPA quality review program.
c. the papers are requested as evidence in an AICPA Joint Trial Board hearing.
d. the papers are transferred as a result of a CPA selling his/her practice to another CPA firm.
5-11
Which of the following is the most likely first step an auditor would perform at the preplan phase of the audit process?
a. Provide the audit teams credentials to a potential new client.
b. Evaluate the internal controls of a potential new client.
c. Tour a potential new clients plants and facilities.
d. Consult and review the work of the predecessor auditor.
5-12
Which of the following would not be included in the auditors working papers?
a. The accounting manual.
b. The results of the preceding years audit.
c. Descriptions of the internal controls.
d. A time budget for the various audit areas.
5-13
Which of the following would not be a consideration of a CPA firm in deciding whether to accept a new client?
a. Clients standing in the business community.
b. Clients probability of achieving an unqualified opinion.
c. Clients relation with its previous CPA firm.
d. Clients financial stability.
5-14
Which of the following statement would least likely appear in an auditors engagement letter?
a. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses.
b. During the course of our audit we may observe opportunities for economy in, or improved controls over, your
operations.
c. Our engagement is subjected to the risk of that material errors or irregularities, including fraud and defalcations, if they
exist, will not be detected.
d. After performing our analytical procedures we will discuss with you the other audit procedures we consider necessary to
complete the engagement.
5-15
At the preplan phase, an auditor obtains knowledge about a new clients business to
a. provide constructive suggestions concerning improvements to the clients internal control.
b. develop an attitude of professional skepticism concerning managements financial statement assertions.
c. understand the nature of the clients business organization and its operating characteristics.
d. evaluate whether the aggregation of known misstatements causes the financial statements to be materially misstated.
5-16
At the preplan phase, an auditor most likely would

a. identify specific internal control activities that are likely to prevent fraud.
b. evaluate the reasonableness of the clients accounting estimates.
c. discuss the scheduled time for the performance and completion of the audit.
d. inquire of the clients attorney for unrecorded pending litigation.
5-17
At the preplan phase, a successor auditor should request the new client to authorize the predecessor to allow a review of the
predecessors
a.
b.
c.
d.
Engagement letter
Yes
Yes
No
No
Working papers
Yes
No
Yes
No
119
120
5-18
At the preplan phase, would the following factors ordinarily be considered in assigning staff for a new engagement?
a.
b.
c.
d.
5-19
Credential of the staff in the audit team

Yes
Yes
No
No
Continuity and periodic rotation of personnel

Yes
No
Yes
No
Which of the following factors most likely would cause an auditor not to accept a new audit engagement?
a. The auditor is not able to review the predecessor auditors working papers.
b. The prospective client does not permit the auditor to enquire its legal counsel concerning the risk of any pending
litigation.
c. The auditor does not fully understand the prospective clients operations and industry.
d. The prospective client does not assess the credentials of the proposed audit team.
5-20
In creating lead schedules for an audit engagement, a auditor often uses automated working paper software. What client
information is needed to begin this process?
a. Interim financial information such as third quarter sales, net income, and inventory and receivables balances.
b. Specialized journal information such as the invoice and purchase order numbers of the last few sales and purchases of
the year.
c. General ledger information such as account numbers, prior-year account balances, and current-year unadjusted
information.
d. Adjusting entry information such deferrals and accruals, and reclassification journal entries.
5-21
An auditor ordinarily uses a working trial balance resembling the financial statements without footnotes, but containing
columns for
a. cash flow increases and decreases.
b. audit objectives and assertions.
c. reconciliations and tick-marks.
d. reclassifications and adjustments.
5-22
At the preplan phase, a matter most likely to be agreed upon between the auditor and the client before implementation of
testing procedures is the determination of
a. evidence to be gathered to provide a sufficient basis for the auditors opinion.
b. procedures to be undertaken to discover litigation, claims, and assessments.
c. pending legal matters to be included in the inquiry of the clients attorney.
d. timing of the auditors physical inventory observation.
5-23
Which of the following documentation is required for an audit in accordance with generally accepted auditing standards?
a. A flowchart of an internal control questionnaire that evaluates the effectiveness of the clients internal controls.
b. A client engagement letter that summarizes the timing and details of the auditors planned field work.
c. An indication in the working papers that the accounting records agree or reconcile with the financial statements.
d. The basis for the auditors conclusions when the assessed level of control risk is at the maximum level for all financial
statement assertions.
5-24
Which of the following statements concerning audit working papers is false?

a. An auditor may support an opinion by other means in addition to working papers.
b. The form of working papers should be designed to meet the circumstances of a particular engagement.
c. An auditors working papers may not serve as a reference source for the client.
d. Working papers should show that the auditor has obtained an understanding of internal control.
5-25
In planning a new audit engagement, which of the following is not a factor that affects the auditors judgment as to the
quantity, type, and content of working papers?
a. The type of report to be issued by the auditor.
b. The content of the clients representations letter.
c. The nature and condition of the clients records.
d. The auditors preliminary evaluation of control risk based on discussions with the client.
5-26
Although the quantity and content of audit working papers vary with each particular engagement, an auditors permanent
file most likely includes
a. schedules that support the current years adjusting entries.
b. prior years accounts receivable confirmations that were classified as exceptions.
c. documentation indicating that the audit work was adequately planned and supervised.
d. analyses of capital stock and other owners equity accounts.
5-27
The audit working paper that reflects the major components of an amount reported in the financial statements is the
a. interbank transfer schedule.
b. carryforward schedule
c. supporting schedule.
d. lead schedule.
5-28
Which of the following factors would least likely affect the content of an auditors working papers?
a. The condition of the clients records.
b. The assessed level of control risk.
c. The nature of the auditors report.
d. The medium used to record and maintain the working papers.
5-29
The permanent file of an auditors working papers most likely would include copies of the
a. lead schedules.
b. attorneys letter.
c. bank statements.
d. debt agreements.
5-30
The current file of an auditors working papers ordinarily should include

a. a flowchart of the internal control procedures.
b. organization charts.
c. a copy of the financial statements.
d. copies of bond and note indentures.
5-31
The current file of an auditors working papers most likely would include a copy of the
a. Bank reconciliation.
b. pension plan contract.
c. articles of incorporation.
d. flowchart of the internal control activities.
5-32
Which of the following statements ordinarily is true concerning the content of working papers? (Hint: Think of the
standards requirement about quantity)
a. Whenever possible, the auditors staff should prepare schedules and analyses rather than the entitys employees.
b. It is preferable to have negative figures indicated in red figures instead of parentheses to emphasize amounts being
subtracted.
c. It is appropriate to use calculator tapes with names or explanations on the tapes rather than writing separate lists onto
working papers.
d. The analysis of asset accounts and their related expense or income accounts should not appear on the same working
paper.
5-33
Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor auditor
regarding the predecessors
a. opinion of any subsequent events occurring since the predecessors audit report was issued.
b. understanding as to the reasons for the change of auditors.
c. awareness of the consistency in the application of GAAP between periods.
d. evaluation of all matters of continuing accounting significance.
121
122
5-34
A, CPA, has been retained to audit the financial statements of C Company. Cs predecessor auditor was B, CPA, who has
been notified by C that Bs services have been terminated. Under these circumstances, which party should initiate the communications
between A and B?
a. A, the successor auditor.
b. B, the predecessor auditor.
c. Cs controller or CFO.
d. The chairman of Cs board of directors.
5-35
Ordinarily, the predecessor auditor permits the successor auditor to review the predecessors working paper analyses
relating to
a.
b.
c.
d.
5-36
Contingencies
Yes
Yes
No
No
Balance Sheet Accounts

Yes
No
Yes
No
Which of the following factors most likely would cause an auditor not to accept a new audit engagement?
a. The prospective client has no formal written code of conduct.
b. The integrity and reputation of the prospective clients management are very bad.
c. Procedures requiring segregation of duties are subject to management override.
d. Management fails to modify prescribed controls for changes in conditions.
5-37
The scope and nature of an auditors contractual obligation to a client is ordinarily set forth in the
a. management representation letter.
b. scope paragraph of the auditors report.
c. engagement letter.
d. introductory paragraph of the auditors report.
5-38
Which of the following documentation is not required for an audit in accordance with generally accepted auditing
standards (GAAS)?
a. A client engagement letter that summarizes the timing and details of the auditors planned field work.
b. The basis for the auditors conclusions when the assessed level of control risk is below the maximum level.
c. A written audit program setting forth procedures necessary to accomplish the audits objectives.
d. An indication that the accounting records agree or reconcile with the financial statements.
5-39
At the preplan phase of an audit, which of the following procedures would an auditor least likely perform?
a. Coordinating the assistance of the prospective clients in gathering evidence.
b. Tour the prospective clients plant and facilities.
c. Selecting a sample of vendors invoices for comparison with receiving reports.
d. Reading the current years interim financial statements.
5-40
At the preplan phase of an audit, a auditor most likely would

a. identify specific internal control activities that are likely to prevent fraud.
b. evaluate the reasonableness of the clients accounting estimates.
c. discuss the timing of the audit procedures with the clients management.
d. inquiry of the clients lawyer as to whether any unrecorded claims are probable of assertion.
5-41
The senior auditor responsible for coordinating the field work usually schedules a pre-audit conference with the audit team
primarily to
a. give guidance to the staff regarding both technical and personnel aspects of the audit.
b. discuss staff suggestions concerning the establishment and maintenance of time budget.
c. establish the need for using the work of specialists and internal auditors.
d. provide an opportunity to document staff disagreements regarding technical issues.
5-42
To obtain an understanding of a continuing clients business at the preplan phase of an audit, an auditor most likely would
a. perform tests of details of transactions and balances.
b. review prior-year working papers and the permanent file for the client.
c. read specialized industry journals.
d. re-evaluate the clients internal control.
5-43
Which of the following audit documents would not have to be retained in the audit working paper files?
a. Working papers used to form the basis for the audit opinion.
b. Memos exchanged between audit team members that contain analyses of client financial data.
c. Emails summarizing conclusions about client business risks.
d. Superseded drafts of documents corrected for errors made by audit staff.
5-44
Which of the following is not a criteria that the SEC would use to determine the retention of audit documents?
a. Documents that are created, sent, or received in connection with the audit or review services.
b. Documents contain conclusions, opinions, analyses, or financial data related to the audit or review services.
c. Documents that are created, sent, or received in connection with the AICPAs peer review program.
d. Documents that are electronic, such as email and voice mail, which contain conclusions, opinions, analyses, or financial
data related to the audit or review services.
5-45
The Sarbanes-Oxley Act of 2002 changed several elements of the audit preplan phase. Which of the following is not a
correct statement regarding these changes?
a. The auditor should now establish an understanding with the management regarding services to be performed in the audit
engagement.
b. The auditor-in-charge of an audit engagement should now be rotated at least every five years.
c. The auditor should now alert to any personal loans to directors or executives of the company that are illegal acts.
d. The auditor should now gain knowledge of the companys code of ethics.
5-46
Auditing standards on consideration of fraud in a financial statement audit expanded the requirements of documentation in
working papers. Which of the following is not one the expanded requirements?
a. The results of additional procedures performed to address the risk of improper revenue recognition.
b. The results of additional procedures performed to address the risk of improper inventory pricing.
c. The results of additional procedures performed to address the risk of biased management estimates.
d. The results of additional procedures performed to address the risk of management override internal controls.
5-47
With regard to assigning staff to an engagement in the preplan phase of an audit, which of the following
is unlikely to be considered by the audit firm?
a. Rotation of the partner-in-charge of the audit of a privately held company every seven years.
b. Rotation of the partner-in-charge of the audit of a publicly held company every five years.
c. Rotation of the partner-in-charge of the audit of all companies every seven years or five years
depending on the size of the companies.
d. Rotation of the partner-in-charge of the audit of a company as per the Sarbanes-Oxley Act of 2002.
5-48
Which of the following statements concerning audit working papers is false?

a. Working papers are the property of the audit client.
b. Working papers contain adjustment and reclassification entries recommended by the auditor.
c. Working papers of a predecessor auditor should be made available to the successor auditor.
d. Working papers support the auditors opinion about the clients financial statements.
5-49
If the external auditor considers the internal auditors to be competence and objective, the external auditor will not proceed
to
a. consider the extent of the effect of the internal auditors work.
b. coordinate external audit work with internal auditors.
c. evaluate and test the effectiveness of the internal auditors work.
d. appoint the internal auditors as team members of the external auditor.
123
124
5-50
PCOABs Auditing Standard No.3 (AS 3) Audit Documentation requires the auditor to document significant findings or
issues in an audit. Which of the following is not an example of a significant finding or issue that required documentation?
a. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures.
b. Disagreement among members of the engagement team about conclusions reached on insignificant accounting
transactions.
c. Unusual and significant accounting estimates identified during the review of quarterly financial information .
d. Significant changes in the assessed level of audit risk for particular audit areas.
5-51
Which of the following is not a characteristic of preplan in an integrated audit?

a. Preplan in an integrated audit is coordinated with the preplan in a financial audit.
b. The auditor considers preplan matters specific to an integrated audit that includes knowledge of the entitys internal control over
financial reporting (ICFR) obtained during other engagements.
c. To effectively plan an integrated audit, the auditor should not consider using the work of others.
d. The auditor considers preplan matters specific to the risk of fraud and the risk of management override of controls in an integrated
audit

5-1 a. 5-2 b. 5-3 d. 5-4 d. 5-5 b. 5-6 b. 5-7 d. 5-8 c. 5-9 a. 5-10 d. 5-11 d.
5-12 a. 5-13 b. 5-14 d. 5-15 c. 5-16 c. 5-17 c. 5-18 a. 5-19 b. 5-20 c. 5-21 d
5-22. d. 5-23 c. 5-24 c. 5-25 b. 5-26 d. 5-27 d. 5-28 d. 5-29 d. 5-30 c. 5-31 a.
5-32 c. 5-33 b. 5-34 a. 5-35 a. 5-36 b. 5-37 c. 5-38 a. 5-39 c. 5-40 c. 5-41 a.
5-42 b. 5-43 d. 5-44 c. 5-45 a. 5-46 b. 5-47 c. 5-48 a. 5-49 d. 5-50 b. 5-51 c.

Simulation Question 5-1 is an adaptation with permission from a case by Jenne, S. E. in the Issues in Accounting Education , a publication of the
American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places
have been changed.
An opening for partnership had just been announced in the local office of Novogardac & Co, a regional CPA firm. The new
partnership position, justified by increased revenues, was cause for celebration among the managers aspiring to become partners in the firm.
Competition mounted for the new position once the announcement was made. Bill Siegel, one of the senior audit managers, was the current
favorite for admission to the partnership. Bill has consistently received favorable performance evaluations from his superiors and had been
viewed as being technically competent throughout his career. In his last annual performance review as a senior manager, he was told that the only
obstacle he had to overcome in order to be admitted to the partnership was to demonstrate an ability to attract new clients. Bill had been making
himself very visible in the business community by joining local business and not-for-profit organizations and he was becoming a local leader in a
respected civic organization. This activity had helped Bill identify prospective clients and, in fact, had resulted in the addition of several new
clients to the firm. At this point he needed just one or two new clients to ensure his admission as a partner.
Part 1
During a round of golf with the controller of a local automobile dealership, Bill asked his golf partner, Tom, for possible new business
leads. Tom thoughtfully considered the question and finally came up with a name. The automobile dealership frequently sold purchase contracts
to local financial institutions. Recently, Sabrina Phil, the president of Provident Credit Union (hereafter, PCU) had mentioned to Tom that she
was unhappy with her current auditor and was considering a change. She complained about high audit fees and noted some difficulties working
with her current auditor. Tom suggested that Bill contact Sabrina to determine whether she was serious about switching auditors, but he warned
that Sabrina was a tough businesswoman with a reputation for being shrewd. Bill was so delighted with the new lead that he happily picked up
the tab for golf and lunch.
Bill wasted no time arranging a meeting with Sabrina. Just as Tom said, Sabrina was unhappy with her current auditor and very
willing to consider a change. Bill noted that a reputable firm had audited PCU the previous year and, as far as he could tell, the accounting
records appeared to be in reasonable order. Based on his experience with similar clients, Bill developed a tentative proposal to perform the audit
of PCU for a fee slightly less than the previous years fee. Sabrina quickly consented and agreed to notify her prior auditor. Permission was
granted for the prior auditor talk freely with Bill regarding PCU. According to Bills best estimates of time required and personnel to be assigned,
Novogradac & Co would be able to recover its normal billing rates for services performed at the proposed fee amount. Bill told Sabrina that the
engagement, including the proposed audit fee, could not be finalized until he performed a more thorough background investigation of PCU and
had obtained approval of the Novogradac partners. This investigation, required by Novogradac prior to acceptance of all new clients, was to
include a more in-depth financial review of the past five years, a credit check, and an evaluation of the general reputation of PCU and Sabrina.
Novogradac required Bill to inform the partner-in-charge of audit, Lucy Ball, and to obtain a favorable vote of the local office partners prior to
acceptance of the new client.
Required
1 a. Given Bills technical competence, why is he being required to demonstrate an ability to bring new clients into the firm in order to be
admitted to the partnership?
1 b. What information and procedures does Novogradac require prior to acceptance of a new audit client?
Part 2
The background review produced the following information:

1. PCU is a small, closely held, and well-established financial institution. It has operated successfully for 20 years under Sabrinas leadership.
Sabrina currently serves as Chairman of the Board of Directors and CEO of PCU. PCU weathered a recent business recession and still maintained
net income comfortably above the average for peer financial institutions.
2. Sabrina has a reputation as an aggressive businesswoman who always lands on her feet. She has used sales of short-term certificates of
deposit (CDs) to raise cash quickly to take advantage of new business opportunities. Similarly, she has sold large portfolios of loans to avoid
reissuing CDs when interest rates were favorable. She personally supervises collection activities on difficult loans and one collection agency
owner familiar with PCU commented that there was not much opportunity left for collection after Sabrina got through.
3. As of the previous audit, total assets of PUC were approximately $10 million. Within the past five years, the total assets had fluctuated from a
low of $8 million to a high of nearly $20 million. Stockholders equity was slightly larger than average when compared to similar financial
institutions. Virtually all the debt of PCU was related to depositor accounts, primarily CDs.
4. Bill visited the predecessor auditor and was allowed to examine and copy some of the working papers from the prior year audit. He noted that
there had been a few more adjusting journal entries proposed than he normally would have expected. In discussing the adjustments with the
predecessor auditor, Bill noted that it had been difficult for the predecessor auditor to convince Sabrina that the adjustments were necessary.
However, Sabrina eventually agreed to make a sufficient number of the proposed adjustments to receive an unqualified audit opinion. As Bill
reached the end of his meeting, the predecessor auditor said, Of course, you hate to lose any client, but if we had to choose one to give up it
would be PCU.
5. Most of the loans held by PCU came from used car dealers, small home repair and remodeling contractors, and door-to-door sales people in the
area. These types of loans were often difficult to collect. Sabrina discounted the loans heavily, paying only a fraction of their face value, and
usually bought them with recourse. Because Sabrina had demonstrated an ability to collect a high percentage of these loans, she always has an
ample supply of sales people and small businesses willing to sell her their loans receivable.
6. Talks with the controller of PCU went reasonably well. The controller was very friendly and tried to be helpful. Overall, the accounting records
appeared to be in reasonably good order. However, Bill was not impressed with the knowledge and abilities of the controller. The controller had
completed a few accounting courses, but did not have a degree in accounting and had not completed any professional certification program in
accounting (e.g., CPA, CMA, CIA, CFE).
125
126
7. Bills business contacts were willing to freely discuss their experience with Sabrina and with PCU. They consistently depicted Sabrina as
disciplined, aggressive, and shrewd. Within PCU she was viewed as direct, overbearing, and intolerant of error.
8. PCU generally had a reputation for paying obligations on time or shortly after the due date. However, it was common for Sabrina to take
exception to the charges billed and it was common for her to attempt to renegotiate the charges prior to making payment. The prior auditor had
been paid within a reasonable time after completion for the engagement.
Bill summarized his background review for Lucy, noting the above points. All things considered, he concluded that PCU would be an
acceptable audit client and recommended to Lucy that Novogradac accept the engagement. Bill fully understood the importance of increased firm
revenues to justify the new partnership position. Annual employee reviews were scheduled the following week and this would be Bills last
opportunity to add another client prior to his evaluation for a partnership position. If Bill were not admitted to the partnership soon, he would
likely be asked to leave the firm to make room for other promising candidates.
Required
2 a. Prepare a list of specific factors/reasons to accept the PCU audit engagement. One factor/reason is provided to help you complete the rest of
about eleven factors/reasons.
i. Successful operation of the business for 20 years. Continuing businesses usually present less audit risk than startup companies with no record of
success.
ii.
iii
2 b. Prepare a list of specific factors/reasons to reject the PCU audit engagement. One factor/reason is provided to help you complete the rest of
about seven factors/reasons.
i. Management control is centered in one person, Sabrina. This situation makes it easier for Sabrina to commit fraud without being detected,
thereby increasing audit risk.
ii.
iii
Part 3
Based on the recommendations of Bill and Lucy, the vote of the local office partners, the PCU audit engagement was accepted. With
the acceptance of PCU, Bills goal to become a partner was realized. Bill acquired a loan (not from PCU) and bought into the partnership. This
was a crowning achievement in Bills career and he was justifiably proud of his promotion.
Unfortunately, all did not go well with the audit of PCU. The controller quit shortly after the clients year-end and the new controller
was less qualified for the position than his predecessor. He apparently overstated his abilities and experience to obtain the position. The new
controller often struggled to understand the unique accounting practices within the financial institution industry. This was an obvious frustration
to Sabrina. Since her own knowledge of detailed accounting procedures was limited, she was unable to resolve technical accounting issues
herself. Sabrina appeared to be looking to the auditors to resolve technical accounting issues as part of the audit. It became apparent that neither
the controller nor Sabrina would be of great help in answering the more difficult accountingrelated questions that were likely to arise during the
audit.
Reconciliation of the beginning balances in the general ledger with the prior year audited financial statements for PCU turned out to
be a major challenge. While Bill was fortunate enough to get copies of the audited trial balance numbers and proposed adjusting entries from the
prior auditor, there was neither a record of which entries had been posted and which had not, nor was there a reconciliation between the audited
trial balance numbers and the resulting financial statements. Either there was a deficiency in the predecessors working papers, or they purposely
withheld critical information.
Attempts to obtain additional information from the predecessor auditor were futile. In some cases it was discovered that an adjustment
was made to the books for a different amount from that proposed by the predecessor auditor. In other cases, incorrect adjustments were made or
no entries were made at all. Account balances were combined under headings on the financial statements different from those used on the trial
balance and there was no documentation detailing the combination of accounts. It took many hours of searching the clients journals and ledgers
to finally track all the entries and to reconcile the clients beginning account balances with the prior year audited financial statements. For most of
their audit clients, this reconciliation was unnecessary because the account balances in the ledger closely matched the amounts reported on the
financial statements and numbers from the trial balance were typically traced to the financial statements in the working papers.
The audit of fixed assets exceeded the budget by a significant amount of time due to the lack of records. The prior controller of PCU
had calculated depreciation expense for depreciable assets for the year under audit before leaving PCU. Unfortunately, he did not leave a copy of
his calculations to support depreciation expense. All efforts to contact the previous controller for an explanation failed. The new controller was
unable to explain how depreciation expense was derived and, due to lack of confidence in his accounting abilities, he was afraid to make any
changes to the amounts calculated by the prior controller. The disclosure of depreciation methods on the prior year financial statements was too
vague to determine which methods were used for each asset or asset group.
The professional staff assigned to audit fixed assets obtained original purchase documentation for each of the fixed assets and by trial
and error attempted to determine the method of depreciation employed. Straight line, sum-of-the-years digits, double declining balance, declining
balance at 1.5 times the straight-line rate, and MACRS (Modified Accelerated Cost Recovery System, a depreciation method used for tax purpose
and defined in the Tax Reform Act of 1986), were all attempted using various estimates of useful lives and salvage values.
Unfortunately, the audit team was unsuccessful in determining the depreciation methods used for any of the assets. It noted that the
amounts recorded for depreciation expense and for accumulated depreciation were consistently between straight-line and double declining
balance amounts. Footnote disclosures were somewhat vague, noting the use of an accelerated method of depreciation for most fixed assets.
The depreciable assets were about 10 percent of total assets on the balance sheet. Most of the assets consisted of the various receivables held by
the financial institution. Thus, it was determined that, in spite of the problems described above, no material error existed in depreciation expense
or accumulated depreciation. A recommendation was made to the client to select a generally accepted method of calculating depreciation and to
document the calculation in the future.
Evidence suggesting the existence of a related party surfaced early in the audit. The building owned and occupied by PCU also housed
a travel agency by the name of East & West Travel (hereafter, EWT). The travel agency operated in the main lobby of the financial institution
with no signs or dividers between the space occupied by PCU and the space occupied by EWT. In fact, it was necessary for employees of both
organizations to pass through the working areas of the other business to enter and exit the building and to access the shared break room and
restrooms. On one occasion, Sabrina was observed correcting the manager of the travel agency and appeared to be threatening his employment
with the agency. Employees of the travel agency would not reveal anything to the auditors.
Discussions with employees of PCU indicated that Sabrina had regular conversations with the manager of the travel agency similar to
the one observed by the audit staff. However, the employees of PCU were unable to verify any direct relationship between the two entities other
than the shared building space. Sabrina denied any ownership, managerial responsibility, or other relationship with EWT. A thorough search was
made for transactions between the two entities. The only transactions noted were the rental payments made by EWT to PCU at an amount
considered by the auditors to approximately fair market value for the space used.
Stockholders equity presented another problem during the audit. When asked whether she had an ownership interest in PCU, Sabrina
flatly denied any ownership whatsoever. When the stock book was examined, however, the audit team found that Sabrina owned approximately
2.5 percent of the outstanding stock in PCU. Due to the obvious misrepresentation by Sabrina to the concern regarding related-party transactions,
Bill made an appointment to talk to Sabrina to review the ownership of PCU. Armed with the stock records, Bill questioned Sabrina regarding
each owner of PCU. At this point, Sabrina acknowledged the ownership noted in the stock records, but quickly countered that it was really
insignificant. Further questioning revealed that Sabrinas aged mother owned approximately 57.5 percent of the outstanding shares of stock.
Sabrina was frequently leaving work at PCU to care for her mother. Discussions with the PCU employees revealed that Sabrinas mother was
very old, in poor health, and dependent on Sabrina for transportation and daily care, including assistance with doctor appointments, grocery
shopping, and meal preparation. There was no evidence that Sabrinas mother had been actively involved in the management oversight of PCU,
participation with the board of directors, or communication with the auditor. No reason was ever discovered for Sabrinas evasive and obviously
incorrect answers.
Required
3 a. When Bill was admitted as a new partner, he acquired a loan to make a substantial financial investment in Novogardac & Co. Why are new
partners required to make a substantial financial investment in the firm as specified in the partnership agreement?
3 b. Audit evidence indicates that EWT may be related to PCU. Why is the possible existence of a related party of concern to the auditors?
3 c. Audit evidence indicates that Sabrina was evasive about her ownership interests in PCU and that her mother owned a majority interest in
PCU. What are the implications of these findings to the audit of PCU?
Part 4
As a result of the issues that arose, the required audit hours greatly exceeded the time budget originally prepared by Bill. Even though
there was not a promised completion date, Sabrina began to be eager to receive the audit opinion and get the auditors out of the building. At one
point she called Lucy Ball and complained that the audit was taking too long. She said that she had made numerous calls to Bill during the past
week and that none of her calls had been returned. But the office receptionist verified that Sabrina had not called the office during the past week
at all. In fact, Bill had been in the PCU building talking to Sabrina the previous day during which time Sabrina had not expressed any concerns
related to the audit or Bills work.
Finally, sufficient appropriate evidence had been gathered to conclude the audit. A number of adjusting journal entries were proposed
and Sabrina fought nearly all of them. Neither she nor her controller demonstrated a sufficient understanding of accounting to challenge the
merits of the entries proposed. When it became clear that Sabrinas challenges had no basis, she finally agreed to a sufficient number of adjusting
entries to allow the financial statements, in the opinion of the auditors, to be fairly stated in all material respects.
The audit was concluded and an unqualified opinion issued. Sabrina waited until she received a 30-day-past-due notice before she
contacted the Novogradac & Co office. She argued over the amount of the bill and again complained about the excessive time that the auditors
took to complete their work. The partners in Novogradac & Co ultimately discounted the bill by 15 percent and Sabrina paid the discounted
amount when the bill was approximately 90 days past due.
Partners in Novogradac & Co each received a salary based on the number of hours they worked and a partnership distribution based
on the size of their partnership investment. The level of salary received was determined by an annual review conducted by the senior partners in
the firm. In order to receive a higher salary, Bill and other partners needed to maintain and increase their client base and charge a higher
proportion of their hours worked to their clients. Note that hours worked for the firm in administrative functions or other activities that could not
billed to a client engagement did not contribute to the revenue of the firm. An increased client base and a higher proportion of hours billed to
clients both resulted in more revenue to Novogradac & Co, and thus justified an increase in salary.
In spite of his increased income as a partner, Bill often found himself a little short of cash. His increase in income as a new partner
was more than offset by the large payments he was required to make on his loan to buy an ownership interest in the firm. It would soon be time to
begin the second audit of PCU and Bill was eager to renew the engagement for another year in order to justify a much-needed increase in salary.
Required
4 a. What factors/reasons might Novogardac & Co have for rejecting to provide future audit services to PCU?
4 b. What factors/reasons might Novogardac & Co have for continuing to provide future audit services to PCU?
Note: You must answer all 4 Parts to earn the extra credit point.
127
128

Simulation Question 5-2 is an adaptation with permission from a case by Jones, A. and C. S. Norman in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the
names and places have been changed.
Part 1
The CPA Firm

As of March 2005, Johnson Keith Niemeyer LLP (hereafter, JKN), a large, regional public accounting firm, had offices in 45 U.S. cities in the
West and Midwest, as well as several international affiliations. Firm headquarters are located in the Midwest, and the professional staff at the
headquarters provides outstanding support to the local offices. JKN has a total of 225 partners and approximately 2,000 supporting professionals
and administrative staff. U.S. offices of the firm generally are staffed with 3-10 partners and 20-100 supporting professional accountants and
administrative personnel. The firm provides a full array of audit, tax, and consulting services for its clients; these are mostly privately held,
owner-managed companies with revenues ranging from $1 million to $50 million, although JKN also serves approximately 80 public companies.
JKN has a reputation for being very conservative in its audit practice. Management has been very careful in its client acceptance and
continuance policies. Before submitting proposals to perform audit services, prospective engagement partners must obtain extensive information
about the potential client to make an informed decision about whether to accept or reject the engagement. If the prospective engagement partners
decision were to accept the client; then, at least one additional audit partner must agree with the decision to accept the client. In the course of
evaluating prospective clients, JKN personnel assess their potential exposure from being associated with a particular client or engagement
(engagement risk).1 JKNs acceptance procedures allow the acceptance of high-risk clients only if the risk can be controlled. That is, the
engagement team must have relevant expertise and experience to manage the risk, as well as adequate compensation for the risk assumed.
Potential clients are evaluated for integrity, industry competence, management experience, and financial condition.
If the prospective client is a public company, then additional due diligence procedures are required. These procedures include
evaluating underwriters and legal counsel, performing background checks on members of management and the board of directors, and evaluating
the financial viability of proposed transactions and investor returns. In these situations, JKNs firm policy requires the approval of the partner
responsible for firm-wide audit and accounting policy, as well as the approval of a concurring partner.
Engagement partners re-evaluate existing audit clients on an annual basis to determine whether any events since completion of the last
audit might cause the firm to discontinue its relationship with the client. If an existing client is planning a public offering of its securities, then
additional due diligence procedures are necessary. In addition, the re-evaluation of existing clients requires concurrence by another audit partner
when certain events or circumstances occur. These events include: a change in majority ownership or management, managements refusal to sign
a representation letter, discovery of fraud or other misrepresentations, a clients unwillingness to pay fees, and regulatory investigations.
Traditionally, audit and tax services have been the core business of the firm. However, for the past five years, JKN management has
not been satisfied with the firms financial results, and its new strategy focuses on non-audit services, primarily management consulting and
personal financial services. Therefore, JKN now promotes itself as a business services firm and as a one-stop shop for its clients business
needs. Recently, the firm formed alliances with other financial services providers around the country and is aggressively promoting its ability to
help with retirement plan administration, insurance, wealth management, and information systems needs for small- and medium-size, closely held
business and their owners.
The Briarwood City Office
The Briarwood City office of JKN is located in the Pacific Northwest and is one of the oldest offices in the firm. Three partners, 30 professional
staff (mostly CPAs), and five administrative staff make up the Briarwood City team. The partners all graduated from highly rated accounting
programs in the U.S. Their areas of specialization/responsibility are as follows:
Andrew (Andy) Stevens: office administration and attest services, including small audits, reviews, and compilations. Andy is very much in tune
with the current JKN strategy and is actively involved in promoting non-audit services and establishing alliances with other professional service
providers. Andy joined the firm 20 years ago and has been a partner for ten years.
Frank Clement: Attest services consisting of large and small audits, reviews, and litigation supporting. Frank also serves as a regional quality
control resource, conducting concurring reviews for other offices and serving four publicly listed clients from Briarwood City. Frank moved to
Briarwood City 18 years ago, after eight years with a national firm in its Chicago office.
Bernard (Bernie) Richards: Tax services. Bernie is known as one of the firms best tax partners. He has excellent corporate and individual client
relationships and is one of the most sought-after instructors at firm-wide training sessions. Bernie has been with the firm for 27 years.
Frank and Bernie are very proud of their long careers as audit and tax partners and the firms rich history providing these services.
However, both men have a number of concerns about the future of the firm. They are not very pleased with the firms new strategy to be a
business services firm. In addition, they are very concerned about living up to the firms responsibilities under the Sarbanes-Oxley Act of 2002.
On the other hand, Andy is trying his best to follow the firm strategy of being a one-stop financial service provider, despite the high chargeable
hour goals and pressure to grow the practice in his respective area. Mark Grumbles, the regional managing partner for JKN, is very supportive of
the firms strategy and frequently reminds everyone about the need to grow the firm and to sell nontraditional services.
Luckily, the Briarwood City office has several very competent audit and tax managers to assist in the administration of client
engagements and to train junior staff members. Stuart Harrison, Paula White, Tom Fitch, and Sue Tracey are very experienced and
knowledgeable managers and have great relationships with the partners and the staff. Stuart is a tax manager and Paula, Tom, and Sue handle the
audit, review, and compilation work. The partners are currently looking to hire at least two more capable managers since everyone is stretched
thin. Grumbles would really like to find someone who is experienced at selling non-audit financial services. An organization chart depicting the
hierarchy for the firm is shown in Figure 1. You should access Data File 5-2 in iLearn for Figure 1, which shows JKNs organization chart.
The Client
Riverside Communications Company (hereafter, RCC) commenced business operations in 1925 as a local exchange telephone service provider in
the southwestern part of the state. In 1958, RCC conducted its initial public offering (IPO), and many local residents in its service area became
shareholders. Later, in 1980, a second public offering was conducted, and subsequently the RCC common stock was listed on NASDAQ. The
primary business of RCC still consists of local exchange (or wireline services) to customers in the southwestern part of the state. However, over
1
Engagement risk is the risk that the audit firm will suffer harm because of a client relationship, even though the audit report issued to the client
was correct.
the past ten years, RCC has significantly expanded its local territory. Furthermore, passage of the Telecommunications Act of 1996 (targeted at
increasing competition in the industry) encouraged RCC to increase its coverage area and the services offered to its customers.
Through its various wholly owned subsidiaries and nonconsolidated equity investees, RCC provides the following services: local
telephone service (wireline), cellular and paging communications services (wireless), cable television services, telecommunications equipment
sales, leasing of a fiber-optic cable network and tower space, financing services, and directory assistance services. RCC has a history of
successful operations and has a long history of paying dividends. Financial information for the past five years is presented in Table 1. You
should access Data File 5-2 in iLearn for Table 1, which shows recent financial results for Riverside Communications Company. During
that period, revenues have increased due to RCCs continued growth into new lines of business; at the same time, net income has declined mainly
because of investments required for the startup of these new lines of business.
Key personnel of RCC are as follows:
Warren England, Chief Executive Officer (CEO): Warren is a CPA and has been with RCC for 20 years. He started working at RCC as the Chief
Financial Officer (CFO) after spending 13 years in a national public accounting firm, the last three as a partner.
Larry Cashman, CFO: Larry has an M.B.A. and was hired as the CFO ten years ago. At the time he was hired at RCC, he has over 20 years of
experience as either a controller or a CFO for public companies in other industries.
Greg Lowman , Controller: Greg is a CPA and was hired five years ago from JKN after serving as the audit senior on the account for four years.
Additional information and firm characteristics of RCC may be found in Table 2. You should access Data File 5-2 in iLearn for Table 2, which
shows firm characteristics and selected data for Riverside Communications Company.
History of the Audit-Client Relationship
JKN has been serving the audit and tax needs of RCC since the 1950s when the firm assisted the Company with its IPO. The relationship between
JKN and RCC has been very good over the years. Because of its good reputation in the community and because of the prestige of performing
audit and tax services for this client, JKN has been able to attract other sizable clients, including three other small public companies. One of these
public clients is also a telecommunications company with lines of business similar to RCC. There are no other significant telecommunications
company clients in any office of the firm. Frank Clement has been handling the audit partner responsibilities on RCC for each of the three years,
ending December 31, 2004. Tom Fitch has just completed his second year as the engagement manager.
Total fees from RCC have averaged approximately $250,000 per year for the past three years under a fixedfee arrangement for the
annual and quarterly audit and tax services, exclusive of services required in connection with the attestation reporting on internal controls
beginning in 2004, as required by Section 404 of the Sarbanes-Oxley Act and for which an additional $75,000 was billed. The total RCC fees
represent approximately 4 percent of total fees for the Briarwood City office of JKN, placing RCC in the top five of all clients based on total fees
billed and collected.
Occasionally, Larry Cashman will call with questions about how to handle the accounting entries and reporting for non-routine or
unusual transactions. In these special situations, Frank Clement often consults with Michael Bryan from the headquarters office, who has
performed the concurring review of the RCC audit for the past three years. When Frank submits a bill to the audit committee for these extra
services, a minor argument or negotiation often takes place between Frank and Larry regarding the size of the bill. Larry argues that these
consultations should be covered in the fixed-fee audit as defined in their engagement letter with JKN.
Since RCC has a calendar year, the audit takes place during JKNs busy season (January and February). Although the firm prefers not
to accept work for less than standard rates during this period, an exception is made for this client, whose fees average only 80 percent of standard
rates. One of the main reasons for this exception is that the senior members of the RCC management team are very crafty negotiators. Warren
England and Larry Cashman both realize that RCC is an important client to JKN. Warren, having been a partner in a public accounting firm,
knows how to play the game. Therefore, because of the significant fee and the prestige of having this client, JKN makes an exception to its usual
policy of demanding full rates for busy season work. Staff members enjoy working on this audit even though the timetable for fieldwork is tight
and the hours are long. Working on this engagement presents a great opportunity to learn and the audit is clean because of good internal controls
and the competent management and accounting staff of RCC.
The audit is always on time with no material audit adjustments ever required. Client personnel prepare the annual report to
stockholders and the Form 10-K for filing with the SEC; the JKN staff has no problems with the adequacy or format of disclosures, or referencing
the financial information in their workpapers. A management letter (i.e., a clients advisory comments letter) is prepared each year with
suggestions for improvements in internal controls or for more efficient methods of handling operations. However, no material weakness on
internal controls has ever been reported to management or to the audit committee of the board of directors pursuant to Statement on Auditing
Standards No. 112 (AU 325) Communication of Internal Control Related Matters Identified in an Audit . In addition, the attestation report on
managements assessment of internal controls in 2004, as required by Section 404 of the Sarbanes-Oxley Act, was unqualified.
Frank Clement and Tom Fitch meet with the audit committee twice each year, once before the audit to obtain their input and to discuss
the audit plan, and once after completion of the fieldwork to discuss the audit findings and the clients advisory comments letter. Larry Cashman
and Warren England are especially sensitive to the matters mentioned in the clients advisory comments letter and always insist that they see the
letter before the audit committee meeting. Frank and Tom have no problem with that procedure because they want to be sure that the facts are
correct and that their staff has reported everything correctly. However, sometimes these discussions are difficult. Larry and Warren sometimes
object to certain information in the letter, claiming that the information is not significant enough to be communicated to the audit committee of
the board of directors.
Required
1. JKN has a risk assessment policy on a clients acceptance/continuance decision. This policy requires the assessment of three types of risk:
a. Engagement risk the risk that JKN will suffer harm because of a client relationship, even though the audit report issued to the client was
correct.
b. Business risk the risk that JKN will suffer economic loss due to inappropriate business strategy or other business decisions.
c. Audit risk the risk that JKN may fail to appropriately modify the opinion issued to the client, even though the financial statements are
materially misstated.
Assume you are following JKNs risk assessment policy in making RCCs continuance decision, identify and explain each type of risk involved
based on the information regarding the Briarwood City office and the history of the audit client relationship with RCC. Use the following format
to answer:
129
130
Type of Risk
a. JKNs engagement risk
b. JKNs business risk
c. JKNs audit risk
1.
2.
1.
2.
1.
2.
Risk Factors Identified
Explain the Risk involved
2. Based on your risk assessment, should JKN continue with this client? Explain why or why not?
In your response, you should consider Section 301 and 407 of the Sarbanes-Oxley Act, NASDAQ rules, and any AICPA guidance that you
believe is relevant. Search the internet for relevant information, for example, websites that offer information on the Sarbanes-Oxley Act of 2002
include:
http://cpcaf.aicpa.org/Resources/Sarbanes+Oxley/
http://www.sarbanes-oxley.com
http://www.theiia.org/iia/guidance/issues/sarbanes-oxley.pdf
http://www.sec.gov/spotlight/sarbanes-oxley.htm
Part 2
Growth Strategy for RCC

It is now Spring 2005, and Frank Clement is presented with a series of transactions contemplated by Larry and Warren. RCCs management is
eager to grow the company into one of the leading providers of wireless communications and Internet services in the North-west. The overall
economy and the stock market have been performing well for the past three years, and RCC stock has been trading at all-time highs, ranging from
$75-$80 per share. Senior management and the board of directors have already met with officials from the investment banking division of Morton
Stosch (hereafter, MS), a very large Wall Street securities firm, and with Whipple Killjoy (hereafter, WK), a large private equity firm from San
Francisco, both of which appear to be excited to be part of an arrangement to grow RCC. The transactions contemplated involve, among other
things, a series of mergers and acquisitions to be financed by various public and private debt and equity offerings. Briefly summarized, these
transactions include:
1. Issue high-yield debt of $550 million. $275 million will be loaned by WK, and the remaining $275 million will be underwritten by MS in a
public offering.
2. Issue $250 million convertible preferred stock. All of this stock will be issued to MS and to WK. In three years, the preferred stock will be
convertible into common stock, and a secondary public offering will likely take place at that time so that the current financiers will be able to
liquidate their investment.
3. Dispose of the directory assistance business for $68 million. Although this business is profitable, it does not fit into the strategic plan as a core
service. RCC has a company that is interested in buying the directory assistance business.
4. Acquire FirstCo, a wireless digital communications company, for $650 million. Since the service area is only about 150 miles from RCC, it
seems to fit with the strategy of expanding the companys wireless footprint. This acquisition will also add 300 employees.
5. Acquire the remaining minority interests in two wireless unconsolidated subsidiaries for $75 million. Currently, RCC is a 25 percent
shareholder in each company and carries these as equity investments. Seven other telecommunications companies own the remaining 75 percent,
with no one company owning more than 15 percent. The plan is to buy out the other seven shareholders.
6. Merge with A&D Telecommunications Company, A&D is a company that is very similar to RCC, but is only about 30 percent of the size of
RCC, based on total revenues. A&D is privately owned by approximately 100 shareholders, mostly members of the Manley family, with Christ
Manley as its CEO. The merger plan is to exchange 40 shares of RCC for each share of A&D. As added inducement for pushing this merger to
the A&D shareholders, RCC is promising to make Chris Manley the Chief Operating Officer (COO) of RCC and to grant him a cash bonus of
$1.2 million if the transaction is approved.
7. Buildout the wireless system. This process requires the purchase of licenses and equipment, as well as the construction of towers.
Warren and Larry explain that RCC is especially ready to take advantage of these ripe times in the telecommunications industry.
The accounting department has assembled projections covering the next five years and, although large losses (as much as $90 million in one year)
are projected in the years 2006-2010, the company expects a profit and positive cash flows in 2010. Borrowings will be sufficient to create cash
reserves in the early periods to meet debt requirements.
Frank Clement sees this project as a tremendous opportunity for the Briarwood office, although it will involve some very difficult
accounting and reporting issues that will include filing several registration statements with the SEC. He will surely need the assistance of Michael
Bryan from the headquarters office. Luckily, most of the immediate work will take place in the summer, which is usually slow; however, this
work might also require individuals to postpone planned vacations. The fees from this type of high-risk work will be billed at premium rates, and
they will provide an opportunity to make up for all those years at 80 percent of standard rates. Therefore, this work for RCC should contribute to
great financial results in 2005 for the Briarwood City office.
The other two partners in the Briarwood office, Andy Stevens and Bernie Richards, are also excited about the opportunity. Mark
Grumbles is delighted. He has been pressuring Frank to sell some of JKNs value-added services, such as wealth management, to the RCC
executives and board members. Grumbles comments that after these transactions take place RCC should be a prime candidate for the firm to
provide other non-audit services. This situation should also help the Briarwood office attract more audit clients.
Required
3. The growth strategy for RCC is very ambitious and aggressive. Identify and explain risk factors associated with RCCs growth strategy in
addition to those that you have identified in Part 1. Use the following format to answer:
Risk Factors Associated with RCCs Growth

Strategy
1. RCCs increasing complexity.
2. Relationship with Morton Stosch.
3. Relationship with Whipple Killjoy.
4. The telecommunication industry.
5. The size of RCC with respect to the other clients
in the Briarwood office.
6. The expertise required of the Briarwood office
with respect to RCC merger and acquisitions.
7. Other risk factors
Explain the Risk Involved
4. Based on your risk assessment of RCCs growth strategy and your risk assessment on RCCs acceptance/continuance decision in Part 1, should
JKN continue with this client? Explain why or why not?
In your response, refer to Chapter 3 for a discussion on relevant professional ethics, for example, Rule 101 on independence of the AICPAs
Code of Professional Conduct and the PCOABs Auditor Independence Rules.
Note: You must answer both Parts 1 and 2 to earn the extra credit point.

Simulation Question 5-3 is an adaptation with permission from a case by Jones, A. and C. S. Norman in the Issues in Accounting Education , a
Introduction
The CPA Firm

As of March 2005, Johnson Keith Niemeyer LLP (hereafter, JKN), a large, regional public accounting firm, had offices in 45 U.S. cities in the
West and Midwest, as well as several international affiliations. Firm headquarters are located in the Midwest, and the professional staff at the
headquarters provides outstanding support to the local offices. JKN has a total of 225 partners and approximately 2,000 supporting professionals
and administrative staff. U.S. offices of the firm generally are staffed with 3-10 partners and 20-100 supporting professional accountants and
administrative personnel. The firm provides a full array of audit, tax, and consulting services for its clients; these are mostly privately held,
owner-managed companies with revenues ranging from $1 million to $50 million, although JKN also serves approximately 80 public companies.
JKN has a reputation for being very conservative in its audit practice. Management has been very careful in its client acceptance and
continuance policies. Before submitting proposals to perform audit services, prospective engagement partners must obtain extensive information
about the potential client to make an informed decision about whether to accept or reject the engagement. If the prospective engagement partners
decision were to accept the client; then, at least one additional audit partner must agree with the decision to accept the client. In the course of
evaluating prospective clients, JKN personnel assess their potential exposure from being associated with a particular client or engagement
(engagement risk).2 JKNs acceptance procedures allow the acceptance of high-risk clients only if the risk can be controlled. That is, the
engagement team must have relevant expertise and experience to manage the risk, as well as adequate compensation for the risk assumed.
Potential clients are evaluated for integrity, industry competence, management experience, and financial condition.
If the prospective client is a public company, then additional due diligence procedures are required. These procedures include
evaluating underwriters and legal counsel, performing background checks on members of management and the board of directors, and evaluating
the financial viability of proposed transactions and investor returns. In these situations, JKNs firm policy requires the approval of the partner
responsible for firm-wide audit and accounting policy, as well as the approval of a concurring partner.
Engagement partners re-evaluate existing audit clients on an annual basis to determine whether any events since completion of the last
audit might cause the firm to discontinue its relationship with the client. If an existing client is planning a public offering of its securities, then
additional due diligence procedures are necessary. In addition, the re-evaluation of existing clients requires concurrence by another audit partner
when certain events or circumstances occur. These events include: a change in majority ownership or management, managements refusal to sign
a representation letter, discovery of fraud or other misrepresentations, a clients unwillingness to pay fees, and regulatory investigations.
Traditionally, audit and tax services have been the core business of the firm. However, for the past five years, JKN management has
not been satisfied with the firms financial results, and its new strategy focuses on non-audit services, primarily management consulting and
personal financial services. Therefore, JKN now promotes itself as a business services firm and as a one-stop shop for its clients business
needs. Recently, the firm formed alliances with other financial services providers around the country and is aggressively promoting its ability to
help with retirement plan administration, insurance, wealth management, and information systems needs for small- and medium-size, closely held
business and their owners.
The Briarwood City Office
The Briarwood City office of JKN is located in the Pacific Northwest and is one of the oldest offices in the firm. Three partners, 30 professional
staff (mostly CPAs), and five administrative staff make up the Briarwood City team. The partners all graduated from highly rated accounting
programs in the U.S. Their areas of specialization/responsibility are as follows:
Andrew (Andy) Stevens: office administration and attest services, including small audits, reviews, and compilations. Andy is very much in tune
with the current JKN strategy and is actively involved in promoting non-audit services and establishing alliances with other professional service
providers. Andy joined the firm 20 years ago and has been a partner for ten years.
2
Engagement risk is the risk that the audit firm will suffer harm because of a client relationship, even though the audit report issued to the client
was correct.
131
132
Frank Clement: Attest services consisting of large and small audits, reviews, and litigation supporting. Frank also serves as a regional quality
control resource, conducting concurring reviews for other offices and serving four publicly listed clients from Briarwood City. Frank moved to
Briarwood City 18 years ago, after eight years with a national firm in its Chicago office.
Bernard (Bernie) Richards: Tax services. Bernie is known as one of the firms best tax partners. He has excellent corporate and individual client
relationships and is one of the most sought-after instructors at firm-wide training sessions. Bernie has been with the firm for 27 years.
Frank and Bernie are very proud of their long careers as audit and tax partners and the firms rich history providing these services.
However, both men have a number of concerns about the future of the firm. They are not very pleased with the firms new strategy to be a
business services firm. In addition, they are very concerned about living up to the firms responsibilities under the Sarbanes-Oxley Act of 2002.
On the other hand, Andy is trying his best to follow the firm strategy of being a one-stop financial service provider, despite the high chargeable
hour goals and pressure to grow the practice in his respective area. Mark Grumbles, the regional managing partner for JKN, is very supportive of
the firms strategy and frequently reminds everyone about the need to grow the firm and to sell nontraditional services.
Luckily, the Briarwood City office has several very competent audit and tax managers to assist in the administration of client
engagements and to train junior staff members. Stuart Harrison, Paula White, Tom Fitch, and Sue Tracey are very experienced and
knowledgeable managers and have great relationships with the partners and the staff. Stuart is a tax manager and Paula, Tom, and Sue handle the
audit, review, and compilation work. The partners are currently looking to hire at least two more capable managers since everyone is stretched
thin. Grumbles would really like to find someone who is experienced at selling non-audit financial services. An organization chart depicting the
hierarchy for the firm is shown in Figure 1. You should access Data File 5-2 in iLearn for Figure 1, which shows JKNs organization chart.
The Client
Riverside Communications Company (hereafter, RCC) commenced business operations in 1925 as a local exchange telephone service provider in
the southwestern part of the state. In 1958, RCC conducted its initial public offering (IPO), and many local residents in its service area became
shareholders. Later, in 1980, a second public offering was conducted, and subsequently the RCC common stock was listed on NASDAQ. The
primary business of RCC still consists of local exchange (or wireline services) to customers in the southwestern part of the state. However, over
the past ten years, RCC has significantly expanded its local territory. Furthermore, passage of the Telecommunications Act of 1996 (targeted at
increasing competition in the industry) encouraged RCC to increase its coverage area and the services offered to its customers.
Through its various wholly owned subsidiaries and nonconsolidated equity investees, RCC provides the following services: local
telephone service (wireline), cellular and paging communications services (wireless), cable television services, telecommunications equipment
sales, leasing of a fiber-optic cable network and tower space, financing services, and directory assistance services. RCC has a history of
successful operations and has a long history of paying dividends. Financial information for the past five years is presented in Table 1. You
should access Data File 5-2 in iLearn for Table 1, which shows recent financial results for Riverside Communications Company. During
that period, revenues have increased due to RCCs continued growth into new lines of business; at the same time, net income has declined mainly
because of investments required for the startup of these new lines of business.
Key personnel of RCC are as follows:
Warren England, Chief Executive Officer (CEO): Warren is a CPA and has been with RCC for 20 years. He started working at RCC as the Chief
Financial Officer (CFO) after spending 13 years in a national public accounting firm, the last three as a partner.
Larry Cashman, CFO: Larry has an M.B.A. and was hired as the CFO ten years ago. At the time he was hired at RCC, he has over 20 years of
experience as either a controller or a CFO for public companies in other industries.
Greg Lowman , Controller: Greg is a CPA and was hired five years ago from JKN after serving as the audit senior on the account for four years.
Additional information and firm characteristics of RCC may be found in Table 2. You should access Data File 5-2 in iLearn for Table 2, which
shows firm characteristics and selected data for Riverside Communications Company.
History of the Audit-Client Relationship
JKN has been serving the audit and tax needs of RCC since the 1950s when the firm assisted the Company with its IPO. The relationship between
JKN and RCC has been very good over the years. Because of its good reputation in the community and because of the prestige of performing
audit and tax services for this client, JKN has been able to attract other sizable clients, including three other small public companies. One of these
public clients is also a telecommunications company with lines of business similar to RCC. There are no other significant telecommunications
company clients in any office of the firm. Frank Clement has been handling the audit partner responsibilities on RCC for each of the three years,
ending December 31, 2004. Tom Fitch has just completed his second year as the engagement manager.
Total fees from RCC have averaged approximately $250,000 per year for the past three years under a fixedfee arrangement for the
annual and quarterly audit and tax services, exclusive of services required in connection with the attestation reporting on internal controls
beginning in 2004, as required by Section 404 of the Sarbanes-Oxley Act and for which an additional $75,000 was billed. The total RCC fees
represent approximately 4 percent of total fees for the Briarwood City office of JKN, placing RCC in the top five of all clients based on total fees
billed and collected.
Occasionally, Larry Cashman will call with questions about how to handle the accounting entries and reporting for non-routine or
unusual transactions. In these special situations, Frank Clement often consults with Michael Bryan from the headquarters office, who has
performed the concurring review of the RCC audit for the past three years. When Frank submits a bill to the audit committee for these extra
services, a minor argument or negotiation often takes place between Frank and Larry regarding the size of the bill. Larry argues that these
consultations should be covered in the fixed-fee audit as defined in their engagement letter with JKN.
Since RCC has a calendar year, the audit takes place during JKNs busy season (January and February). Although the firm prefers not
to accept work for less than standard rates during this period, an exception is made for this client, whose fees average only 80 percent of standard
rates. One of the main reasons for this exception is that the senior members of the RCC management team are very crafty negotiators. Warren
England and Larry Cashman both realize that RCC is an important client to JKN. Warren, having been a partner in a public accounting firm,
knows how to play the game. Therefore, because of the significant fee and the prestige of having this client, JKN makes an exception to its usual
policy of demanding full rates for busy season work. Staff members enjoy working on this audit even though the timetable for fieldwork is tight
and the hours are long. Working on this engagement presents a great opportunity to learn and the audit is clean because of good internal controls
and the competent management and accounting staff of RCC.
The audit is always on time with no material audit adjustments ever required. Client personnel prepare the annual report to
stockholders and the Form 10-K for filing with the SEC; the JKN staff has no problems with the adequacy or format of disclosures, or referencing
the financial information in their workpapers. A management letter (i.e., a clients advisory comments letter) is prepared each year with
suggestions for improvements in internal controls or for more efficient methods of handling operations. However, no material weakness on
internal controls has ever been reported to management or to the audit committee of the board of directors pursuant to Statement on Auditing
Standards No. 112 (AU 325) Communication of Internal Control Related Matters Identified in an Audit . In addition, the attestation report on
managements assessment of internal controls in 2004, as required by Section 404 of the Sarbanes-Oxley Act, was unqualified.
Frank Clement and Tom Fitch meet with the audit committee twice each year, once before the audit to obtain their input and to discuss
the audit plan, and once after completion of the fieldwork to discuss the audit findings and the clients advisory comments letter. Larry Cashman
and Warren England are especially sensitive to the matters mentioned in the clients advisory comments letter and always insist that they see the
letter before the audit committee meeting. Frank and Tom have no problem with that procedure because they want to be sure that the facts are
correct and that their staff has reported everything correctly. However, sometimes these discussions are difficult. Larry and Warren sometimes
object to certain information in the letter, claiming that the information is not significant enough to be communicated to the audit committee of
the board of directors.
Growth Strategy for RCC
It is now Spring 2005, and Frank Clement is presented with a series of transactions contemplated by Larry and Warren. RCCs management is
eager to grow the company into one of the leading providers of wireless communications and Internet services in the North-west. The overall
economy and the stock market have been performing well for the past three years, and RCC stock has been trading at all-time highs, ranging from
$75-$80 per share. Senior management and the board of directors have already met with officials from the investment banking division of Morton
Stosch (hereafter, MS), a very large Wall Street securities firm, and with Whipple Killjoy (hereafter, WK), a large private equity firm from San
Francisco, both of which appear to be excited to be part of an arrangement to grow RCC. The transactions contemplated involve, among other
things, a series of mergers and acquisitions to be financed by various public and private debt and equity offerings. Briefly summarized, these
transactions include:
1. Issue high-yield debt of $550 million. $275 million will be loaned by WK, and the remaining $275 million will be underwritten by MS in a
public offering.
2. Issue $250 million convertible preferred stock. All of this stock will be issued to MS and to WK. In three years, the preferred stock will be
convertible into common stock, and a secondary public offering will likely take place at that time so that the current financiers will be able to
liquidate their investment.
3. Dispose of the directory assistance business for $68 million. Although this business is profitable, it does not fit into the strategic plan as a core
service. RCC has a company that is interested in buying the directory assistance business.
4. Acquire FirstCo, a wireless digital communications company, for $650 million. Since the service area is only about 150 miles from RCC, it
seems to fit with the strategy of expanding the companys wireless footprint. This acquisition will also add 300 employees.
5. Acquire the remaining minority interests in two wireless unconsolidated subsidiaries for $75 million. Currently, RCC is a 25 percent
shareholder in each company and carries these as equity investments. Seven other telecommunications companies own the remaining 75 percent,
with no one company owning more than 15 percent. The plan is to buy out the other seven shareholders.
6. Merge with A&D Telecommunications Company, A&D is a company that is very similar to RCC, but is only about 30 percent of the size of
RCC, based on total revenues. A&D is privately owned by approximately 100 shareholders, mostly members of the Manley family, with Christ
Manley as its CEO. The merger plan is to exchange 40 shares of RCC for each share of A&D. As added inducement for pushing this merger to
the A&D shareholders, RCC is promising to make Chris Manley the Chief Operating Officer (COO) of RCC and to grant him a cash bonus of
$1.2 million if the transaction is approved.
7. Buildout the wireless system. This process requires the purchase of licenses and equipment, as well as the construction of towers.
Warren and Larry explain that RCC is especially ready to take advantage of these ripe times in the telecommunications industry.
The accounting department has assembled projections covering the next five years and, although large losses (as much as $90 million in one year)
are projected in the years 2006-2010, the company expects a profit and positive cash flows in 2010. Borrowings will be sufficient to create cash
reserves in the early periods to meet debt requirements.
Frank Clement sees this project as a tremendous opportunity for the Briarwood office, although it will involve some very difficult
accounting and reporting issues that will include filing several registration statements with the SEC. He will surely need the assistance of Michael
Bryan from the headquarters office. Luckily, most of the immediate work will take place in the summer, which is usually slow; however, this
work might also require individuals to postpone planned vacations. The fees from this type of high-risk work will be billed at premium rates, and
they will provide an opportunity to make up for all those years at 80 percent of standard rates. Therefore, this work for RCC should contribute to
great financial results in 2005 for the Briarwood City office.
The other two partners in the Briarwood office, Andy Stevens and Bernie Richards, are also excited about the opportunity. Mark
Grumbles is delighted. He has been pressuring Frank to sell some of JKNs value-added services, such as wealth management, to the RCC
executives and board members. Grumbles comments that after these transactions take place RCC should be a prime candidate for the firm to
provide other non-audit services. This situation should also help the Briarwood office attract more audit clients.
Part 1
The Project
The next few months are very busy for Frank, Tom, and several JKN staff people assigned to the project. Feelings in the office are mixed about
the impact of RCC. Everyone wants to be in a successful environment, but not everyone is willing to be challenged by such a large project that
involves overtime hours and postponing vacations. Frank and Tom work very well together and are very keen about the success of this project. In
fact, they want to exceed RCCs expectations.
The project involves many meetings with the executive team from RCC and the underwriters from MS and WK, along with the
professional who represent their interests. Several meetings are held at the MS offices in San Francisco. Since MS is accustomed to working with
very large national accounting firms, they are somewhat skeptical of JKN. However, since JKN has been the independent auditor for RCC during
the years to be reported in the offering statements, no changes are feasible. Nevertheless, MS hires specialists from the mergers and acquisitions
group of a national firm to monitor JKNs work. These specialists are expected to be heavily involved in the preparation of the pro forma
financial information that will be included in the registration statements to be filed with the SEC as part of the planned transactions.
Frank and Tom are challenged like they never have been before. Not only are they involved with the RCC project, but they are also
maintaining other client responsibilities, including a fraud investigation concerning another client with international operations that will require
several trips to Asia in the coming months. Frank and Tom find themselves working weekends and nights and are frequently out of town at
meetings.
Some tricky audit and accounting issues come up for the RCC project, such as business combinations, accounting for intangible assets,
asset impairments, early debt extinguishment, revenue recognition, accounting for derivatives, and issuance of comfort letters to underwriters.
Additionally, Frank and Tom discover that the financial statements of A&D must be restated because of errors in previous years that were not
133
134
detected by the local CPA firm. Nevertheless, they receive help from Michael Bryan when needed, and they get through the project. During the
period from May to November of 2005, RCC files ten Form 8-Ks, a Form S-3, a Form S-4, and two Form 10-Qs with the SEC. All of these steps
require the involvement of JKN. Total billings for the project were approximately $1.2 million, an average of 110 percent of standard rates
because firm policy is to bill high-risk SEC work at a premium.
Tom comments that he got more public company experience during this six-month period than he had in the entire eight years of his
career prior to that time. Frank told the other partners in Briarwood City how lucky he was to have Tom on the project, because Tom really
demonstrated his technical talent while gaining the respect of the other outside professionals on the project. Apparently, Larry Cashman and Greg
Lowman felt the same way. On one occasion during a meeting at RCC, they hinted very strongly to Tom that they would certainly enjoy having
someone with his skills on their team.
Required
1. As the project unfolds, you can see that the client relationship between RCC and JKN is changing in a number of ways. Identify these changes
in the auditor-client relationship and explain what might be Frank Clements concerns for JKN in the next 12-18 months with respect to the RCC
audit? Use the following format to answer:
JKN (Auditor) Client (RCC) Relationship
1. The outside specialists hired by MS on behalf of
RCC.
2. Restatement of the A&Ds financial statements.
3. Billing of the project at 110 percent of standard
rates.
4. Impact of Section 206 of the Sarbanes-Oxley
Act if Tom decided to pursue the invitation to
take a position on the RCC management team.
Frank Clements Concerns in the Next 12-18 months
Part 2
Year-End Audit
In November 2005, when it came time to plan the year-end audit, Larry Cashman asked Frank and Tom to prepare a fee estimate, knowing that
the audit would take on a new dimension because of the recent transactions. Larry also told Frank that RCC would seek proposals from several
national accounting firms.
Frank had already given RCCs expansion some thought, and realized that JKN would probably have to compete with the national
firms for continued business with RCC. However, Frank also had other business concerns. For example, there was the impact of the client on
office attitude and morale. Now, RCC would be the largest and most complex client for the Briarwood City office. No longer would fees
averaging 80 percent of standard rates. Some staff would rather not be involved in such a complex pressure situation. On the other hand, more
ambitious staff would be disappointed if they could not participate in such an important assignment.
Finally, after discussions with Mark Grumbles, Stevens, and Richards, Frank quotes a fee of $750,000 for the 2005 audit and tax
work, including $200,000 applicable to the attestation report on internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002.
Frank and Tom estimate that this fee will result in 100 percent of standard rates, but they cannot be as sure of themselves as in the past because of
the uncertainty about how the new RCC will function. The proposal is sent to the RCC audit committee; very soon thereafter, Larry calls Frank
and tells him to reduce the quote. Frank agrees to reduce the quote to $700,000, but no more. He believes that 93 percent of standard rates will
still be acceptable, assuming an accurate estimate.
After all the fee quotes are in, which includes JKN and two of the national firms, Frank receives a call from Warren England, the CEO
at RCC, who mentions that he would really like to see JKN continue as auditors, but explains the pressure from the new investors, who have a
representative on the audit committee. Warren also says the JKN quote is substantially higher than the competitors quotes and wants to know if
this quote really reflects bottom-line pricing. Frank is sure that the larger firms are attempting to buy the business, but he also realizes that they
have substantially greater resources and are in a better position to negotiate. Nevertheless, he agrees to reduce the estimate once more, this time to
$650,000.
Required
2 a. Identify some JKNs engagement risks based on the information regarding the Briarwood City office and the history of the audit client
relationship with RCC. Engagement risk is the risk that JKN will suffer harm because of a client relationship, even though the audit report issued
to the client was correct.
2 b. Identify some risk factors associated with RCCs growth strategy
2 c. With respect to the identified JKNs engagement risks in 2 a. and the identified risk factors associated with RCCs growth strategy in 2 b.,
explain any concerns you have regarding the following issues:
1. JKNs willingness to negotiate its fee estimate to RCC.
2. JKNs ability to successfully complete the year-end audit for RCC.
3. JKNs ability to continue with this client.
Use the following format to answer:
Issues
1. JKNs willingness to negotiate its fee estimate to
RCC.
2. JKNs ability to successfully complete the yearend audit for RCC.
3. JKNs ability to continue with this client.
Explain any Concern You Have
In your response, refer to Chapter 3 for a discussion on relevant professional ethics, for example, Rule 101 on independence of the AICPAs
Code of Professional Conduct and the PCOABs Auditor Independence Rules.
Note: You must answer both Parts 1 and 2 to earn the extra credit point.
135
136
Chapter 6
Audit Plan - Objectives
LO6-1 Distinguish between overall audit objective and specific audit objectives.
LO6-2 Explain the auditors responsibility to detect and report errors and fraud.
LO6-3 Identify the fraud risk factors (the Fraud Triangle) relating to fraudulent
financial reporting and misappropriation of assets.
LO6-4 Explain the auditors responsibility to detect and report illegal acts.
LO6-5 Discuss specific audit objectives.
LO6-6 Understand the relationships among the five basic categories of management
assertions, the eight categories of specific audit objectives, and the three aspects
of information reflected in the financial statements.
137
138
Chapter 6 Audit Plan Objectives

In conducting either a financial audit or an integrated audit, the auditor accomplishes two categories of audit
objectives: an overall audit objective and specific audit objectives. The overall audit objective relates to the auditors
responsibilities for detecting material misstatements, whereas the specific audit objectives relate to the audit
procedures that the auditor uses to detect material misstatements. Figure 6-1 shows the two categories of audit
objectives
Figure 6-1 Two Categories of Audit Objectives
The Audit Process
Audit Plan
Tests of Controls
Tests of Balance
Audit Report
Preplan and
Documentation CH 5
Objectives CH 6
Financial Audit
Integrated Audit
Evidence CH 7
a. Form an Audit Opinion
1. Overall Audit Objective
b. Detect and Report Errors and
Fraud
c. Detect and Report Illegal Act

2. Specific Audit Objectives
Audit Program CH 10
a. Divide the Financial

Statements into 5 Major
Transaction Cycles
b. Identify 5 Basic Categories of
Management Assertions
within each Transaction Cycle
c. Map the 5 Basic Categories
of Management Assertions
into 8 Types of Specific
Audit Objectives
d. Group the 5 Basic Categories
of Management Assertions
and the 8 Types of Specific
Audit Objectives into 3
Aspects of Information
Reflected in the Financial
Statements
Overall Audit Objective

Form an Audit Opinion
AU 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally
Accepted Auditing Standards states:
The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which
they present fairly, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted
In order to accomplish this overall objective, the auditor is responsible for detecting material misstatements
in the financial statements as AU 200 further states
The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial sta tements are free of
material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is
able to obtain reasonable, but not absolute, assurance that material misstatements are detected.
Detecting Errors and Fraud

AU 240 Consideration of Fraud in a Financial Statement Audit defines misstatements into error and fraud, and
provides expanded guidance on the auditors responsibility for fraud detection (also known as fraud audit). Errors
are unintentional misstatements (e.g., mistakes in journal entries) or omissions in financial statements. Fraud, in
contrast, is intentional fraudulent financial misstatement (e.g., falsification of accounts) or omission in financial
statements, and misappropriation of assets (e.g., theft of inventory). As indicated by the definitions, intent is the
primary difference between an error and a fraud. AU 240 requires the auditor to:
Consider the risk of errors and frauds (also known as fraud risks) in an audit plan.
An auditor should consider the risk that errors or frauds may occur while planning an audit engagement. The auditor
should consider the risk factors at both the financial statement level and at the individual account balance or class of
transactions level. The fraud risk factors relating to fraudulent financial reporting is presented in Table 6-1. The
fraud risk factors relating to misappropriation of assets is presented in Table 6-2. For each of these two types of
fraud, the fraud risk factors are further classified based on three characteristics generally present for fraud to occur:
1. Incentives/Pressures Management or other employees have incentives or pressures to commit fraud.
2. Opportunities Circumstances provide opportunities for management or employees to commit fraud.
3. Attitudes/Rationalization An attitude, character, or set of ethical values exist that allow management or
employees to commit a dishonest act or they are in an environment that causes them to rationalize committing a
dishonest act. These three conditions are often referred to as the Fraud Triangle.
The auditor should also consider the risks of material misstatement due to three common fraud conditions
throughout the audit. These common fraud conditions may be identified during fieldwork that change or support a
judgment regarding the assessment of the fraud risks. Table 6-3 presents examples of the three common fraud
conditions that the auditor should consider throughout the audit.
Increase emphasis on professional skepticism.
Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence.
Putting aside any prior beliefs as to management's honesty, members of the audit team must exchange ideas or
brainstorm how frauds could occur. These discussions are intended to identify fraud risks and should be conducted
while keeping in mind the characteristics that are present when frauds occur: incentives, opportunities, and ability to
rationalize. Throughout the audit, the engagement team should think about and explore the question, "If someone
wanted to perpetrate a fraud, how would it be done?" From these discussions, the engagement team should be in a
better position to design audit tests responsive to the risks of fraud.
Discuss fraud with management.
The engagement team is expected to inquire of management and others in the organization as to the risk of fraud and
whether they are aware of any frauds. The auditors should make a point of talking to employees in and outside
management. Giving employees and others the opportunity to "blow the whistle" may encourage someone to step
forward. It might also help deter others from committing fraud if they are concerned that a co-worker will turn them
in.
Perform unpredictable audit test.
139
140
During an audit, the engagement team should test areas, locations and accounts that otherwise might not be tested.
The team should design tests that would be unpredictable and unexpected by the client.
Respond to management override of controls.
Because management is often in a position to override controls in order to commit financial-statement fraud, the
standard includes procedures to test for management override of controls on every audit. Three fraud testing
procedures that the auditor must perform in every audit are briefly described in Table 6-4.
AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate
fraud audit into the audit of financial statements. Typically, this 10-step fraud audit is to be integrated as an ongoing
audit process throughout the audit of financial statements as follows:
1. Understand the nature of fraud and the manner in which fraud may be committed at the audit preplan.
2. Develop and maintain professional skepticism throughout the audit process.
3. Brainstorm and share knowledge of fraud with other audit team members at the audit preplan and throughout the
audit process.
4. Obtain information useful in identifying and assessing fraud risks at the audit plan.
5. Identify specific fraud risk factors at the audit plan (see Table 6-1 and Table 6-2).
6. Evaluate the effectiveness of clients internal control against the specific fraud risk factors at the audit plan and
tests of controls (TOC).
7. Perform and adjust audit procedures relating to the specific fraud risk factors at the tests of controls (TOC) and
tests of balances (TOB) (see Table 6-4).
8. Evaluate evidence and consider common fraud conditions and determine whether fraud specialists are needed to
complete the fraud audit at the completing the audit (CTA) (see Table 6-3).
9. Communicate and report fraud to management, audit committee, and the board of directors at the audit report (see
Table 6-5).
10. Document Step 1 through to Step 10 above throughout the audit process.
Finally, it should be noted that AU 240 states that even a properly planned and performed audit may not
detect a material misstatement resulting from fraud because of 1. The concealment aspect of fraudulent activity such
as fraud often involves collusion or falsified documents and 2. The need to apply professional judgment in the
identification of evaluation of fraud risk factors and other conditions.
Table 6-1 Fraud Risk Factors Relating to Misstatement Arising from Fraudulent Financial Reporting
Fraud Risk Factors for Fraudulent Financial Reporting
Incentives/Pressures
(1) Financial stability or profitability is threatened by economic, industry, or client operating conditions, such as:
High degree of competition or market saturation, accompanied by declining margins.
High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates.
Significant decline in customer demand and increasing business failures in either the industry or overall economy.
Operating losses making the treat of bankruptcy, foreclosure, or hostile takeover imminent.
Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and
earnings growth.
Rapid growth or unusual profitability especially compared to that of other companies in the same industry.
New accounting, statutory, or regulatory requirements.
(2) Excessive pressure exists for management to meet the requirements or expectations of third parties due to the following:
Profitability or trend level expectations of investment analysts, institutional investors, significant creditors, or other external parties,
including expectations created by management in, for example, overly optimistic press releases or annual report messages.
Need to obtain additional debt or equity financing to stay competitive including financing of major research and development or capital
expenditures.
Marginal ability to meet exchange listing requirements or debt repayment or other debt covenant requirements.
Perceived or real adverse effects of reporting poor financial results on significant pending transactions, such as business combinations or
contract awards.
(3) Information available indicates that management or the board of directors personal financial situation is threatened by the entitys financial
performance arising from the following:

Significant financial interests in the entity.
Significant portions of their compensation (e.g., bonuses, stock options, and earn-out arrangements) being contingent upon achieving
aggressive targets for stock price, operating results, financial position, or cash flow.
Personal guarantees of debts of the entity.
(4) There is excessive pressure on management or operating personnel to meet financial targets set up by the board of directors or management,
including sales or profitability incentive goals.
Opportunities
(1) The nature of the industry or the clients operations provides opportunities to engage in fraudulent financial reporting that can arise from the
following:
Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm.
A strong financial presence or ability to dominate a certain industry sector that allows the entity to dictate terms or conditions to suppliers
or customers that may result in inappropriate or non-arms length transactions.
Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult
to corroborate.
Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult substance over form
questions.
Significant operations located or conducted across international borders in jurisdictions where differing business environments and
cultures exist.
Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business
justification.
(2) There is ineffective monitoring of management as a result of the following:
Domination of management by a single person or small group without compensating controls.

Ineffective board of directors or audit committee oversight over the financial reporting process and internal control.
(3) There is a complex or unstable organizational structure, as evidenced by the following:
Difficulty in determining the organization or individuals who have controlling interest in the entity.
Overly complex organizational structure involving unusual legal entities or managerial lines of authority.
High turnover of senior management, counsel, or board members.
(4) Internal control components are deficient as a result of the following:

Inadequate monitoring of controls, including automated controls and controls over interim financial reporting.
High turnover rates or employment of ineffective accounting, internal audit, or information technology staff.
Ineffective accounting and information systems, including situations involving material weaknesses.
Attitudes/Rationalizations
Risk factors reflective of attitudes/rationalizations by board members, management, or employees that allow them to engage in and/or justify
fraudulent financial reporting may not be susceptible to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence
of such information should consider it in identifying the risks of material misstatement arising from fraudulent financial reporting. For example,
auditors may become aware of the following information that may indicate a risk factor:
Ineffective communication, implementation, support, or enforcement of the clients values or ethical standards by management or the
communication of inappropriate values or ethical standards.
Nonfinancial managements excessive participation in or preoccupation with the selection of accounting principles or the determination
of significant estimates.
Known history of violations of securities laws or other laws and regulations, or claims against the client, its senior management, or board
members alleging fraud or violations of laws and regulations.
Excessive interest by management in maintaining or increasing the entitys stock price or earnings trend.
A practice by management of committing to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts.
Management failing to correct known material weaknesses on a timely basis.
An interest by management in employing inappropriate means to minimize reported earnings for tax-motivated reasons.
Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality.
141
142

The relationship between management and the current or predecessor auditor is strained, as exhibited by the following:
(1) Frequent disputes with the current or predecessor auditor on accounting, auditing, or reporting matters.
(2) Unreasonable demands on the auditor, such as unreasonable time constraints regarding the completion of the audit or the issuance of
the auditors report.
(3) Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate
effectively with the board of directors or audit committee.
(4) Domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditors
work or the selection or continuance of personnel assigned to or consulted on the audit engagement.
Source: AU 240
Table 6-2 Fraud Risk Factors Relating to Misstatements Arising from Misappropriation of Assets
Fraud Risk Factors for Misappropriation of Assets
Incentives/Pressures
(1) Personal financial obligations may create pressure on management or employees with access to cash or other assets susceptible to theft to
misappropriate those assets.
(2) Adverse relationships between the entity and employees with access to cash or other assets susceptible to theft may motivate those employees
to misappropriate those assets. For example, adverse relationships may be created by the following:
Known or anticipated future employee layoffs.

Recent or anticipated changes to employee compensation or benefit plans.
Promotions, compensation, or other rewards inconsistent with expectations.
Opportunities
(1) Certain characteristics or circumstances may increase the susceptibility of assets to misappropriation. For example, opportunities to
misappropriate assets increase when there are the following:
Large amounts of cash on hand or processed.

Inventory items that are small in size, of high value, or in high demand.
Easily convertible assets, such as bearer bonds, diamonds, or computer chips.
Fixed assets that are small in size, marketable, or lacking observable identification of ownership.
(2) Inadequate internal control over assets may increase the susceptibility of misappropriation over those assets. For example, misappropriation
of assets may occur because there is the following:
Inadequate segregation of duties or independent checks.
Inadequate management oversight of employees responsible for assets, for example, inadequate supervision or monitoring of remote
locations.
Inadequate job applicant screening of employees with access to assets.

Inadequate record keeping with respect to assets.
Inadequate system of authorization and approval of transactions, for example, in purchasing.
Inadequate physical safeguards over cash, investments, inventory, or fixed assets.
Lack of complete and timely reconciliations of assets.
Lack of timely and appropriate documentation of transactions, for example, credits for merchandise returns.
Lack of mandatory vacations for employees performing key control functions.
Inadequate management understanding of information technology, which enables information technology employees to perpetrate a
misappropriation.
Inadequate access of controls over automated records, including controls over and review of computer systems event logs.
Attitudes/Rationalizations
Risk factors reflective of employee attitudes/rationalizations that allow them to justify misappropriations of assets, are generally not susceptible
to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence of such information should consider it in identifying
the risks of material misstatement arising from misappropriation of assets. For example, auditors may become aware of the following attitudes or
behavior of employees who have access to assets susceptible to misappropriation:
Disregard for the need for monitoring or reducing risks related to misappropriations of assets.
Disregard for internal control over misappropriation of assets by overriding existing controls or by failing to correct known internal
Fraud Risk Factors for Misappropriation of Assets
control deficiencies.
Behavior indicating displeasure or dissatisfaction with the company or its treatment of the employee.
Changes in behavior or lifestyle that may indicate assets have been misappropriated.
Source: AU 240
Table 6-3 Examples of the Three Common Fraud Conditions the Auditor Should Consider Throughout the
Audit
Common Fraud Conditions
Discrepancies in the accounting

records.
Conflicting or missing evidential

matter.
Problematic
or
unusual
relationships between the auditor and
management.
Examples
(1) Transactions that are not recorded in a complete or timely manner.
(2) Transactions that are improperly recorded as to amount, accounting period, or classification.
(3) Unsupported or unauthorized balances or transactions.
(4) Last-minute adjustments that significantly affect financial results.
(5) Evidence of employees access to systems and records inconsistent with their authorized duties.
(6) Tips or complaints to the auditor about alleged fraud.
(1) Missing documents.
(2) Documents that appear to have been altered.
(3) Photocopied or electronically transmitted documents when original documents are expected.
(4) Significant unexplained items on reconciliations.
(5) Inconsistent, vague, or implausible responses from management or employee to inquiries.
(6) Unusual discrepancies between the clients records and confirmation replies.
(7) Missing inventory or physical assets of significant magnitude.
(8) Unavailable or missing electronic evidence inconsistent with the record retention policies.
(9) No record of key systems development, program changes, and implementations.
(1) Denial of access to records, facilities, certain employees, customers, vendors, or others.
(2) Undue time pressure imposed by management to resolve complex or contentious issues.
(3) Complaints by management about the conduct of the audit.
(4) Management intimidation of audit team members in resolution of disagreements.
(5) Unusual delays by the management in providing requested information.
(6) Unwillingness to facilitate auditors testing using computer-assisted audit techniques (CAATs).
(7) Denial of access to key IT operations staff and facilities.
(8) Unwillingness to add or revise disclosures in the financial statements.
Table 6-4 Three Fraud Testing Procedures the Auditor Must Perform to Test for Management Override of
Controls on Every Audit
Procedure
Examine journal entries and other

adjustments for evidence of possible
misstatements due to fraud.
Review accounting estimates for

biases that could result in material
misstatement due to fraud.
Evaluate the business rationale for

significant unusual transactions.
Brief Description
Fraud often involves the recording of inappropriate or unauthorized journal entries even when
there are effective internal controls in place. The auditor is required to:
(1) Obtain an understanding of the clients financial reporting process and the controls over journal
entries and other adjustments.
(2) Identify and select journal entries and other adjustments for testing.
(3) Determining the timing of the testing.
(4) Inquire of individuals involved in the financial reporting process about inappropriate or
unusual activity in processing journal entries and other adjustments.
Fraudulent financial reporting is often accomplished through intentional misstatement of
accounting estimates. The auditor is required to:
(1) Consider the potential for management bias when reviewing current year estimates.
(2) Perform a retrospective review of prior year estimates to identify any changes in the
managements judgments and assumptions that might indicate a potential bias.
(3) Evaluate whether circumstances producing bias estimates represent a risk of a material
misstatement due to fraud.
The auditor should gain an understanding of the clients rational for significant unusual
transactions that suggest fraudulent financial reporting or misappropriation of assets. The auditor is
required to consider whether:
(1) The form of such transactions is overly complex.
(2) Management has discussed the nature of and accounting for such transactions with the audit
committee.
(3) Management is placing more emphasis on the need for a particular accounting treatment (i.e.,
its form) than on the underlying economics of the transaction (i.e., its substance).
(4) Transactions that involve unconsolidated related parties, including special purpose entities,
have been properly reviewed and approved by the audit committee.
(5) Transactions involve previously unidentified related parties that do not have the substance or
the financial strength without assistance from the client.
143
144
Reporting Errors and Fraud

Errors detected by the auditor should be corrected through journal entries, whereas frauds detected by the auditor, in
contrast, should be handled as shown in Table 6-5.
Table 6-5 Auditor's Reporting of Fraud
Condition
(1) The auditor determines that
has no material effect on the
statements.
(2) The auditor determines that
has material effect on the
statements.
Reporting Requirement
the fraud
financial
the fraud
financial
(3) The auditor is precluded

investigating the effect of the fraud.
from
The auditor should:

(a) Refer the fraud to a level of management that is at least one level above those involved.
(b) Be satisfied that the fraud has no implications for other parts of the audit.
The auditor should:
(a) Insist that the financial statements be revised. If management agrees, should issue an
unqualified opinion. If management refuses, should issue a qualified or an adverse opinion.
(b) Report the fraud to the board of directors or the audit committee.
The auditor should:
(a) Issue a qualified opinion or disclaimer on the basis of a scope limitation.
(b) Report the matter to the board of directors or the audit committee
Detecting Illegal Acts

An auditor's professional responsibility to illegal acts by clients first surfaced in the late 1970s, after Congress
passed the Foreign Corrupt Practices Act of 1977. This Act requires public companies to refrain from making bribes
to foreign governments and to maintain adequate internal control to prevent bribes from occurring. Arguing that
auditors generally lack the expertise in detecting illegal acts, the AICPA issued AU 328 Illegal Acts by Clients,
which stated that the auditors have no responsibility for detecting illegal acts committed by their clients. They are
only responsible for reporting suspected illegal acts to the appropriate authorities of their clients.
In 1988, the AICPA issued AU 317 Illegal Acts by Clients, which superseded AU 328. AU 317 defines
illegal acts by clients as violations of laws or governmental regulations. It also expands and clarifies an auditors
responsibility to illegal acts by clients. Recently, under the Auditing Standards Boards Clarity Project, this
standard is now known as AU 250 Considerations of Laws and Regulations in an Audit of Financial Statements ,
which requires the auditor to detect two different types of illegal acts committed by clients:
1. Illegal acts with direct effects on the financial statements.
These are material illegal acts relating to laws and governmental regulations that have a direct effect on the financial
statements, for example, whether a provision for income taxes has been properly reflected in the financial statements
in conformity with the IRS. Here, the auditor has the responsibility to design the audit to provide reasonable
assurance of detecting such illegal acts. In other words, the responsibility to detect illegal acts that have a direct
effect on the financial statements is the same as the responsibility to detect errors and frauds.
2. Illegal acts with indirect effects on the financial statements.
These are material illegal acts relating to laws and governmental regulations that have only an indirect effect on the
financial statements, for example, activities that violate regulations under the Food and Drug Administration (FDA),
environmental protection agencies and equal employment opportunity agencies. These activities should be accrued
or disclosed as contingent liability in the financial statements. However, the auditor may not be aware of such illegal
acts unless s/he is informed about them. An example is insider trading. While the direct effects of the purchase or
sale of securities may be disclosed, their indirect effect, the possible contingent liability for violating securities laws,
may not be disclosed. If the auditor is informed or aware of illegal acts that indirectly affect the financial statements,
s/he has the responsibility to apply audit procedures specifically directed to ascertaining the probability of such
illegal acts as follows:
When there is no suspicion (no probability) of illegal acts.
The auditor should inquire of management concerning: 1. the client's compliance with laws and regulations, 2. the
client's policies that may prevent illegal acts, and 3. directives issued by the client and periodic representations
obtained by the client concerning compliance with laws and regulations. The auditor should also request a written
representation from the client's management (also known as a client's representation letter) stating that no violation
or possible violation of laws or regulations has occurred that need to be disclosed or accrued (i.e., provision for
contingency).
When there is suspicion (probability) of illegal acts.

The auditor should 1. Inquire of management at a level above the persons involved to obtain information on the
nature of the acts and the circumstances surrounding the acts. 2. Consult with the client's legal counsel or other
specialists about applications of law and possible effects of the act on the financial statements. 3. Perform additional
audit procedures as necessary to obtain a further understanding of the nature of the acts such as a. Examine
supporting documentation and compare with accounting records, b. Confirm information with third parties, c.
determine if the transaction has been properly authorized, and d. Consider whether similar transactions have
occurred and perform procedures to identify them.
Finally, it should be noted that AU 250 requires the auditor to provide reasonable assurance that direct
effect illegal acts are detected (the same reasonable assurance that error and frauds are detected), but it has no such
requirement for indirect effect illegal acts.
Reporting Illegal Acts
The auditor is responsible to communicate and report illegal acts as follows:
Communication
The auditor should inform the audit committee or any other group inside the client having equivalent authority about
the illegal acts. The communication may be oral or written. If oral, the auditor should document it. Moreover, if it
is necessary to disclose the illegal acts to outside parties such as the SEC, a successor auditor or a subpoena issued
by a court, the auditor should seek legal advice.
Reporting
The auditor must report illegal acts by clients whether the illegal acts have material direct or indirect effects on the
clients' financial statements. The reporting requirements are as shown in Table 6-4 below:
TABLE 6-4 Auditors' Reporting of Illegal Acts
Illegal Acts
(1) Material illegal acts are not accrued for or disclosed by the client.
(2) The auditor is prevented by the client from obtaining sufficient appropriate evidence
concerning the illegal acts.
(3) The auditor is not prevented by the client but is unable to obtain sufficient
appropriate evidence concerning the illegal acts.
(4) The client refuses to accept the qualified, adverse, or disclaimer opinion issued by
the auditor concerning the illegal acts.
Reporting Requirement
Issue a qualified or an adverse opinion depending on
the extent of materiality.
Issue a disclaimer opinion.
Issue a qualified opinion.
Contact the audit committee
withdrawing from the engagement.
and
consider
Specific Audit Objectives

In conducting either a financial audit or an integrated audit, the auditor accomplishes specific audit objectives in
four distinctive steps:
1. Divide the financial statements into five major transaction cycles.
2. Identify five basic categories of management assertions within each transaction cycle.
3. Map the five basic categories of management assertions into eight specific audit objectives.
4. Groups the five basic categories of management assertions and the eight specific audit objectives into three
aspects of information reflected in the financial statements.
Divide the Financial Statements into Five Major Transaction Cycles
In a typical financial statement audit, a client's financial statements are divided into smaller segments. The division
makes the audit more manageable and facilitates the assignment of members of the audit team to each segment. A
conventional way to segment the financial statements is to keep closely related types of transactions and account
balances in the same segment, also known as the Transaction Cycle Approach. An example of the transaction cycles
approach is to group related class of transactions, such as sales and sales returns, and account balances, such as
accounts receivable and cash in bank, in the trial balance to a revenue cycle.
A client's financial statements are usually divided into the following five interrelated transaction cycles:
145
146
1. Capital cycle. A client begins by obtaining capital, usually in the form of cash which links the capital cycle to the
general cash.
2. Expenditure cycle. Cash is used to purchase raw materials to produce goods and services which link the general
cash to the expenditure cycle.
3. Payroll cycle. Cash is also used to hire labor and administrative personnel which link the general cash to the
payroll cycle.
4. Inventory cycle. The combined output of the expenditure and payroll cycles is the input to the inventory cycle.
The inventory is subsequently sold and the billings and collection activities link the inventory cycle to the revenue
cycle.
5. Revenue cycle. The cash generated in the revenue cycle is used to pay dividends and interest in the capital cycle
and to restart the cycles again.
General cash and investments are usually not stand alone transaction cycles. They are usually audited as
part of the above five transaction cycles.
Identify Five Basic Categories of Management Assertions within each Transaction Cycle
Assertions are explicit and implicit representations by management that are embodied in financial statements. Much
of an auditor's work during a financial audit or an integrated audit is to attest these financial statement assertions
made by the management. AU 500 Audit Evidence and AS 15 Audit Evidence identify five basic categories of
implicit or explicit assertions made by the management:
1. Existence or Occurrence. Implicit or explicit assertion made by the management that asset and liability balances
stated in the balance sheet actually exist at the balance sheet date and that revenue and expense transactions stated in
the income statement actually occurred during the accounting period. For example, management asserts that
inventories in the balance sheet actually exist at balance date and that sales in the income statement actually
occurred during the accounting period.
2. Completeness. Implicit or explicit assertion made by the management that all accounting transactions and
balances that should have been recorded in the financial statements have been recorded. For example, management
asserts that there are no unrecorded inventories and that all sales occurred are included in the income statement.
3. Rights and Obligations. Implicit or explicit assertion made by the management that assets stated in the financial
statements are actually owned by the client and liabilities stated in the financial statements are actually owed by the
client. For example, management asserts that inventories are owned by the company and that accounts payable are
owed to other parties.
4. Valuation and Allocation. Implicit or explicit assertion made by the management that asset and liability balances
stated in the balance sheet, and revenue and expenses transactions stated in the income statement have all been
recorded in the financial statement at the appropriate amount. For example, management asserts that inventories are
valued at the lower of cost or market and that depreciation is made to plant and equipment in the appropriate
amount.
5. Presentation and Disclosure. Implicit or explicit assertion made by the management that all components of the
financial statements are properly classified, described, and disclosed in conformity with GAAP. For example,
management asserts that amounts presented as extraordinary items in the income statement are properly classified
and described.
The auditor identifies the above five basic categories of implicit or explicit assertions for each account
within a particular transaction cycle.
Map the Five Basic Categories of Management Assertions into Eight Types of Specific Audit Objectives
The auditor maps the management's assertions that have been identified into specific audit objectives. These specific
audit objectives are almost identical to the management's financial statement assertions because the auditor's work is
to attest these financial statement assertions made by the management. The reasons that specific audit objectives and
management assertions are not identical are management's assertions are not always those of the auditor and the
auditor needs additional guidance (specific audit objectives) in considering the client's internal control and in
accumulating sufficient appropriate evidence required by the Performance category of the AICPAs four
fundamental principles underlying an audit.
The eight types of specific audit objectives are:
1. Validity. The specific objective of verifying that the financial items included in the financial statements should
actually be included.
2. Completeness. The specific objective of verifying that the financial items that should be included in the financial
statements have actually been included.
3. Ownership. The specific objective of verifying that assets included in the financial statements are indeed owned
by the client.
4. Valuation. The specific objective of verifying that financial items included in the financial statements are properly
valued.
5. Classification. The specific objective of verifying that financial items have been properly classified in the
6. Cutoff. The specific objective of verifying that transactions occurring near the balance sheet date have been
recorded in the proper accounting period.
7. Accuracy. The specific objective of verifying that account balances agree with related subsidiary ledger amounts
and the total in the general ledger.
8. Disclosure. The specific objective of verifying that financial items are properly presented in the financial
statements and the related disclosures are clearly expressed.
The five basic categories of management assertions are mapped into the eight types of specific audit
objectives as follows:
Management Assertions
1. Existence or Occurrence
2. Completeness
3. Rights and Obligations
4. Valuation or Allocation
5. Presentation and Disclosure

1. Validity (change to Existence or Occurrence)
2. Completeness
3. Ownership (change to Rights and Obligations)
4. Valuation (change to Valuation and Allocation)
5. Classification
6. Cutoff
7. Accuracy
8. Disclosure (change to Understandability)
Group the Five Basic Categories of Management Assertions and the Eight Types of Specific Audit Objectives
into Three Aspects of Information Reflected in the Financial Statements
In 2006, consistent with international auditing standards (ISAs), AU 500 Audit Evidence groups the five basic
categories of management assertions and the eight types of specific audit objectives into three aspects of information
reflected in the financial statements as follows:
1. Transaction-related information. Assertions (objectives) about classes of transactions and events during the period
under audit.
2. Balance-related information. Assertions (objectives) about account balances at period end.
3. Presentation-related information. Assertions (objectives) about presentation and disclosure.
Under these three aspects of information, the specific audit objectives of validity is now changed to
existence or occurrence; ownership to rights and obligations; valuation to valuation and allocation, and
disclosure to understandability. The eight types of specific audit objectives are now defined as follows:
1. Existence the specific audit objective of verifying that all assets, liabilities, and equity interests included in the
financial statements actually exist at the date of the financial statements.
Occurrence the specific audit objective of verifying that all transactions and events that have been recorded have
occurred, disclosed, and pertain to the client.
2. Completeness the specific audit objective of verifying that all transactions and events, assets, liabilities, and
equity interests that should have been recorded and included in the financial statements have been recorded and
included.
3. Rights and Obligations the specific audit objective of verifying that the client holds or controls the rights to
assets and that liabilities are the obligation of the client.
4. Valuation and Allocation the specific audit objective of verifying that all assets, liabilities, and equity interests
are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments
are recorded appropriately.
5. Classification the specific audit objective of verifying that all transactions and events have been recorded in the
proper accounts and that financial and other information is presented and described appropriately.
6. Cutoff the specific audit objective of verifying that all transactions and events have been recorded in the correct
accounting period.
147
148
7. Accuracy the specific audit objective of verifying that amounts and other data relating to recorded transactions
and events have been recorded appropriately and that financial and other information are disclosed fairly.
8. Understandability the specific audit objective of verifying that financial and other information in disclosures are
expressed clearly.
Table 6-5 describes the five management assertions and the eight specific audit objectives grouped into the
three aspects of information reflected in the financial statements.
Table 6-5 Management Assertions and Specific Audit Objectives Grouped into Three Aspects of Information
Reflected in the Financial Statements
1. Transaction-Related
Information
Assertions (Objectives) about Classes
of Transactions and Events during the
Period under Audit
Occurrence
Transactions and events that have been
recorded have occurred and pertain to the
client.
Completeness
All transactions and events that should
have been recorded have been recorded.
Accuracy
Amounts and other data relating to
recorded transactions and events have
been recorded appropriately.
2. Balance-Related Information
Assertions
(Objectives)
about
Account Balances at Period End
Existence
Assets, liabilities, and equity interests
exist.
Completeness
All assets, liabilities, and equity
interests that should have been recorded
have been recorded.
Valuation and Allocation
Assets, liabilities, and equity interests
are included in the financial statements
at appropriate amounts and any
resulting valuation or allocation
adjustments are recorded appropriately.
Classification
Transactions and events have been
recorded in the proper accounts.
Cutoff
Transactions and events have been
recorded in the correct accounting period.
3. Presentation-Related
Information
Assertions
(Objectives)
about
Presentation and Disclosure
Occurrence
Disclosed events and transactions have
occurred.
Completeness
All disclosures that should have been
included in the financial statements
have been included.
Accuracy and Valuation
Financial and other information are
disclosed fairly and at appropriate
amounts.
Classification and Understandability

Financial and other information is
presented and described appropriately,
and disclosures are expressed clearly.
Rights and Obligations

The client holds or controls the rights to
assets, and liabilities are the obligation
of the client.
An Audit Program for Transaction-, Balance-, and Presentation-Related Information

Following a certain audit test methodology, auditors develop an audit program (to be discussed in Chapter 10) that
contains all the audit procedures they would use to test the three aspects (transaction-, balance-, and presentationrelated) of information reflected in the financial statements. For example, an audit program may prescribe audit
procedures for transaction-related information such as transactions relating to inventory actual occurred (i.e.,
occurrence), that they are completed (i.e., completeness or no valid transactions were left out), that they are
classified properly (i.e., classification, e.g., as an asset rather than an expense), and that they are recorded accurately
(i.e., accuracy) and in the correct period (i.e., cutoff). Similarly, the audit program may prescribe audit procedures
for balance-related information such as inventory represented in the inventory account balance exists (i.e. existence),
the client owns (i.e., rights and obligations) the inventory, that the balance is complete (i.e., completeness), and that
the inventory is properly valued (i.e., valuation and allocation). Finally, the audit program may prescribe audit
procedures for presentation-related information such as the financial statements properly classify and present (i.e.,
classification) the inventory (e.g., inventory is appropriately presented as a current asset on the balance sheet) and
that all required disclosures (i.e., understandability) having to do with inventory (e.g., footnote indicating that the
client uses the LIFO inventory method) are complete (i.e., completeness), accurate (i.e., accuracy), and
understandable (i.e., understandability).
Finally, it should be noted that:

1. Auditors in practice may use different terms to express the management assertions and specified audit objectives
as long as all the three aspects of information (i.e., transaction-, balance, and presentation-related) in Table 6-7 are
addressed by prescribing the appropriate audit procedures.
2. There are overlaps among some of the transaction-related and balance-related information. For example:
a. If some sales were recorded in the current year that should have been recorded in the subsequent year (i.e.
transaction-related cutoff), the related accounts receivable do not exist at the balance sheet date (i.e., balance-related
existence).
b. If some sales that took place in the current year were not recorded until the subsequent year (i.e., transactionrelated cutoff), current year sales and accounts receivable are not complete (i.e., balance-related completeness).
c. If some expenses are inappropriately capitalized (i.e., transaction-related classification), the related expenses are
not complete (i.e. transaction-related completeness) and the related assets for not exist ( i.e., balance-related
existence).
3. Although all balance-related assertions (objectives) apply to nearly every account, not every assertion (objective)
is equally important for each account. Recognizing the assertions (objectives) that deserve the most emphasis
depends on an understanding of the clients business and of the particular type of account being audited. For
example, auditors typically consider the completeness assertion (objective) to be the most important assertion
(objective) for liability accounts for two reasons. First, when all obligations are not properly included in the liability
account, the result is an understatement of liabilities and often an overstatement of net income. Second, management
is more likely to have an incentive to understate a liability than to overstate it.
149
150
6-1
Which of the following statements is true?

a. The auditor is responsible to search for errors and frauds.
b. The auditor is responsible to provide complete assurance of detecting errors and fraud.
c. The auditor is not responsible for detecting errors and frauds.
d. The auditor is responsible to provide reasonable assurance of detecting errors and fraud.
6-2
When an auditor is informed or aware of illegal acts that indirectly affect the client's financial statements, the auditor has the
responsibility to
a. design the audit to provide reasonable assurance of detecting such illegal acts.
b. apply audit procedures specifically directed to ascertaining the probability that such illegal acts have occurred.
c. design the audit to provide complete assurance of detecting such illegal acts.
d. apply specific audit procedures that will ferret out such illegal acts.
6-3
Implicit or explicit assertion made by the management that asset and liability balances stated in the balance sheet actually exist at the
balance sheet date and that revenue and expense transactions stated in the income statement actually occurred during the accounting
period is classified as
a. valuation and allocation assertion.
b. rights and obligation assertion.
c. completeness assertion.
d. existence or occurrence assertion.
6-4
Confirmation of accounts receivable by the auditor is

a. a test of control.
b. a test of transaction.
c. a test of balance.
d. a test of control and transaction.
6-5
Which of the following confirmations is least likely used by an auditor in connection with the tests of balances?
a. Bond trustees on bond payable.
b. Customers on accounts receivable balances.
c. IRS on refundable income taxes.
d. Suppliers on accounts payable balances.
6-6
Which of the following factors is most important concerning an auditors responsibility to detect errors and frauds?
a. The susceptibility of the accounting records to intentional manipulations, alterations, and the misapplication of
b. The probability that unreasonable accounting estimates result from unintentional bias or intentional attempts to misstate
c. The possibility that management fraud, defalcations, and the misappropriation of assets may indicate the existence of
illegal acts.
d. The risk that mistakes, falsifications, and omissions may cause the financial statements to contain material
misstatements.
6-7
An auditor should recognize that the application of auditing procedures may produce evidential matter indicating the
possibility of errors or frauds and therefore should
a. plan and perform the engagement with an attitude of professional skepticism.
b. not depend on internal accounting control features that are designed to prevent or detect errors or frauds.
c. design audit tests to detect unrecorded transactions.
d. extend the work to audit most recorded transactions and records of an entity.
6-8
When using the transaction cycle approach in the audit plan, the reason for treating the capital cycle separately from
expenditure cycle is that
a. the transactions are related to financing a company rather than to its operations.
b. most capital cycle accounts involve few transactions, but each is often highly material and therefore should be audited
extensively.
c. both a and b above.
d. neither a nor b above.
6-9
Which of the following statements best describes the auditors responsibility with respect to illegal acts that do not have a material
effect on the clients financial statements?
a. Generally, the auditor is under no obligation to notify parties other than personnel within the clients organization.
b. Generally, the auditor is under an obligation to see that stockholders are notified.
c. Generally, the auditor is obligated to disclose the relevant facts in the auditors report.
d. Generally, the auditor is expected to compel the client to adhere to requirements of the Foreign Corrupt Practices Act.
6-10
Which of the following is not a proper match of an auditors specific objective with managements assertion?
a. Ownership matches with rights and obligations.
b. Existence matches with existence or occurrence.
c. Classification matches presentation and disclosure.
d. Completeness matches with completeness.
6-11
Which of the following statements is not true?

a. Balance-related audit objectives are applied to account balances.
b. Transaction-related audit objectives are applied to classes of transactions.
c. Balance-related audit objectives are applied to the ending balance in balance sheet accounts.
d. Balance-related audit objectives are applied to both beginning and ending balances in balance sheet accounts.
6-12
Which of the following statements is true?

a. The auditors specific objectives follow and are closely related to management assertions.
b. Managements assertions follow and are closely related to the auditors objectives.
c. The auditors primary responsibility is to find and disclose fraudulent management assertions.
d. Assertions about presentation and disclosure deal with whether the accounts have been included in the financial
statements at appropriate amounts.
6-13
Which of the following statements is not true?

a. An example of a completeness assertion would be that the notes payable account in the balance sheet includes all such
obligations of the entity.
b. An example of a valuation or allocation assertion would be that property, plant, and equipment are recorded at current
market value.
c. An example of an existence or occurrence assertion would be that sales in the income statement represent exchanges of
goods or services that actually took place.
d. An example of a rights and obligations assertion would be that amounts capitalized for leases in the balance sheet
represent the cost of the entitys rights to leased property.
6-14
When planning the audit, if the auditor has no reason to believe that illegal acts exist, the auditor should
a. include audit procedures which have a strong probability of detecting illegal acts.
b. include some audit procedures designed specifically to uncover illegalities.
c. make inquiries of management regarding their policies and regarding their knowledge of violations, and then rely on
normal audit procedures to detect errors, frauds, and illegalities.
d. do nothing.
6-15
If a long-term note receivable is included on an accounts receivable listing, there is a violation of the
a. completeness objective.
b. existence objective.
c. timing objective.
d. classification objective.
6-16
Which of the following procedures would an auditor most likely perform in planning a financial statement audit?
a. Inquiring the clients legal counsel concerning pending litigation.
b. Identifying the clients management assertions relating to individual accounts.
c. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities.
d. Examining control procedures to verify the effectiveness of internal controls.
151
152
6-17
At the planning phase, which of the following is most likely to be agreed upon with the audit client before implementation
of the audit procedures?
a. Evidence to be gathered to provide a sufficient basis for the auditors opinion.
b. Timing of inventory observation procedures to be performed.
c. Procedures to be undertaken to discover litigation, claims, and assessments.
d. Procedures to be included in the testing the internal controls.
6-18
When an auditor becomes aware of a probable illegal act by a client, the auditor should
a. consult with the clients legal counsel or other specialists about the effect of the act on the financial statements.
b. determine the reliability of the managements representations in the clients representation letter.
c. consider whether other similar acts may have occurred.
d. recommend remedial actions to the audit committee.
6-19
Which of the following immaterial amount of misstatement could most likely have a material effect on a clients financial
statements?
a. A piece of obsolete office equipment that has not retired.
b. A petty cash fund disbursement that was not properly authorized.
c. An illegal payment to a foreign official that was not recorded.
d. An uncollectible account receivable that was not written off.
6-20
Which of the following information discovered during an audit most likely would raise a question concerning a possible
illegal act?
a. Related party transactions, although properly disclosed, were pervasive during the year.
b. The entity prepared several very large checks payable to cash during the year.
c. Material internal control weaknesses previously reported to management were not corrected.
d. The entity was a campaign contributor to several local political candidates during the year.
6-21
Which of the following circumstances most likely would cause an auditor to consider whether material misstatements due
to fraud exist in an entitys financial statements?
a. Differences are discovered during the clients annual physical inventory count.
b. Material weaknesses previously communicated to those charged with governance have not been corrected.
c. Clerical errors are listed on a monthly computer-generated exception report.
d. Supporting accounting records and documents are frequently denied access to the auditor when requested.
6-22
What assurance should an auditor provide on direct effect illegal acts and indirect effect illegal acts that are both material to a clients
financial statements?
a.
b.
c.
d.
6-23
Direct effect illegal act

Reasonable
Reasonable
Limited
Limited
Indirect effect illegal act

None
Limited
None
Limited
The primary objective of tests of transactions performed as substantive tests is to

a. comply with generally accepted auditing standards.
b. attain assurance about the reliability of the accounting system.
c. detect material misstatements in the financial statements.
d. evaluate whether managements policies and procedures operated effectively.
6-24
Which of the following is a false statement about specific audit objectives?

a. There should be a one-to-one relationship between specific audit objectives and procedures.
b. Specific audit objectives should be developed in light of management assertions about the financial statement
components.
c. Selection of tests to meet audit objectives should depend upon the understanding of internal control.
d. The auditor should resolve any substantial doubt about any of managements material financial statement assertions.
6-25
The objective of tests of transactions performed as substantive tests is to

a. comply with generally accepted auditing standard.
b. attain assurance about the reliability of the accounting system.
c. detect material misstatements in the financial statements.
d. evaluate whether managements policies and procedures operated effectively.
6-26
An auditor observes the mailing of monthly statements to a clients customers and reviews evidence of follow-up on errors
reported by the customers. This test of controls most likely is performed to support managements financial assertion(s) of
a.
b.
c.
d.
6-27

Yes
Yes
No
No
Existence or Occurrence
Yes
No
Yes
No
Each of the following might, by itself, form a valid basis for an auditor to decide to omit an audit test except for the
a. difficulty and expense involved in testing a particular item.
b. assessment of control risk at a low level (i.e., small %).
c. inherent risk involved.
d. relationship between the cost of obtaining evidence and its usefulness.
6-28
Which of the following statements reflects an auditors responsibility for detecting errors and fraud?
a. An auditor is responsible for detecting employee errors and simple fraud, but not for discovering fraudulent acts
involving employee collusion or management override.
b. An auditor should plan the audit to detect errors and fraud that are caused by departure from GAAP.
c. An auditor is not responsible for detecting errors and fraud unless the application of GAAS would result in such
detection.
d. An auditor should design the audit to provide reasonable assurance of detecting errors and fraud that are material to the
6-29
Which of the following circumstances most likely would cause an auditor to consider whether material misstatements exist
in a clients financial statements?
a. The client is in a declining industry with increasing business failures and a significant decline in customer demand.
b. Employees who handle cash receipts are not bonded.
c. Bank reconciliations usually include in-transit deposits.
d. Equipment is often sold at a loss before being fully depreciated.
6-30
Which of the following characteristics most likely would heighten an auditors concern about the risk of intentional
manipulation of financial statements?
a. Turnover of senior accounting personnel is low.
b. Insiders recently purchased additional shares of the clients stock.
c. Management places substantial emphasis on meeting earning projections.
d. The rate of change in the entitys industry is slow.
6-31
Disclosure of illegal acts to parties other than a clients senior management and its audit committee or board of directors
ordinarily is not part of an auditors responsibility. However, to which of the following outside parties may a duty to disclose illegal
acts exist?
a.
b.
c.
d.
To the SEC when the

Client reports an
Auditor change ___
Yes
Yes
No
Yes
To a Successor Auditor
when the Successor makes
appropriate inquiries_____
Yes
No
Yes
Yes
To a Governmental Agency
from which the Client receives
financial assistance_________
No
Yes
Yes
Yes
153
154
6-32
An auditor concludes that a client has committed an illegal act that has not been properly accounted for or disclosed. The
auditor should withdraw from the engagement if the
a. auditor is precluded from obtaining sufficient appropriate evidence about the illegal act.
b. illegal act has an effect on the financial statements that is both material and direct.
c. auditor cannot reasonable estimate the effect of the illegal act on the financial statements.
d. effect of the illegal act on the financial statements is material, and the client refuses to accept the auditors report as
modified for the illegal act.
6-33
Three conditions generally present for fraud to occur are often refer to as the fraud triangle. Which of the following
conditions is not present in this fraud triangle?
a. Management or other employees lack professional skepticism to commit fraud.
b. Circumstances provide opportunities for management or employees to commit fraud
c. Management or other employees have incentives or pressures to commit fraud
d. An attitude exist that allows management or employees to commit fraud.
6-34
Management is often in a position to override internal controls in order to commit fraud. Which of the following
procedures is not required to test for management override of controls on every audit?
a. Review accounting estimates for biases that could result in material misstatement due to fraud.
b. Evaluate the business rationale for significant unusual transactions.
c. Test the existence and occurrence of separation of duties.
d. Examine journal entries and other adjustments for evidence of possible misstatements due to fraud.
6-35
An auditor must assess the risks of material misstatement due to common fraud conditions throughout the audit. Which of the
following is not a common fraud condition that the auditor must assess throughout the audit?
a. Conflicting or missing evidential matter.
b. Unrealistic audit time budget constraint.
c. Discrepancies in the accounting records.
d. Problematic or unusual relationships between the auditor and management.
6-36
An independent audit has the responsibility to design the audit to provide reasonable assurance of detecting errors and
fraud that might have a material effect on the financial statements. Which of the following, if material, is a fraud as defined
in auditing standards?
a. Misappropriation of an asset or groups of assets.
b. Clerical mistakes in the accounting data underlying the financial statements.
c. Mistakes in the application of accounting principles.
d. Misinterpretation of facts that existed when the financial statements were prepared/
6-37
What assurance does the auditor provide that errors, fraud, and direct-effect illegal acts that are material to the financial
statements will be detected?
a.
b.
c.
d.
6-38
Errors
Limited
Reasonable
Limited
Reasonable
Fraud
Negative
Reasonable
Limited
Limited
Direct-Effect Illegal Act

Limited
Reasonable
Reasonable
Limited
If some sales were recorded in the current year that should have been recorded in the subsequent year, the related accounts
receivable do not exist at the balance sheet date. Which of the following overlaps between transaction- and balance-related
information is true?
a.
b.
c.
d.
Transaction-related Information
Rights and Obligation
Valuation and Allocation
Occurrence
Cutoff
Balance-related Information
Completeness
Classification
Accuracy
Existence

6-1 d. 6-2 b. 6-3 d. 6-4 c. 6-5 d. 6-6 d. 6-7 a. 6-8 c. 6-9 a. 6-10 c. 6-11 c.
6-12 a. 6-13 b. 6-14 c. 6-15 d. 6-16 b. 6-17 b. 6-18 a. 6-19 c. 6-20 b. 6-21 d.
6-22 a. 6-23 c. 6-24 a. 6-25 c. 6-26 c. 6-27 a.
6-28 d. 6-29 a. 6-30 c. 6-31 d.
6-32 d. 6-33 a. 6-34 c. 6-35 b. 6-36 a. 6-37 b. 6-38 d.
155
156

Simulation Question 6-1 is an adaptation with permission from a case by Strand, C. A., S.T. Welch, S.A. Holmes, and S.L. Judd in the Issues in
Background Information for all Scenarios
Crystal Smith had been the Director of the Finance Department of Junction Falls, USA, for nearly eight years. On a recent trip to
Florida, she visited her sister and decided that she would like a change of scenery. Crystal interviewed for several jobs and accepted an
accounting position in the Finance Department of a large Florida city. Her replacement in Junction Falls is Joe Metros. Joe, who had been the
Deputy Director of the Finance department in a nearby town for the past five years, is very pleased with this new position because it represents a
promotion.
A reporter from the Junction Falls Daily Observer interviewed Joe for a feature article in the business section. Joe talked about his
family and the many civic activities that he supported, both financially and by volunteering his time. He also discussed his vision for the future of
the Finance Department and identified a number of short-term and long-term goals. Initially, Joe wants to implement a number of changes
designed to improve the efficiency and effectiveness of departmental operations. He plans to eliminate a number of accounts that are rarely used.
He also hopes that financial information can be provided more quickly when requested by citizens or other city agencies. He notes that prompt
responses should increase public confidence in the Finance Department. Joe is especially concerned about the extent of employee turnover. Five
of the seven department employees have held their current positions less than one year, and training costs can be rather significant. Joe has been
told that the previous Director, Crystal Smith, was very controlling and task-oriented, and that this may have caused employees to seek
employment elsewhere.
Joe notes that the city does not have an internal audit staff. However, the local accounting firm of Watson & Watson, LLP has audited
the citys Comprehensive Annual Financial Report for each of the past 13 years. The city has been growing steadily for the past several decades
and currently has a population just over 73,000. Last year, Junction Falls collected over $89 million in gross operating revenues. In addition to
Joe, the Finance Department includes the following personnel:
You should access Data File 6-1 in iLearn for Figure 1, which presents the organizational chart of the Finance and Accounting
Services of Junction Falls.
Libby Jones, Chief Accountant. She manages and maintains the General Ledger. Libby is also responsible for general office
management and day-to-day operations in the department. She earned a degree in accounting from the local university and has worked for the
department for 15 years. Libby is 37; her husband owns a local hardware store.
Marsee Weston, Senior Accountant. She is responsible for monitoring fixed assets. She also maintains all records of city fixed/real assets
and maintains/monitors all city construction and acquisition of real asset contracts. Marsee has been employed by the department for eight
months. She is 39; her husband teaches mathematics at the local high school.
Scott Smyth, Senior Accountant. He is the Cash Manager; maintains bank relations; manages all city investments; monitors debt-service
requirements; performs all wire transfers of city funds; and reconciles all bank accounts. Scott is 32 and has been employed by the department
for seven months. Scotts wife is a sales associate at one of the local automobile dealers.
Cathy Elign, Staff Accountant. She maintains all records pertaining to Accounts Receivable; invoices those who owe funds; maintains
control of all Petty Cash Funds within the city; accounts for all daily deposits from departments and divisions within the city; and is also the
secondary payroll clerk. Cathy is 27 and has been employed by the department for almost nine months. Her husband is employed by the U.S.
Postal Service.
Bob Thomas, Accounts Payable Clerk. He processes all city payments to payees for last names beginning with A through L. Bob is 36
and has worked in the department for almost two years. He is single and has lived in town his entire life except for the five years he served in
the U.S. Navy.
Nora Stewart, Accounts Payable Clerk. She processes all city payments to payees for last names beginning with M through Z. Nora is
20, and has been employed by the department for six months. She is single and lives in an apartment complex near an university campus.
Chuck Sanchez, Payroll Clerk. He processes all bi-weekly and monthly payrolls and maintains all payroll records. Chuck is 31, recently
divorced, and has been working in the department for ten months. Chuck lives in an older neighborhood with his 7-year-old son.
Scenario #1
Joe has recently implemented several changes within the Finance Department; changes he believes will improve operations and boost
morale. First, he informed all employees that he expects them to take full advantage of all of their earned vacation days. Since employees must
work in the department for at least one year before they can apply for vacation, Bob and Libby are currently the only employees who are eligible
to take any paid vacation days. Bob is planning a one-week fishing trip to Lost Pines Lake this summer, but Libby insists that she cannot take nay
vacation because there are so many new employees. Libby does appear to be busy. She is usually the first to arrive at work each day and the
last to leave at night. However, Libby will lose quite a few days of leave time if she does not take a vacation soon. Joe has insisted that she take a
break. Libby agrees to do this, but only takes one day at a time.
Joe has also created new controls within the accounts payable function. First, the two accounts payable clerks (Nora and Bob) check
each others documents for accuracy at the close of each workday. Each Tuesday, Libby collects the invoices to be paid for that week and
prepares the documentation so that checks can be drawn and mechanically signed in the nightly cycle. The following morning, Libby collects the
printed checks, verifies the amount of each check with the register, confirms that all supporting documentation is attached, sends the checks to the
mailroom for delivery to the vendors, forwards the daily check register to Scott for use in the bank reconciliation, and returns the invoices to Nora
and Bob for inclusion in the vendor files. Libby is also responsible for periodically reconciling the Accounts Payable subsidiary ledger to the
control account.
Joe arrives at work on Wednesday and is surprised to find the office locked. As he opens the door, he hears the phone ringing. It is
Libbys husband, who informs Joe that Libby had an automobile accident on the way to work and is being admitted to Junction Falls Hospital for
observation. Joe plans to take over Libbys duties until she recovers. He begins by collecting the checks that were printed the previous night,
along with their supporting documentation. After completing the necessary reconciliation, he hands over the paid invoices to Bob and Nora for
filing. Nora is surprised to find an invoice made payable to Zenith Enterprises. She does not recall processing this invoice the previous day.
Scenario #2
Scenario #3
Scenario #4
Scenario #5
In addition to his other duties, Chuck makes arrangements for the hiring of temporary help for Junction Falls. Departments submit
formal request forms to Chuck a week in advance detailing what type of temporary help is needed and estimating how long the associated labor
shortage would persist. Chuck then relays the information to Manpower Staffing Services, a local temporary agency that provides Junction Falls
with the needed employees. Manpower bills the city once a month for all services provided since the last billing period. Chuck receives the bill
directly from the temporary agency. After examining the accompanying documentation for accuracy, he forwards the bill to Nora for payment.
Joe recently asked Libby to compile a list of significant budget variances for his review. Libby noted that a problem appeared to be
developing in personnel services (which represented more than 10 percent of all expenditures). She did some quick calculations and discovered
that two-thirds of the budgeted amount for salaries and benefits was spent in just seven months. Overall, personnel-related expenditures are 15
percent greater than they were at this same time last year. When asked if he had any ideas on what could have caused this budget shortage, Chuck
suggested that perhaps the hiring of additional employees and the 3 percent across-the-board pay raise that was awarded everyone at the start of
the fiscal year were not reflected in the current year budget.
Each Tuesday evening, the city runs checks for the invoices that are due that week. Then, on Wednesday morning, Libby verifies the
amount of each check with the register and confirms that all supporting documents are attached. After conducting the reconciliation, Libby
forwards the paid invoices to Bob and Nora for filing. Nora is curious. The documentation attached to the Manpower Staffing Services check is
vague. There are no specifics as to the days worked or the work performed. She has placed a call to the temp agency requesting more information,
but has not yet received a reply.
In an attempt to discover new areas where cost savings might be achieved, Joe has spent much of his spare time examining the files
containing the Junction Falls RFPs (Requests for Proposal). Joe concludes that most low bidders are awarded a contract. Occasionally, however,
the low bid is not accepted. For example, because the low bidder was notorious for delivering spoiled merchandise, they did not get the contract.
Instead, the Lone Start Farm Patch was awarded the bid to supply fruits and vegetables to the Junction falls Jail. Joe notes that most files contain
several bids, some as many as a dozen. Joe finds one file (to supply computers to certain city offices) that contains only a solitary bid from Able
Computers. Joe asks Marsee, who prepares all specs for fixed asset RFPs and approves all contracts, what caused such a poor response from
potential suppliers. Marsee points out to Joe that the RFP specified that supplier personnel must be able to respond to a city call for maintenance,
upgrades, or repairs within 30 minutes. She suggests that perhaps many suppliers were not willing to guarantee such a prompt response time.
In preparation for the upcoming annual audit, Bill Watson, the external auditor, asked Marsee to provide him with a list of all fixed
assets, including the inventory identification number, date of purchase cost, and current location of each item on the list. After a week, Marsee
still has not printed out the list for the auditor. The audit starts in two weeks. When asked about the delay, Marsee says that she has been so busy
that she has not had time to think about any new projects. Marsee is busy, and often arrives very early for work and leaves the office late at
night.
One Monday during lunchtime, Bob receives a phone call from Able Computers, asking whether Ables last request for payment has
been processed. Since Marsee is unavailable to respond to this query, Bob calls the city office that was to have received the computers and learns
that no such delivery from Able Computers.
Joe is collecting information to start the annual Junction Falls budget. By next week he should have a detailed budget request package
from each operating department, which contains not only financial and statistical data about prior period activities, but also wish lists for the
next fiscal year. Joe notes that ad valorem taxes (levied as a percentage of the value of the property being taxed) have provided the major source
of city funds for several years. One trend disturbs him, however. Cash collections have declined this year, despite the fact that the mayor had
announced a significant increase in the tax base. Joe decides to spend the weekend checking out this anomaly. He discovers one possible
explanation: numerous modifications or credits of billed tax amounts have been recorded in the receivable ledger. The following week, Joe asks
Cathy about the large number of tax adjustments. She explains that an apparent computer glitch in the individual taxpayer assessment software
created the need to reduce originally recorded amounts to their lower, correct totals.
Cathy calls in sick with a virus one Thursday and Scott agrees to substitute as the cashier. At the end of the day he is exhausted. He
never has a minute to even catch his breath. He wonders what caused people to pick this day to come in and pay their taxes. He tells Joe they
must have known that Cathy was absent and decided to take this opportunity to pick on Scott. As he is preparing the deposit, Scott confirms that
it has indeed been a busy day. The deposit is much larger than usual.
The following Wednesday, Libby receives a phone call from a taxpayer who is very irritated about an overdue notice that has just
come in the mail for property taxes that, according to the county, are now 60 days delinquent. According to the caller, these taxes were paid
several weeks ago and the taxpayer has a receipt to prove it. Libby asks Cathy to print out a copy of the taxpayers accounts receivable record.
After some searching, Cathy informs Libby that she cannot locate any record to the account.
The auditors from Watson & Watson, LLP have just started their work on the Comprehensive Annual Financial Report for Junction
Falls. Bill Watson, the partner-in-charge of the city audit, is chatting with Scott Smyth and discovers that they share a mutual interest in investing.
Scott says that he particularly enjoys investing in options, futures, and commodities. He notes that his investing interest is what attracted him to
his current position in Junction Falls. Scott indicates that he was pleasantly surprised to discover that Junction Falls needed someone to manage
its investment portfolio. He admits that even though the pay is not particularly great, he really likes the autonomy inherent in the position. He
decides what to buy and when to sell (within certain very broad guidelines), and apart from creating a report of his investing activities for the
Junction Falls Council each quarter, he manages the investment portfolio as he sees fit. Bill notes in his working papers that Scott also has broad
authority to make wire transfers between each of the citys four bank accounts. No external approval is required.
Bill, Scott, Joe, and Marsee decide to go to a local caf for lunch. Scott offers to drive his Jaguar sedan since it can easily
accommodate four individuals. Marsee, Scott, and Joe have been with the Department for less than one year, so the luncheon conversation centers
on where everyone worked before coming to the Finance Department, and how long each has lived in Junction Falls. Joe and Marsee discover
that they grew up in Junction Falls, just three blocks from each other. Scott only recently moved here from Big City. At that point, the waitress
arrives with their orders, and the conversation turned to other topics for the duration of the meal.
157
158
Later that afternoon, Bill continues his conversation with Scott about his move to Junction Falls, and the many differences between
Junction Falls and Big City. Scott admits that he misses the fast pace of his former hometown, but says that it was best that he left Big City to
gain a fresh start on life. Although he owned a consulting firm in Big City, he had overextended his credit cards by taking too many cash
advances. Ultimately, he filed for personal bankruptcy.
Required
For each of the five scenarios above answer the following three questions:
1. List all the fraud risk factors in each of the five scenario.
2. Identify all other circumstances or information that are of concern in each of the five scenario
3. Explain whether it is probable, reasonably possible, or remote that fraud (misappropriation of assets) may be occurring in the Finance
Department in each of the five scenario. You should research FASB SFAS No.5 (AICPA 1975), Accounting for Contingencies, to learn more
about the distinction between these terms.
Note: Probable is a future event(s) that is (are) likely to occur; reasonably possible means the possibility of the event is more than remote but less
than likely; and, remote means the chance of the event is slight.

Simulation Question 6-2 is an adaptation with permission from a case by Ballou, B. and J. M. Mueller in the Issues in Accounting Education , a
Humble Beginning
Brian Techno, CEO and founder of Speedcom, was born in 1938 in San Jose, California. The first in his family to attend college,
Brian earned good grades in his engineering curriculum at The California Institute of Technology. This was also where he discovered his natural
ability to build and wire just about anything. After graduating in 1960, Brian married Mindy, his high school sweetheart, and moved to Modesto
about 100 miles north of San Jose. This was where it all began, through the haphazard purchase of a farm lot in the neighboring town of Tracy. It
just happened to have on it an 18-foot tall antenna.
In his spare time, Brian put his wiring skills to use and convinced nearby residence to let him string some wires to their television sets.
Soon Brian was urging the rest of Tracy to trade their rabbit ears for wires to his antenna, making Brian an early pioneer of the cable television
industry. Over the next several years, Brian acquired other plots of land in neighboring towns and built more antennas and strung more wires.
One week before quitting his job with a factory, he went into the First National Bank at Tracy to borrow $45,000 to purchase a failing cable
franchise in Tracy. Brian convinced several local businessmen to contribute $25,000, and the local bank agreed to lend the remaining $20,000.
Brian told Mindy that they would either make a mint or go broke. Mindy had no idea that Brian would make that claim many more times in the
future.
By the late 1960s, Brians cable business was doing well and he purchased a 60-acre farm property in Tracy and built a large home for
Mindy and their two sons, Tony and Sam. Brian and Mindy were easily the most successful residents in the history of Tracy, and the more
successful they became, the less popular they became. As in most small towns, all 2,900 townspeople in Tracy were at about the same
socioeconomic level, at least until Brians success. Brian and Mindy wanted to feel at home in Tracy and tried everything to earn acceptance in
the town. Brian ran for a position on the school board and lost. He hosted barbeques at his home few came. He went as far as attending the
church preferred by the mayor, which differed from his own religious denomination. Finally, in 1975, his goal to be accepted in the community
was realized when he was invited to sit on the board of the local bank. Not only was this a great personal triumph, but also he foresaw needing a
loan from time to time.
Growing Pains
Success
Tony and Sam both returned to the family business after finishing their degrees at California Institute of Technology. Brians ambition
was contagious, and as it grew, the family took significant risks and leveraged the company in order to acquire and develop more rural cable
systems in Central California. Often, they were only one step ahead of the creditors. By the mid-1980s, as a result of several large acquisitions,
the company had 160,000 subscribers and 250 employees. Based on Brians financial management strategy, there was not a bank within a 200mile radius to which he was not in debt. Frankly, he had borrowed about as much as he could. Over a plate of Mindys meatloaf one fall evening
in 1987, they decided to go public Speedcom was born.
By the late-1990s, Speedcom was among the five largest cable companies in the country, with over 15,000,000 subscribers. The public
offering had given Brian the cash needed to take the company to the next level. Although the greatest cluster of subscribers was in the Central
California, Brian had developed other clusters in the Northern California. Sam developed the strategy of clustering subscribers in geographic
areas, which was lauded by analysts. Clustering helped to keep operating costs low and gave Speedcom a much greater cash margin than its
competitors.
Based on age, experience, and interests, the top Speedcoms governance hierarchy was structured with Brian as CEO, Sam as COO,
and Tony as CFO and Chair of the Audit Committee. Based on the requirements in the Sarbanes-Oxley Act of 2002, Tony later resigned from the
Audit Committee, and the President of First National Bank at Tracy, Jonny Kinsey, took Tonys place as Chair.
Brian and Tony designed the IPO such that Class A shares with one vote each were issued. The Techno family retained all Class B shares,
with five votes per share, five the Techno family final word on who would hold board seats. Most other members of the Board of Directors were
good friends of Brian. Mindys cousin from San Jose also held a seat. Coincidentally, these were about the only shareholders willing to travel to
small town Tracy for board meetings or annual shareholder meetings. Board and shareholder meetings alike were mostly informational where
Brian shared with those present about the companys recent victories and the deals put together by the two sons and him. Figure 1 provides an
organizational chart for Speedcoms directors and senior executives. You should access Data File 6-2 in iLearn for Figure 1, which presents
the organizational chart of Speedcom.
Outside the boardroom, the Techno family continued to run the business just as they always had at the dinner table over Mindys
cooking with little thought to investors, analysts, or other stakeholders. Brian continued to make the deals that had made Speedcom successful.
He sought smaller competitors within geographic clusters for acquisition, most of which had unused capacity that could be developed by Sam to
further expand Speedcoms subscriber base. In November 2002, Brian had six to eight deals on the table, most with commitments to purchase
stock at some agreed upon price. Brians deal-making required him to keep Speedcom highly leveraged. But, in his mind, he had mastered that art
and he knew that Speedcoms goal to become industry giant depended on it. At times, Speedcoms debt was ten times its market capitalization
and ten times that of any competitor. However, annual revenues approached $4 billion, and the stock price continued to climb. Brian, Sam, and
Tony increased their ownership by purchasing a large volume of stock. Brian had faith that the company would continue to prosper, enabling him
to divest some of his shares upon retirement.
Like his father, Sam was always looking for a profitable deal in new service lines such as wireless and digital. In 2000, for example,
Sam discovered Neo Wireless, a new cellular company in rural Southern California. Though available at quite a discount, Neo Wireless was in
the midst of a lawsuit with the FCC (Federal Communications Commission) over a disputed tie bid for a wireless spectrum (the FCC auctions
wireless airspace to wireless companies). Sam believed that although Neo Wireless was much smaller than the other tie-bidder, it would
eventually come out of the lawsuit with the spectrum and would be a profitable company with high growth potential. Sam wanted to create a new
cluster in the Southern California, where Neo Wireless would be a stand-alone entity and a personal project for Sam.
Brian also had established various privately owned business over the years. He insisted upon keeping his salary from Speedcom at a
conservative amount, for example, his average salary over the years 1998 to 2004 was $800,000 per year, and these businesses allowed him to
subsidize his personal income. In addition, Brian insisted that Tony and Sam also draw modest salaries; Tony was earning an average of
$550,000 and Sam an average of $400,000 per year. One of Brians businesses, MediaMarket LLC, was an advertising company that that focused
primarily on telemarketing services. It had several small Tracy area clients and Speedcom. MediaMarket handled the majority of Speedcoms
marketing to potential subscribers for services in areas where it had services available. Brian also created ServiceLink LLC, a customer service
outsourcing agency. Its primary revenue stream was from Speedcom, but other clients included the local First National Bank and two other banks
from surrounding towns. Both MediaMarket and ServiceLink were located in Speedcoms office building. Mindy and Sams wife, Emily, also
operated a florist and home interiors business. Often, Brian would redecorate Speedcoms offices to provide business for Mindy and Emily. Brian
could see the value in his small companies. MediaMarket and ServiceLink lowered Speedcoms operating costs and both of the companies
received professional management services from Speedcom. Figure 2 presents a summary of Speedcoms financial statements. You should
access Data File 6-2 in iLearn for Figure 2, which presents a summary of Speedcoms financial statements.
By 2003, the sentiment toward the Techno family was warm. After all, the Techno family treated folks in Tracy like extended family.
They built youth recreation facilities, sponsored an annual fair, and built a library and seniors center. Brian was rumored to have never turned
away anyone who came to him in financial difficulty. Further, townsfolk were often invited as personal guests of the Techno family to San
Francisco 49ers pro football games and shows at the historic San Francisco Theatre (they had acquired both in the 1990s). Brian was finally
admired by all and wealthy beyond belief. He had realized his dreams hose for his company and for himself.
Required
1. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial
statements. Step 1 requires the auditor to understand the nature of fraud and the manner in which fraud may be committed at the audit preplan.
This understanding is to be integrated with the auditors understanding of a clients business at the audit preplan phase (refer to Chapter 5).
Research the Internet or other relevant sources for a better understanding of Speedcoms telecommunication industry. Using the format below,
document at least three pieces of information of your understanding of the history, products, regulation, and risk of telecommunication industry.
Reference/cite the source of your information. One piece of information is provided under each of the four subheadings to help you complete the
rest.
Your Understanding of Speedcoms Telecommunication Industry
A. History of the Telecommunication Industry
1. The telecommunication industry experienced unprecedented, rapid growth in the mid-1990s, introducing an array of services and competitors
to an industry once known only for home phone service and the industry giant AT&T.
2. (source: http://...)
3.
4.
B. Products in the Telecommunication Industry
1. Products offered by the telecommunication industry can be sorted into three categories: phone-related, television-related, and Internet-related.
3.
4.
C. Regulation of the Telecommunication Industry
1. The telecommunication industry is regulated by the Federal Communication Commissions various Acts: the Communications Act of 1934,
the Cable Communications Policy Act of 1984, the Cable Television Consumer Protection Competition Act of 1992, and the
Telecommunications Act of 1996.
3.
4.
D. Risks in the Telecommunication Industry
1. Telecommunications historically has been an industry with a high level of merger-and-acquisition activity. Larger companies frequently
acquire smaller companies for their capacity or existing customer revenue streams. In the late 1990s, however, the acquiring firms share prices
159
160
began to tumble as the purchased capacity could not be turned into revenue.
3.
4.
statements. Step 5 requires the auditor to identify specific fraud risks at the audit plan. This identification of fraud risks is to be integrated with
the auditors consideration of the Fraud Triangle at the audit plan phase (refer to Table 6-1 and Table 6-2 in Chapter 6). Based on your
understanding and documentation of the telecommunication industry in 1. above, state what you believe to be factors that would increase the risk
of fraud at Speedcom. Using the format below, state at least three fraud risk factors of Speedcom for each of the three characteristics of the
Fraud Triangle. If you make any assumption for your answer, state your assumption.
Your Identification of Speedcoms Fraud Risk Factors
A. Incentives/Pressures
1. (assumption, if any)
2.
3.
B. Opportunities
1. (assumption if any)
2.
3.
C. Attitudes/Rationalization
2.
3.

Simulation Question 6-3 is an adaptation with permission from a case by Knapp, M. C. and C. A. Knapp in the Issues in Accounting Education , a
Humble Beginning
The Brooks Brothers Tangle with the SEC
As a small child, Brooklyn native David Brooks loved horses. In 1969, when he was 14 years old, Brooks went to work at a local
racetrack as a groom to help support his family. Brooks loved the tough job, which involved arriving at the racetrack in the wee hours of the
morning, wiping down sweaty horses, wrestling large bales of hay, and mucking (cleaning out) horse stalls. Although he wanted to spend his
life working in the horseracing industry, Brooks' family encouraged him to pursue a more stable and pragmatic career after he graduated from
high school. Because he was intrigued by the stock market, David Brooks eventually decided to major in business at one of New York City's
prominent universities. The young extrovert relied on a variety of part-time jobs to finance an undergraduate business degree with a concentration
in accounting at New York University.
Ironically, Brooks' successful business career provided the path for him to return to his first love. More than three decades after having
worked at one of the lowest ranking jobs in horseracing, David Brooks quickly rose to the pinnacle of that sport by spending tens of millions of
dollars to establish his own stable, Bulletproof Enterprises. At its height, Brooks' stable included more than 400 racehorses. In 2004, one of
Brooks' horses, Timesareachanging, won the Little Brown Jug, which is the equivalent of the Kentucky Derby for standardbred horses that
specialize in pacing.1
In the mid-1980s, Jeffrey Brooks, David Brooks' brother and best friend, founded a small brokerage firm, Jeffrey Brooks Securities.
Jeffrey recruited David to join the firm and become his right-hand man. Several years later, in 1992, the two brothers ran afoul of the Securities
and Exchange Commission (SEC) when one of their subordinates was charged with insider trading. The SEC alleged that the Brooks brothers had
failed to establish proper control procedures to prevent their subordinates from improperly using material non-public information obtained from
their clients.
In addition to a $405,000 fine, the SEC filed separate injunctions against the brothers. The SEC banned David Brooks from serving as
a director, officer, or employee of a brokerage firm or an investment company for five years. The injunction did not prohibit him from serving as
an executive of an SEC registrant that was other than a brokerage or investment company.
A few months before the SEC sanctioned the Brooks brothers, David, with the financial backing of his brother, organized a small
company based in Westbury, New York, a Long Island suburb of New York City. That company, DHB Capital Group, Inc., which was
subsequently renamed DHB Industries, Inc. (DHB is David Brooks' initials), was intended to serve as the umbrella organization for a corporate
conglomerate that Brooks hoped to build. Brooks' goal was to identify and then purchase small, underperforming companies and convert them
into profitable operations by retooling their business models.
In 1994, Brooks attempted to register DHB on the NASDAQ stock exchange to provide it greater access to the nation's capital
markets. The NASDAQ denied Brooks' application because of the sanctions that had been levied against him by the SEC. In defending that
decision, the NASDAQ observed that given the extremely serious nature of the SEC allegations made against Brooks, and the fact that he was
only recently enjoined it was necessary to exclude his company from the NASDAQ to protect investors and the public interest and to maintain
1
Standardbreds are a breed of horses developed in North America that dominates harness racing. There are two types of harness races: trotting
and pacing races.
public confidence in that market. Brooks appealed the NASDAQ's decision to the SEC. After reviewing the matter, the SEC ruled in favor of the
NASDAQ:
The facts remain that Brooks has a history of serious securities laws violations and a significant ownership
interest in DHB, and proposes to retain his position as a DHB director. We do not find it unreasonable that the
NASD2 reviewing both Brooks' past conduct and his proposed level of involvement in DHB, remains uneasy
about the potential for illicit conduct in connection with the operation of DHB or the market for its securities,
and unwilling to expose public investors to that possibility.
Despite being rejected by the NASDAQ, the strong-willed Brooks persevered in his effort to have DHB's securities listed on a national stock
exchange. A few years later, he finally accomplished that goal when those securities were registered on the American Stock Exchange.
Timing is Everything
Patriot or Profiteer?
Hurricane Brooks
Brooks used the initial financing provided to him by his brother and the capital that DHB raised through a public stock offering to
acquire five small firms during the 1990s. DHB's principal operating unit would become Point Blank Body Armor, a Florida-based firm
purchased out of bankruptcy for a cash payment of $2 million. Throughout the existence of DHB, the Point Blank subsidiary accounted for
upward of 95 percent of its annual consolidated revenues. Point Blank's primary product was the Interceptor Vest, a bullet-resistant vest used by
all branches of the U.S. military and by law enforcement agencies.
Brooks' acquisition of Point Blank was a timely decision. The small company had struggled for decades, but three circumstances
ultimately triggered a surge in the demand for bullet-resistant vests after Point Blank was acquired by DHB. First, the September 11, 2001,
terrorist attacks convinced law enforcement agencies throughout the nation to increase their budgets for weaponry and protective equipment for
their personnel. Second, in early 2003, President George W. Bush's launching of Operation Iraqi Freedom, commonly referred to by the press as
the Second Gulf War, prompted the U.S. Army and U.S. Marine Corps to purchase large quantities of bullet-resistant vests. Finally, one of Point
Blank's primary competitors, Second Chance Body Armor, was forced into bankruptcy in 2004 after being sued repeatedly by law enforcement
agencies for allegedly manufacturing a large number of defective protective vests.
Brooks relied on his outgoing personality, persistent manner, and, most importantly, three Washington, DC-based political lobbyists to
outmaneuver his competitors when vying for protective vest contracts put up for competitive bids by the U.S. military. Between 2001 and 2005,
the U.S. military purchased nearly one million protective vests from DHB, accounting for the majority of the company's revenues during that time
frame. In a period of only six months in 2004, Brooks landed three large contracts for body armor from the Pentagon totaling nearly $500 million.
By comparison, DHB's total revenues in 2000 had been only $70 million, while the company's total stockholders' equity at the end of that year
had been a negative $5 million due to a retained earnings deficit of more than $29 million.
The rapid expansion of DHB's Point Blank subsidiary caused the company's revenues and profits to soar. By 2004, DHB's annual
revenues were approaching $350 million, and the company's net income had topped $30 million. Despite those impressive figures, some analysts
were concerned by the company's weak operating cash flows. In 2004, for example, the company had a negative net operating cash flow of $10
million despite reporting the $30 million profit. You should access Data File 6-3 in iLearn for Exhibit 1, which presents the audited income
statements and balance sheets included in DHB's 2004 Form 10-K, filed with the SEC in early 2005.
DHB's sudden financial success focused considerable attention on David Brooks, the company's chairman of the board and chief
executive officer (CEO). The Industrial College of the Armed Forces, a military agency administered by the Joint Chiefs of Staff, lauded Brooks
for developing life-saving body armor technology for hundreds of thousands of U.S. soldiers. Military officials also praised Brooks for
establishing a charitable foundation that provided financial assistance for wounded veterans.
Not all of the attention focused on Brooks and his company was favorable. In 2003, a group of DHB employees maintained that the
company's protective vests suffered from flaws similar to those evident in the products of Second Chance Body Armor. In November 2004,
Brooks and his two top subordinates, Sandra Hatfield, DHB's chief operating officer (COO), and Dawn Schlegel, DHB's chief financial officer
CFO), were disparaged by the press when they received financial windfalls upon selling most of their DHB stock. Brooks, alone, received more
than $180 million from the sale of the majority of his DHB stock, an amount that was six times greater than DHB's net income for 2004. News
reports of Brooks' huge stock market gain caused one organization to label him a body armor profiteer. A DHB spokesperson responded by
defending Brooks' sale of his stock. The American economic system rewards those who take great risks with commensurate benefits. The
compensation Mr. Brooks received is directly attributable to the risk he undertook in aiding the capitalization of DHB and achieving
extraordinary results for the company.
The large stock sales by Brooks, Hatfield, and Schlegel were followed by a sharp decline in DHB's stock price. More bad news was
soon to follow for the company. Within a few months, additional allegations surfaced that a large number of Point Blank vests being used by
military personnel in Iraq had critical, life-threatening flaws. Those allegations were followed by the U.S. military recalling more than 20,000
Point Blank vests. Then, in April 2005, DHB's audit firm resigned, citing deficiencies in the method used by the company to value its
inventory. The announcement was particularly unsettling to investors because it was the third time since 2001 that a DHB audit firm had resigned
after commenting on major problems involving the company's internal controls.
David Brooks' public image was sullied even more in November 2005, when several major publications reported that he had spent
more than $10 million on a bat mitzvah party for his 13-year-old daughter in the elegant Rainbow Room in midtown Manhattan. Brooks used
DHB's corporate jet to fly several famous musicians to the party to serenade invited guests, including 50 Cent, Aerosmith, Kenny G, Stevie
Nicks, and Tom Petty. Brooks, who was decked out in a hot pink suede bodysuit during the affair, also handed out party bags to the bat mitzvah
guests that contained a wide range of merchandise, including a digital camera and an Apple iPod, allegedly purchased with DHB corporate funds.
In July 2006, amid growing concerns regarding the reliability of DHB's accounting records, the company's board dismissed David
Brooks and hired a team of forensic accountants to investigate those records. That investigation revealed that Brooks and his two top
subordinates, Sandra Hatfield and Dawn Schlegel, had orchestrated a large-scale accounting fraud that had grossly inflated DHB's reported
At the time, the National Association of Securities Dealers (NASD) oversaw the operations of the NASDAQ.
161
162
operating results and financial condition.3 In addition to uncovering the massive fraud, the year-long forensic investigation yielded disturbing
insights into the company's corporate culture during David Brooks' reign:
Brooks exercised absolute control over every aspect of DHB's business, using the company's weak corporate
governance and almost nonexistent internal controls to facilitate and hide the financial fraud he directed through
Schlegel and Hatfield Brooks' control extended to DHB's board of directors, which consisted of Brooks'
friends and neighbors and Schlegel. At all times, Brooks had a chokehold over DHB's board which exercised no
real oversight Brooks also controlled the flow of information with DHB's outside auditors, who regarded
Brooks as the key decision-maker.
Brooks used threats of physical harm to enforce his policies and directives. When anyone questioned the accounting and financial reporting
practices underlying the fraud at DHB, Brooks became furious and threatening. During one board meeting, Brooks told a board member who
questioned one of his decisions, You know what we do to outsiders you know what we do to people that are not on the team.
A primary target of Brooks' anger and threats was the company's independent auditor. When DHB's audit engagement partner
questioned the authenticity of certain journal entries, Brooks told another company official that if she [the audit partner] were not careful, she
would be wearing cement blocks on her feet in the Atlantic Ocean. Later, during that same audit, the audit engagement partner questioned
Brooks directly regarding circumstances that took place during the company's prior audit, which was performed by a different accounting firm.
During this conversation, Brooks stated that someone should put a bullet in the brain of the previous year's audit engagement partner.
Brooks also routinely withheld critical information from DHB's auditors, including information regarding significant related-party
transactions. DHB purchased many of the components used to manufacture its protective vests from Tactical Armor Products (TAP), a privately
owned company based in Florida. In early 2003, after discovering that Brooks' wife was TAP's CEO, DHB's auditors insisted that the company
issue an amended Form 10-K for fiscal 2002 to disclose that fact. In truth, Brooks exercised total control over TAP's operations, a fact that was
not divulged to the auditors nor disclosed in the amended Form 10-K.4
In addition to repeatedly failing to disclose that TAP was a related-party entity, Brooks also failed to disclose in DHB's SEC
registration statements that he had been sanctioned by the federal agency in 1992. This information was allegedly a material fact that would have
been of significant interest to DHB's stockholders, prospective investors, and a wide range of other parties involved with the company.
According to a federal prosecutor, a principal goal of Brooks' accounting fraud was to ensure that DHB consistently reported gross
profit margins of 27 percent or more and increased earnings, to correspond to the expectations of professional stock analysts. One facet of the
fraud was a series of bogus journal entries. From 2003 through 2005, Dawn Schlegel instructed her subordinates on DHB's accounting staff to
record multimillion-dollar entries that reclassified components of cost of goods sold as operating expenses. Although these reclassification entries
did not improve the company's bottom line profits, they did serve the purpose of significantly inflating DHB's gross profit ratio each period.
The major focus of the DHB fraud was the company's inventory accounts. From 2003 through 2005, DHB's period-ending inventories
were consistently and materially inflated. Throughout that three-year period, Hatfield was responsible for assigning values to inventory and
Schlegel was responsible for reviewing and approving the inventory valuation before incorporating it into the company's consolidated financial
statements. Brooks directly supervised Schlegel and Hatfield in performing all their duties, and demanded to review all financial statements
and disclosures DHB included in its [SEC] filings.
Near the end of fiscal 2004, Hatfield realized that DHB would fall well short of the 27 percent gross profit margin that Brooks
believed was necessary to satisfy financial analysts tracking the company's stock. To solve this problem, Hatfield increased the already overstated
value of the company's year-end inventory by several million dollars through various pricing manipulations. The offsetting reduction of cost of
goods sold allowed DHB to reach the 27 percent threshold for gross profit margin and to inflate its reported net income.
When DHB's controller reviewed the company's year-end inventory values for 2004, he immediately realized that they were
overstated. After preparing schedules documenting the inventory overstatements, the controller went to Hatfield and Schlegel, who
acknowledged that the inventory was overstated. Despite that acknowledgment, the two executives refused to correct the inventory values.
Troubled by concerns over the company's inflated inventory values, the controller turned in his resignation.
Before leaving DHB, the controller informed the company's independent auditors that he believed the year-end inventory values were
overstated. The auditors then raised this matter directly with Brooks. Brooks and Hatfield told the auditors that the controller's inventory analysis
was incorrect and that there were no real problems in the inventory.
After meeting with the auditors, Brooks stormed into the controller's office. During Brooks' subsequent trial, the controller testified
that an enraged Brooks called him a ___ snake and flung water all over me. While an unidentified man blocked the door to the
controller's office, Brooks shouted I am going to kick your ___. Brooks then confiscated the controller's inventory analysis and violently
ejected him from the premises. When DHB's auditors subsequently questioned Brooks regarding the controller's ejection from the company's
headquarters, Brooks responded that the controller had violated internal policies and procedures when he had told them of his concerns
regarding the valuation of inventory.
The circumstances surrounding the resignation of DHB's controller served to heighten the auditors' concern regarding the valuation of
year-end inventory. Making matters worse, Brooks instructed his subordinates to file the company's 2004 Form 10-K with the SEC before the
auditors had concluded their investigation of DHB's inventory, a decision that deeply troubled the auditors. To placate the auditors, Brooks
amended the company's 2004 Form 10-K. This amendment disclosed a material weakness in DHB's inventory valuation process.5
DHB's Management Report on Internal Control over Financial Reporting in the amended 2004 Form 10-K noted that there existed
certain significant deficiencies in the Company's systems of inventory valuation rendering it inadequate to accurately capture cost of materials
and labor components of certain work in progress and finished goods inventory. The report went on to observe, however, that the material
weakness did not affect the Company's financial statements or require any adjustment to the valuation of its inventory or any other item in its
DHB's auditors insisted on including an updated version of their report on the company's internal controls in the amended Form 10-K.
This updated report identified two additional material weaknesses in internal controls that were not documented in DHB's management report on
Hatfield had worked for Brooks in several capacities after he organized the company in 1992. Brooks eventually appointed her as DHB's COO
in December 2000. Schlegel's first connection with DHB was as an independent auditor. In late 1999, Brooks hired her to serve as DHB's CFO.
Schlegel, who was a CPA, also served on the company's board of directors.
4
Brooks used his control of both companies to funnel millions of dollars from DHB to himself via TAP.
5
The amended Form 10-K was filed with the SEC prior to the date that the original 2004 Form 10-K was released to the public.
internal controls. You should access Data File 6-3 in iLearn for Exhibit 2, which contains excerpts from the auditors' updated internal control
report that described these two items. The first item involved DHB's decision to file its original 2004 Form 10-K prior to the auditors completing
their final review of key financial statement amounts in that document. The second of the two additional material weaknesses indicated that
DHB's audit committee did not have a proper understanding of its important oversight role for the company's financial reporting process.
To mitigate the damage caused by the reporting of these two additional material weaknesses, Brooks took the unusual step of
including an insert in the amended 2004 Form 10-K that challenged the auditors' updated internal control report. In this insert, DHB maintained
that the two additional material weaknesses identified by the auditors were not, in fact, true material weaknesses. See Exhibit 3 of Data File 6-3
in iLearn. DHB's auditors resigned shortly after this contentious disagreement was aired in the company's SEC filings.
DHB's Form 10-Q for the first quarter of fiscal 2005 reported a net income of $7.6 millionthe company's net operating cash flow for
that period was a negative $5.0 million. The company's gross profit margin for that quarter was 27.4 percent, a figure that was almost identical to
the gross profit margins realized by the company for fiscal 2003 and 2004. DHB surpassed the magic 27 percent gross profit threshold for the
first quarter of 2005 because Hatfield and Schlegel had inflated the quarter-ending inventory by adding 63,000 nonexistent vest components to
the company's inventory accounting records.
The decision to add fictitious items to DHB's inventory posed a vexing problem for the co-conspirators that they had not anticipated;
namely, how to conceal that fact from the company's new auditors, the company's fourth audit firm in four years. (In prior periods, the three
executives had overstated DHB's inventory values by increasing the cost-per-unit assigned to individual inventory items rather than by adding
fictitious items to the accounting records.) Near the end of 2005, Brooks came up with a plan for solving the problem posed b y the fictitious
inventory. Brooks told Schlegel to include the cost of the $7 million of bogus vest components in a large write-off entry that was necessary for a
line of business that DHB was discontinuing.6
A few months later, during the fiscal 2005 audit, DHB's auditors questioned Brooks regarding the inventory included in the loss from
discontinued operations. Brooks told the auditors that the $7 million of vest components had to be written off because the U.S. military had
changed its color requirements for the vests in which those components were to be incorporated. When asked where the obsolete vest components
were, the quick-thinking Brooks replied that they no longer existed because the warehouse in which they had been stored had been destroyed by a
hurricane a few months earlier. Brooks later relayed this bogus explanation to Schlegel so that she would be prepared to corroborate it with the
auditors. In exasperation, Schlegel asked Brooks why he had told that story, since they had nothing to support it, and the auditors would want
support and details. Despite her concern, Schlegel did as she was instructed and confirmed the story when DHB's auditors queried her regarding
the $7 million inventory item.
When the auditors continued to press for additional details regarding the written-off inventory, a flummoxed Brooks altered his story.
He told the auditors that the hurricane explanation was a lie made up by his subordinates, which he had not known when he passed that
information to the auditors. This troubling about-face and the inability of Brooks or his subordinates to account for the mysterious $7 million of
inventory caused DHB's auditors to begin seriously questioning whether they could issue an opinion on the company's 2005 financial statements.
In early March 2006, the auditors told Brooks that they would not be able to release their audit report on DHB's 2005 financial
statements in time for the company to meet the SEC filing deadline for its 2005 Form 10-K. Law enforcement authorities subsequently
discovered that Brooks attempted to shop for a favorable audit opinion by replacing those auditors with another audit firm that he had secretly
contacted. That effort proved unsuccessful. A few months later, in July 2006, Brooks' turbulent tenure as DHB's founder and top executive came
to an end when he was dismissed by the company's board.
The following month, DHB recalled its audited financial statements for 2003 and 2004 and warned third parties that they should no
longer rely on them. DHB issued restated financial statements for those two years that radically altered the company's previously reported
operating results. DHB's restated income statement for 2004, for example, reported a $9.5 million net loss, compared to the $30 million net
income the company had originally reported for that year. You should access Data File 6-3 in iLearn for Exhibit 4, which presents DHB's
restated income statements and balances sheets for 2003 and 2004.
The SEC filed a civil complaint against Hatfield and Schlegel on August 18, 2006. The SEC alleged that the two individuals had
participated in an accounting fraud that had grossly inflated DHB's reported operating results and financial condition. Law enforcement
authorities subsequently filed criminal fraud charges against both Hatfield and Schlegel.
On October 25, 2007, the SEC filed a civil complaint against David Brooks that alleged he was the master architect of the DHB fraud.
Later that morning, federal law enforcement authorities arrested Brooks in his lavish home on Long Island, and then filed more than one dozen
criminal charges against him during his arraignment. Two days prior to Brooks' arrest, his former close friend and confidante, Dawn Schlegel,
had pleaded guilty to two criminal charges, conspiracy to defraud the government, and conspiracy to conceal tax information. In exchange for
sentencing considerations, Schlegel agreed to serve as the government's star witness during the criminal trial of Brooks and Hatfield.
Required
statements. Step 5 requires the auditor to identify specific fraud risks at the audit plan. This identification of fraud risks is to be integrated with
the auditors consideration of the Fraud Triangle at the audit plan phase (refer to Table 6-1 and Table 6-2 in Chapter 6). Based on your reading
of the case above, document what you believe to be factors that would increase the risk of fraud at DHB. Using the format below, document at
least three fraud risk factors of DHB for each of the three characteristics of the Fraud Triangle. If you make any assumption for your answer,
state your assumption.
Your Identification of DHBs Fraud Risk Factors
A. Incentives/Pressures
2.
3.
B. Opportunities
1. (assumption if any)
6
In August 2005, a government agency decertified the bullet-resistant material being used in the manufacture of a certain product line of
DHB's vests, which caused DHB to discontinue that product line.
163
164
Your Identification of DHBs Fraud Risk Factors

2.
3.
C. Attitudes/Rationalization
2.
3.
2. Exhibits 1 and 4 in iLearn present DHB's original 20032004 balance sheets and income statements and the restated balance sheets and income
statements for those two years, respectively. Review the original and restated financial statements for 2004 and identify the material differences
between them. Using the format below, identify at least four material differences and state what could be the probable cause of these material
differences. If you make any assumption for your answer, state your assumption.
1.
2.
3.
4.
Material Differences
Probable Cause of the Material Differences

(state assumption, if any)
Chapter 7
Audit Plan - Evidence
LO7-1 Understand the terminology of audit evidence.
LO7-2 Distinguish between vouching and tracing for evidence.
LO7-3 Describe the relationships among seven broad categories of evidence, eight
categories of specific audit objectives, and sixteen prescriptive terms of audit
procedures.
LO7-4 Apply analytical procedures in audit plan.
LO7-5 Apply analytical procedures in tests of balances.
LO7-6 Understand Benfords Law in tests of balances.
LO7-7 Apply analytical procedures in completing the audit.
LO7-8 Apply other audit procedures to assess a clients going concern status.
165
166
Chapter 7 Audit Plan - Evidence

This chapter discusses the auditors main consideration of audit evidence in financial and integrated audits. Figure
7-1 presents the auditors main consideration of audit evidence.
Figure 7-1 Main Considerations of Audit Evidence in Financial and Integrated Audits
The Audit Process
Audit Plan
Preplan and
Documentation CH 5
Tests of Controls
Tests of Balances
Financial Audit
Audit Report
Integrated Audit
Consider Persuasiveness
of Evidence
Objectives CH 6
Consider Appropriateness
(Reliability and Relevant)
Evidence CH 7
External Evidence
(More Reliable)
Consider Sufficiency
(Quantity or Sample size)
Internal Evidence
(Less Reliable)
Strong Internal Control

(More Reliable)
Program and
Technology CH 10
Weak Internal Control

(Less Reliable)
Obtain Indirectly
(Less Reliable)
Obtain directly
(More Reliable)
From Qualified Person

(More Reliable)
Objective Nature
(More Reliable)
Obtain Timely
(More Reliable)
From Unqualified Person

(Less Reliable)
Subjective Nature
(Less Reliable)
Obtain Untimely
(Less Reliable)
Terminology of Audit Evidence

In practice, an auditor typically finds it necessary to rely on evidence that is persuasive rather than convincing
beyond all doubt in issuing an audit opinion. The persuasiveness of evidence is the degree to which the auditor is
convinced that the evidence supports the audit opinion. The AICPAs third Fundamental Principle underlying an
audit requires the auditor to consider two determinants of the persuasiveness of evidence appropriateness and
sufficiency. The appropriateness of evidence is the measure of the quality of audit evidence in providing
support for, or detecting misstatements in, the classes of transactions, account balances, and disclosures and related
assertions. The sufficiency of evidence is the measure of the quantity of evidence. AU 500 Audit Evidence and AS
15 Audit Evidence s refer "appropriateness" to the reliability and relevance of evidence, and "sufficiency" to the
quantity of evidence. In practice, the auditor uses the term reliability of evidence as being synonymous to
appropriateness of evidence. In addition, the auditor uses the term sample size as being synonymous to
sufficiency of evidence.
The reliability of evidence depends upon several factors that are briefly discussed in Table 7-1.
Table 7-1 Factors Affecting the Reliability of Evidence
Factors Affecting the Reliability of Evidence

Source
Internal Control
Direct Knowledge
Qualification of Provider
Objectivity
Timeliness
Evidence obtained from independent external source is more reliable than evidence obtained from within
the client's organization. For example, external evidence such as communications from banks, attorneys, or
customers is more reliable than internal evidence such as answers obtained from inquiries of the client.
Similarly, external documents such as a bank statement from external source are more reliable than internal
documents such as a check.
When the clients internal controls are strong, evidence obtained is more reliable than when they are weak.
For example, if internal controls over sales and billing are strong, the auditor can obtain more reliable
evidence from sales invoices and shipping documents than if the controls are weak.
Evidence obtained directly by the auditor through examination, observation, computation, or inspection is
more reliable than evidence obtained indirectly via the client. For example, if the auditor calculates the
gross profit margin and compares it with previous periods, the evidence would be more reliable than if the
auditor relied on the calculations of the controller.
Evidence obtained from a qualified person is more reliable than evidence obtained from an unqualified
person. For example, an accounts receivable confirmation from an accountant is more reliable than that
from a person who is not familiar with the business world.
Objective evidence is more reliable than subjective evidence that requires judgment. Examples of objective
evidence include the confirmation of accounts receivable and bank balances and the physical count of
securities and cash. Examples of subjective evidence include the observation of obsolescence of inventory
and the inquiry of allowance for uncollectible accounts receivable.
The timeliness of audit evidence can refer either to when it is obtained or to the period covered by the
audit. Evidence is more reliable for balance sheet accounts when it is obtained as close to the balance sheet
date as possible. For example, the auditors count of marketable securities on the balance sheet date would
be more reliable than a count few months earlier. Evidence is more reliable for income statement accounts
when there is a sample from the entire period under audit rather than from only a part of the period. For
example, a random sample of sales transactions for the entire year would be more reliable than a sample
from only the first six months.
The relevance of evidence means that evidence must be pertinent to the auditors specific objective or the
management assertion being tested. An example is if the auditors specific objective were to examine the existence
(i.e. existence objective) of inventory, the auditor would obtain relevant evidence by observing the clients physical
inventory count (inventory-taking). However, such evidence would not be relevant in determining whether the
goods were owned by the client (i.e., rights and obligations objective) or their costs (i.e. valuation and allocation
objective). Another example is if an auditor were concerned that a client was failing to bill customers for shipments
(i.e., completeness objective), the auditor would select a sample of shipping documents and traced each to recorded
sales transactions in the sales journal to determine whether shipments have been billed; the evidence would be
relevant for testing the specific audit objective of completeness. However, if the auditor were to select a sample of
sales transactions from the sales journal and vouched each to shipping documents to determine whether sales were
supported by adequate documentations (i.e., occurrence objective), the evidence would not be relevant for
completeness (but relevant for occurrence) and therefore would not be considered reliable evidence for the specific
audit objective of completeness. Figure 7-2 presents an overview the relationships among vouching and tracing (the
direction of testing) and occurrence and completeness (the specific objectives).
167
168
Figure 7-2 Relationships among Vouching and Tracing (the direction of testing), and Occurrence and
Completeness (the specific audit objective)
Tracing for Completeness
Source Documents
Accounting Records
For example, the auditor traces a sample of sales invoices to their entries in the accounts receivable balance in the general ledgers to test the
completeness assertion (completeness objective).
Vouching for Occurrence
Source Documents
Accounting Records
For example, the auditor vouches the accounts receivable balance in the general ledger to the related sales invoices to test the existence or
occurrence assertion (occurrence objective).
The quantity of evidence is determined primarily by the sample size the auditor selected. For a given
TOC or TOB procedure, the evidence obtained from a sample of 100 would ordinarily be more sufficient than from
a sample of 50.
The persuasiveness of evidence can be evaluated only after considering the combination of reliability,
relevance and quantity of evidence. A large sample of evidence provided by an independent party is not persuasive
unless it is relevant to the audit objective being tested. A large sample of evidence that is relevant but not objective
is also not persuasive. Similarly, a small sample of only one or two pieces of highly reliable evidence also typically
lacks persuasiveness. The auditor must evaluate a combination of all factors influencing appropriateness and
sufficiency when determining the overall persuasiveness of evidence.
Finally, both persuasiveness and cost must be considered in deciding the type or types of evidence for
a given audit. The persuasiveness and cost of all alternative types of evidence should be considered before selecting
the best type or types of evidence. In practice, the auditors goal is to obtain a sufficient amount of appropriate
evidence at the lowest possible total cost. However, it should be noted that cost is never an adequate justification for
omitting a necessary evidence gathering procedure or not gathering an adequate sample size of evidence.
Seven Broad Category of Evidence
When planning an audit, the auditor considers seven broad categories of evidence. Brief comments on these seven
broad categories of evidence are provided in Table 7-2.
Table 7-2 Seven Broad Categories of Evidence
Category of Evidence
(1) Physical evidence
(2) Confirmations
Comments
Two common types of physical evidence obtained by the auditor are (a) examination of tangible assets, and
(b) observation of a client's activities. For example, the auditor counts and examines inventory to determine
that the inventory existed. Or, the auditor observes the receipt of incoming mail to determine that all checks
received through the mail are properly banked. In general, physical evidence meets the audit objective of
existence but it does little to meet the audit objective of valuation and allocation, and rights and
obligations.
Confirmations are written evidence obtained by the auditor through direct communication with
(3) Documentary evidence
(4) Written representation
(5) Oral evidence
(6) Mathematic evidence
(7) Analytical evidence
Comments
independent third parties outside of the client's organization. Typically, confirmations meet the audit
objective of existence. In general, the reliability of evidence obtained through confirmations depends upon
the third party's qualification and willingness to cooperate. The auditor frequently confirms with third
parties for the following evidence:
Third parties
Items Confirmed
(a) Bank
.........Checking account balances and cash in bank
(b) Bond trustees
.........Bond payable
(c) Customers
.........Accounts receivable balances
(d) Lessors
.........Lease terms
(e) Public warehouse managers .........Inventory stored in pubic warehouse
(f) Vendors or suppliers
.........Accounts payable balances
Two common types of documentary evidence obtained by the auditor are: (a) external documents created
outside the client's organization and held by the client, such as bank statements, vendors' invoices and
statements, contracts, and customer purchase orders, and (b) internal documents created by and held within
the client's organization which either (i) have been transmitted to and returned by outsiders to the client,
such as paid checks, or (ii) have never been transmitted to outsiders but have only been circulated within
the client's organization, such as copies of purchase orders, copies of sales invoices, receiving reports,
credit memoranda, bank reconciliation and trial balance. The auditor reads, inspects, examines, traces,
vouches or compares these documents to meet the audit objectives of occurrence, completeness and rights
and obligations. In general, external documentary evidence is more reliable than internal evidence. Table 73 presents some common internal and external documents.
Written representation is evidence in the form of a signed statement by responsible and knowledge persons
within or outside the client's organization. The auditor routinely asks for a signed management (client)
representation letter from the client's management revealing, among other things, the existence of
contingent liability or possible violation of laws or regulations by the client's personnel. The auditor also
requests the client's lawyer for a lawyer's representation letter regarding any pending litigation, claims and
assessments known to the lawyer. Written representation may pertain to any of the audit objectives.
Oral evidence is evidence obtained by the auditor through inquires of the client's key personnel. Oral
evidence is not sufficient appropriate evidence by itself. The auditor normally obtains further corroborating
evidence through other audit procedures.
Mathematical evidence involves re-computations, extensions, footings and cross-footings, reconciliation
and tracing by the auditor to verify the mathematical accuracy of the client's financial records.
Mathematical evidence provides reliable evidence for the audit objectives of valuation and allocation,
classification, cutoff and accuracy, but it does little to meet the audit objectives of existence or occurrence
and understandability.
Analytical evidence obtained by the auditor involves the use of ratio and comparisons of relationships
among financial items, such as industrial averages and prior year financial information, and non-financial
items, such as number of employees and direct labor hours. The auditor scans, compares, and analyzes
financial and non-financial information for analytical evidence. Analytical evidence meets the audit
objectives of existence or occurrence, completeness, valuation and allocation, and accuracy. In general, the
reliability of analytical evidence depends upon the plausibility of the relationships among the data, and the
availability and reliability of the data.
Table 7-3 Common Internal and External Documents
Common Internal Documents
Business Documents
Sales invoices
Purchase orders
Canceled checks
Payment vouchers
EDI agreements
Legal Documents
Labor and fringe benefit agreements
Sales contracts
Lease agreements
Royalty agreements
Maintenance contracts
Accounting Documents
Estimated warranty liability schedules
Depreciation and amortization schedules
Standard cost computations and schedules
Management exception reports
Other Documents
Employee time cards
Common External Documents
Business Documents
Vendor invoices and monthly statements
Customer orders
Sales and purchase contracts
Loan agreements
Third-party documents
Confirmation letters from legal counsel
Confirmation statements from banks
Confirmation replies from customers
Other Documents
Industry trade statistics
Credit rating reports
Data from computer service bureaus
169
170
Common Internal Documents
Common External Documents
Shipping and receiving reports

Scrap or obsolescence inventory reports
Market research surveys
Pending litigation reports
Variance reports
The Relationships between Seven Categories of Evidence and Eight Types of Specific Audit Objectives
Recall the eight types specific objectives discussed in Chapter 6:
1. Existence the specific audit objective of verifying that all assets, liabilities, and equity interests included in the
financial statements actually exist at the date of the financial statements.
Occurrence the specific audit objective of verifying that all transactions and events that have been recorded have
occurred, disclosed, and pertain to the client.
2. Completeness the specific audit objective of verifying that all transactions and events, assets, liabilities, and
equity interests that should have been recorded and included in the financial statements have been recorded and
included.
3. Rights and Obligations the specific audit objective of verifying that the client holds or controls the rights to
assets and that liabilities are the obligation of the client.
4. Valuation and Allocation the specific audit objective of verifying that all assets, liabilities, and equity interests
are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments
are recorded appropriately.
5. Classification the specific audit objective of verifying that all transactions and events have been recorded in the
proper accounts and that financial and other information is presented and described appropriately.
6. Cutoff the specific audit objective of verifying that all transactions and events have been recorded in the correct
accounting period.
7. Accuracy the specific audit objective of verifying that amounts and other data relating to recorded transactions
and events have been recorded appropriately and that financial and other information are disclosed fairly.
8. Understandability the specific audit objective of verifying that financial and other information in disclosures are
expressed clearly.
Table 7-4 presents a summary of the relationships between the seven categories of evidence and the eight
types of specific audit objectives
Table 7-4 Relationships between Seven Categories of Evidence and Eight Types of Specific Audit Objectives
(2) Confirmations
(5) Oral evidence
Types of Specific Audit Objectives

Existence but not valuation and allocation, and rights and obligations.
Existence.
Occurrence, completeness and rights and obligations.
Any specific audit objectives.
None on its own.
Valuation and allocation, classification, cutoff, and accuracy but not existence or occurrence and
understandability.
Existence or occurrence, completeness, valuation and allocation, and accuracy.
The Relationships among Seven Categories of Audit Evidence, Eight Types of Specific Audit Objectives, and
Sixteen Prescriptive Terms of Audit Procedures
When planning an audit, the auditor prescribes audit procedures for obtaining audit evidence pertinent to specific
audit objectives. The auditor uses sixteen prescriptive terms to prescribe the audit procedures. These sixteen
prescriptive terms are based on the seven categories of evidence. Table 7-5 presents the sixteen prescriptive terms
based on the seven categories of evidence. Table 7-6 provides comments on the sixteen prescriptive terms.
Table 7-5 Sixteen Prescriptive Terms of Audit Procedures based on Seven Categories of Evidence
(2) Confirmation
(5) Oral evidence
Prescriptive Terms of Audit Procedures

Count, Inspect, Observe, Examine.
Confirm.
Compare, Examine, Read, Trace, Vouch, Inspect.
Request, Confirm
Inquire.
Foot, Cross-foot, Re-compute, Reconcile, Trace, Extend.
Compute, Scan, Compare, Analyze.
Table 7-6 Comments on the Sixteen Prescriptive Terms of Audit Procedures

Prescriptive Terms
(1) Analyze
(2) Compare
(3) Confirm
(4) Count
(5) Examine
(6) Extend
(7) Foot & Cross-Foot
(8) Inquire
(9) Inspect
(10) Observe
(11) Read
(12) Re-compute
(13) Reconcile
(14) Scan
(15) Trace
(16) Vouch
Comments
A procedure used by the auditor to study and compare relationships among financial and non-financial
items. For example, the auditor performs a trend analysis of the sales data.
A procedure used by the auditor to compare financial items from two different sources. For example, the
auditor compares the unit-selling price on the invoice to the standard price list.
A procedure used by the auditor to obtain information from an independent party outside the client's
organization. For example, the auditor confirms accounts receivable and payable with debtors and creditors,
respectively.
A procedure used by the auditor to provide physical evidence of the quantity of the financial items on hand.
For example, the auditor counts the cash on hand at the balance sheet date.
A procedure used by the auditor to conduct a detailed study of documents, records and tangible assets. For
example, the auditor examines a sample of vouchers to determine whether they are properly authorized.
A procedure used by the auditor to multiply a set of figures. For example, the auditor extends the client's
inventory listing by multiplying the quantities in units by the cost per unit.
A procedure used by the auditor to add a column of figures (footing) and a row of figures (cross-footing) to
determine whether a client's calculation is correct. For example the audit foots the accounts receivable aging
schedule to determine its accuracy.
A procedure used by the auditor to produce oral or written evidence of financial items. For example, the
auditor obtains a management representation letter, which states that the client's management has made all
accounting records available to the auditor.
A procedure used by the auditor to carefully scrutinize documents, records and tangible assets. For example,
the auditor inspects the physical condition of certain inventories.
A procedure used by the auditor to watch or witness the performance of some activities. From these
observations the auditor obtains direct evidence about the existence of physical evidence. For example, the
auditor observes the client's inventory count procedure.
A procedure used by the auditor to determine the facts of a written document. For example, the auditor reads
the minutes of the client's corporate meetings.
A procedure used by the auditor to independently recalculate financial items to determine their mathematical
accuracy. For example, the auditor re-computes the depreciation schedule.
A procedure used by the auditor to explain the differences between the balances of financial items shown in
the client's bank and that provided by the outside party. For example, the auditor reconciles the client's cash
on hand as per the cash-book with the cash in bank as per the bank statement.
A procedure used by the auditor to perform a less detailed scrutiny of documents, records and tangible
assets. For example, the auditor scans the sales journal for large and unusual transactions.
A procedure used by the auditor to test financial items from the source documents to the accounting records.
For example, the auditor traces a sample of sales invoices to their entries in the accounts receivable balance
in the general ledgers to test the completeness assertion (completeness objective).
A procedure used by the auditor to test financial items from the accounting records to the source documents.
For example, the auditor vouches the accounts receivable balance in the general ledger to the related sales
invoices to test the existence or occurrence assertion (occurrence objective).
Figure 7-3 depicts the relationships among the seven categories of audit evidence, the eight types
of specific audit objectives, and the sixteen prescriptive terms of audit procedures. Note that there is not necessary a
one-to-one relationship among audit evidence, specific audit objective and prescribed audit procedure. Audit
evidence pertinent to a specific audit objective is ordinarily obtained by prescribing several audit procedures. For
example, evidence pertinent to the specific audit objective of existence of inventory is ordinarily obtained by
prescribing several audit procedures such as count, inspect, observe, and examine physical inventory.
171
172
Figure 7-3 Relationships among Seven Categories of Audit Evidence, Eight Types of Specific Audit
Objectives, and Sixteen Prescriptive Terms of Audit Procedures

(8 broad types)
Pertinent to
Audit Evidence
(7 Broad Categories)
To obtain
Audit Procedures
(16 Prescriptive Terms)
Evaluation of Audit Evidence

Once the seven categories of evidence have been gathered (see Tables 7-2 through to 7-6), the auditor evaluates their
reliability (low, medium, or high) based on the factors that affect their reliability (see Table 7-1). For example, if the
auditor tested for the specific audit objective of existence of inventory and used the audit procedure of inquiry with
the warehouse manager to obtain the evidence, then the reliability of the evidence is generally regarded as low
because not only internal source of evidence is less reliable (see Table 7-1) but also oral evidence gathered through
inquiry alone is not sufficient to accomplish any specific audit objective (See Table 7-4 and Table 7-5). In other
words, to accomplish the existence objective, the auditor would need to corroborate the oral evidence with more
reliable direct knowledge evidence (see Table 7-1) such as conducting test counts of the inventory for physical
evidence (see Table 7-4 and Table 7-5).
Analytical Procedures
Recall in Table 7-5 the 7th category of evidence (analytical evidence) and the audit procedures associated with it
(compute, scan, compare, and analyze). The audit procedures for gathering the analytical evidence are collectively
known as analytical procedures. Analytical procedures are defined in AU 520 Analytical Procedures as "evaluations
of financial information made by a study of plausible relationships among both financial and non-financial data."
These procedures are based on the presumption that plausible relationship among data may reasonably be expected
to exist. For example, accounts receivable and sales should bear a plausible relationship to one another. Thus, if
gross sales for a company decrease substantially from one period to the next, an auditor might reasonably expect a
substantial decrease in accounts receivable as well.
Analytical procedures range from simple comparisons to complex statistical models. Auditor uses six
common types of analytical procedures in the audit process. These are:
1. Compare client and industry data.
2. Compare client data with similar prior-period data.
3. Compare client data with client-determined expected results.
4. Compare client data with auditor-determined expected results.
5. Compare client data with expected results, using non-financial data.
6. Perform financial ratio analysis on client data.
These six common types of analytical procedures are commonly used in the audit process as shown in Figure 7-4.
Figure 7-4 Analytical Procedures used in the Audit Process

The Audit Process
Audit Plan
Tests of Controls
Analytical
Procedures #1, #2
#5, #6
Not Applicable
Tests of Balance
Analytical
Procedures #3, #4,
#5
Analytical
Procedure #6,
Benfords Law
Audit Report
Not Applicable
Analytical Procedures in Audit Plan

An auditor uses analytical procedures in planning an audit to:
1. Enhance an understanding of the client's business.
2. Identify areas that may represent risk of misstatement.
3. Direct attention to areas of greater risk, and to plan for more effective and efficient audit procedures.
Analytical procedures used in planning an engagement include reviewing financial information to identifying
unexpected relationships or trends. For example, a comparison of general ledger balances with similar balances
from prior periods and with budgeted or forecasted balances. Various ratios or trends may also be computed to
facilitate the analysis. In addition to financial data, non-financial data may be used as part of the analytical
procedures. For example, quality control reports prepared near year-end may identify production problems, which
may suggest that significant amounts of inventory sold during the latter part of the year may be returned or may
significantly increase future warranty claims. The use of analytical procedures in planning an audit typically
involves five steps as shown in Table 7-7.
Table 7-7 Analytical Procedures in Audit Plan Phase
Steps in Analytical
Procedures
(1) Determine
computations/comparisons to be
made
(2) Develop expectations
Comments
Types of calculation and comparison commonly used include the following:
(a) Absolute data comparisons. For example, comparing the amount of an account balance with an expected
or predicted amount.
(b) Common-size financial statements. This involves calculating the percentage of a related total that a
financial statement item represents. For example, cash as a percentage of total assets. The percentage is
then compared with an expected amount.
(c) Ratio analysis. Ratios can be analyzed individually or in related groups such as activity, profitability,
liquidity, leverage, and solvency. Table 7-8 provides a summary of the common ratios and their
interpretations under each category of ratios.
(d) Trend analysis. Trend analysis involves comparing certain data (absolute, common-size, or ratio) across
accounting periods.
Typical information that an auditor uses for developing expectations
include:
(a) Financial information from comparable prior periods. For example, an expectation that total payroll
costs will equal last year's amount adjusted for a predictable increase resulting from higher wage rates
and/or higher payroll taxes.
(b) Anticipated results, such as projections or forecasts. For example, an expectation that current year data
can be extrapolated from prior interim or annual data.
(c) Relationships among elements of financial information. For example, an increase in the average
amount of debt outstanding would lead to an expected increase in interest expense.
(d) Information regarding the industry in which the client operates. For example, an expectation that
173
174
Steps in Analytical
Procedures
(3) Perform the

computations/comparisons
(4) Analyze data and identify

significant differences
(5) Determine effects on audit

planning.
Comments
inventory turnover should be reasonably consistent across companies in the same industry. Data of other
companies within an industry may be obtained from sources such as Dun & Bradstreet, Robert Morris
Associates, and Standard & Poor
(e) Relationship between financial and non-financial information. For example, a client's share of the
market may be used to develop expectation about its sales.
This step involves gathering data to be used in computing the absolute amount, the common-size
percentage, ratios and so on. It also includes gathering the industry data for comparison purposes.
Computer software is commonly used in making the calculations and comparisons, and may also be used in
extracting information from company and industry databases.
This typically involves reconsidering the methods and variables used in developing the expectations and
making inquiries of management. Management's response should ordinarily be corroborated with other
evidential matter. When an explanation for the difference cannot be obtained, the auditor must determine
the impact on the audit plan.
Unexplained significant differences ordinarily indicate increase risk of misstatement in the account or
accounts involved in the computation and comparison. The auditor will then plan to perform more effective
and efficient tests on the accounts.
Table 7-8 Common Ratios Used for Ratio Analysis
Category
Activity
Activity ratios measure the
managements effectiveness in
managing available resources.
Profitability
Profitability ratios measure the
generating return on investment
in assets and equity.
Liquidity
Liquidity ratios measure the
managements ability to meet
current obligations.
Ratio
Interpretation
Asset Turnover = Net Sales / Total Assets
Measures capital intensity: the larger the number the more a

client is able to generate sales with its asset base.
Inventory Turnover = Cost of Goods Sold /

Average Inventory
Measure inventory management: the larger the number the

faster a client is able to turn over its inventory.
Trends in the inventory turnover ratio are used by auditors to
identify potential inventory obsolescence.
Days in Inventory Turnover = 365 days /

Inventory Turnover
Measure inventory management: the larger the number the

longer a client is holding on the inventory.
Accounts Receivable Turnover = Net Sales

/ Average Accounts Receivable
Measure credit effectiveness: the larger the number the faster

a client is able to turn over its credit sales.
Trends in the accounts receivable turnover ratio are used by
auditor to assess the reasonableness of the allowance for
uncollectible accounts.
Days in Accounts Receivable Turnover =

365 days/ Accounts Receivable Turnover
Return on Total Assets = Operating Income
Before Interest and Taxes/ Average Total
Assets
Measure credit effectiveness: the larger the number the

longer a client takes to collect accounts receivable.
Measure asset management: the higher the number the
higher the rate of return on investment in assets.
Return on Common Equity = Operating

Income Before Interest and Taxes / Average
stockholders Equity
Measure equity management: the higher the number the

higher the rate of return on stockholders investment in the
company.
Profit Margin = Operating Income Before

Interest and Taxes / Net Sales
Measure operating profitability: the higher the number the

higher the rate of return on operations.
This ratio is useful to auditors in assessing potential
misstatements in operating expenses and related balance
sheet accounts.
Gross Profit Margin or Percentage = (Net

Sales Cost of Goods Sold )/ Net sales
Measure operating profitability: the larger the number the

larger the portion of the net sales available to cover all
expenses after deducting the cost of product.
This ratio is useful to auditors in assessing misstatements in
sales, cost of goods sold, and inventory.
Measure working capital management: the larger the ratio
the greater adequacy of current assets to cover current
liabilities.
Current Ratio = Current Assets / Current

Liabilities
Quick Ratio = (Cash + Marketable
Securities + Net Accounts Receivable) /
Current Liabilities
Measure working capital management: the larger the ratio

the greater a company is ability to meet its current liabilities
with cash or and near-cash assets.
Category
Solvency (Leverage)
Solvency ratios measure the
managing borrowed funds or in
generating income on borrowed
funds.
Ratio
Interpretation
Free Cash Flow = Cash Flow from

Operations Capital Expenditure
Measure the cash flow remaining after covering cash

outflows for operations and capital expenditures: the larger
the number the higher a company has the capacity to finance
operations and capital expenditures with operating cash
flows.
Measure long-term debt management: if the ratio is too high,
a company may have used up its borrowing capacity; if the
ratio is too low, available debt leverage to a company is not
being used to the stockholders benefit.
Debt to Equity = Total Liabilities/

Stockholders Equity, or
Debt to Total assets = Total Debt/Total
Assets
Times Interest Earned = Operating Income
Before Interest and Taxes / Interest Expense
Measure interest expense management: the number of times

a company is able to make interest payments by generating
positive cash flow from operations.
Analytical Procedures in Tests of Balances

An auditor uses analytical procedures in tests of balances (TOB) either:
1. As a TOB procedure to achieve an audit objective related to a particular management assertion, or
2. To provide audit evidence to corroborate evidence obtained from other audit testing procedures.
For some assertions, analytical procedures are effective and efficient TOB procedures. For other assertions,
however, analytical procedures are not as effective and efficient. Several factors determine the effectiveness and
efficiency of an analytic procedure. These are shown in Table 7-9.
It should be note that AU 520 states that analytical procedures must be applied (mandatory) at audit plan
and completing the audit, but that analytical procedures may be applied (not mandatory) at tests of balances
(substantive tests).
Table 7-9 Factors Affecting the Effectiveness and Efficiency of an Analytical Procedure
Factors
(1) Nature of the assertion.
(2) Plausibility and predictability

of the relationship.
(3) Availability and reliability of

data.
(4) Precision of the expectation.
Comments
Analytical procedures are effective and efficient for assertions in which misstatements would not be
apparent from TOB of individual transaction. For example, comparisons of aggregate salaries paid with the
number of personnel may indicate unauthorized payments that may not be apparent from testing individual
transactions.
Analytical procedures are more effective and efficient for expected relationships that are plausible and
predictable. As a rule of thumb:
(a) Relationships are more predictable in a stable than a dynamic or unstable environment.
(b) Relationships are more predictable for income statement accounts (representing transactions over a
period of time) than balance sheet accounts (representing amounts at a point in time).
(c) Relationships involving transactions subject to management discretion are less predictable. For example,
management may delay advertising expenditures.
Analytical procedures are more effective and efficient when data is readily available and reliable. As a rule
of thumb:
(a) Audit data (current or prior year) is more reliable than un-audited data.
(b) Data is more reliable when obtained from sources outside than from sources within the client.
(c) Data is more reliable when the client has adequate separation of duty.
(d) Data is more reliable when the client has adequate internal controls.
(e) Reliability of expectations increases as sources of data increase.
Analytical procedures are more effective and efficient when the expected relationships are more precise.
The precision of the expected relationships depends on:
(a) The number of relevant variables that affect the amount being audited, e.g., sales are affected by prices,
volume and product mix. The more variables, the more precise is the expectation.
(b) The number of relevant variables that are evaluated by the auditor. The more variables evaluated, the
more precise the expectation.
(c) The level of detail in the data used to develop the expectation. The more detailed the data, the more
precise the expectation. For example, monthly amounts are more precise than annual amount; comparison by
location or line of business is more precise than company-wide comparisons.
Benfords Law in Tests of Balances

A complex analytical procedure that can be used as a TOB procedure is the application of Benfords Law. Benfords
Law is a numerical probability theory that establishes the probability of the appearance of numerical digits in
naturally occurring sets of numbers. The Benfords Law establishes the following approximate probabilities of
175
176
occurrence as first digits: 1-30%, 2-18%, 3-12%, 4-10%, 5-8%, 6-7%, 7-6%, 8-5%, and 9-4%. A perpetrator, who
has no knowledge of the Benfords Law, would create accounting numbers by assuming that all the fraudulently
created numbers have an equal probability of occurrence as the first digit. Thus, by checking the probability of
occurrence of the first digit in a sample of accounting numbers under consideration, the auditor is able to detect
potential accounting frauds. For example, a purchasing officer in charge of the purchasing department is authorized
to approve payments of vouchers to a maximum limit of $5,000. If the auditor finds a higher than expected
probability of occurrence (i.e., more than 10%) of 4 as a first digit in a sample of vouchers (i.e., vouchers at $4,001
to $4,999), then it is very likely that the purchasing officer intentionally divided large voucher payments into smaller
voucher payments of just under the maximum limit of $5,000 to avoid seeking higher level of approval for the
voucher payments. Thus, the purchasing officers spending pattern is likely to be further investigated by the auditor.
It should be note that large samples of numbers adhere more closely to the probability of occurrence of the
Benfords Law than small samples. Moreover, the application of the Benfords Law can result in false positives (i.e.,
wrong conclusion) in practice. For example, an HMOs fee schedule can create clustering (i.e., groups of set fees),
and hence results in false non-compliant number repetition in a medical offices billing.
Analytical Procedures in Completing the Audit
An auditor uses analytical procedures at the completing the audit phase either as part of the final review of the
audited financial statements or to assess whether the client continues as a going concern. Table 7-10 provides some
comments on applying the analytical procedures for these two purposes.
Table 7-10 Applying Analytical Procedures at Completing the Audit Phase
As Part of the Final Review
Assessment of a Client's Going Concern Status
As part of the final review of the audited financial statements,

analytical procedures are used to determine whether the anticipated
opinion on the financial statements is appropriate. For this purpose, the
auditor should consider:
(1) The adequacy of data collected in response to unusual or
unexpected balances identified as part of the preliminary analysis.
(2) The existence of unusual or unexpected balances not otherwise
identified during the examination of the financial statements.
When the final review identifies unusual or unexpected balances not
addressed during other phases of the engagement, the auditor must
determine whether additional procedures should be performed before
expressing an opinion on the financial statements.
At the completion of the audit, an auditor uses analytical procedures to

assess whether a client will continue as a going concern, e.g., a low
current ratio indicates a potential going concern problem.
Altman (1968) developed a model for predicting bankruptcy as
follows:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Z = discriminant Z score
X1 = net working capital/total assets
X2 = retained earnings/total assets
X3 = earnings before interest and taxes/total assets
X4 = market value of equity/total debt (liabilities)
X5 = net sales/total assets
A client will be a going concern if Z is greater than 2.99
The predictive accuracy of Altman's model is about 95% one year
prior to bankruptcy. Since auditors are responsible for assessing a
client's going concern status for a reasonable period of time; and a
reasonable period of time is defined as one year beyond the date of
client's year-end financial date according to AU 570 Going Concern,
the model's high predictive accuracy of one year prior to bankruptcy
(95%) renders it a very effective analytical procedure for assessing a
client's going concern status.
Other Audit Procedures to Assess a Clients Going Concern Status

In addition to performing analytical procedures, an auditor also performs other audit procedures to identify
conditions and events that indicate there could be substantial doubt about a client's ability to continue as a going
concern. These other audit procedures include:
1. Review of subsequent events.
2. Review of compliance with the terms of debt and loan agreements.
3. Reading of minutes of meetings of stockbrokers, board of directors, and important committees of the board.
In performing these audit procedures, the auditor seeks to identify conditions and events that indicate a
substantial doubt about a client's ability to continue as a going concern. Table 7-11 shows some of these conditions
and events. After considering these conditions and events in the aggregate; if the auditor believes there is substantial
doubt about a client's ability to continue as a going concern, s/he should identify the management's plan, if any, for
mitigating the adverse conditions and events, and consider the effectiveness and feasibility of the management's
plan. Table 7-12 describes the auditors considerations about the managements plan.
Table 7-11 Conditions and Events that Indicate a Substantial Doubt
Conditions and Events
(1) Negative financial trend
(2) Non-financial indicators
(3) Internal factors
(4) External factors
Examples
(a) Recurring operation losses
(b) Working capital deficiencies
(c) Negative cash flows
(d) Adverse key financial ratios
(a) Arrearages in dividends
(b) Denial of trade credit from suppliers
(c) Restructuring of debt
(d) Noncompliance with statutory capital requirements
(e) Need new source/method of financing
(f) Need to dispose substantial assets
(a) Work stoppages/labor difficulties
(b) Over dependence on the success of a particular project
(c) Uneconomic long-term commitments
(d) Need to significantly revise operation
(a) Adverse legal proceedings
(b) Loss of a key franchise, license, patents, copyright , trademark
(c) Loss of a principal customer or supplier
(d) Uninsured or underinsured policies against drought, earthquake, fire or flood.
Table 7-12 Managements Plan and Auditors Consideration

Managements Plan
(1) Plans to dispose of assets
(2) Plans to borrow money or

restructure debt
(3) Plans to reduce or delay
expenditure
(4) Plans to increase ownership
equity
Auditors Consideration
(a) Restrictions on disposal of assets, e.g., covenants on assets
(b) Marketability of assets
(c) Direct/indirect effects of disposal of assets
(a) Availability of debt financing, e.g., new credit line, factoring of receivables, sale -leaseback of assets
(b) Availability/committed loans to the client
(c) Effects of additional borrowings
(a) Feasibility of reducing overheads or administrative expenditures
(b) Postponing maintenance or research and development projects
(c) Lease rather than purchase assets
(a) Feasibility of increasing ownership equity
(b) Arrangements to raise additional capital
(c) Arrangements to reduce dividend requirement
(d) Arrangements to accelerate cash disbursement from affiliates or other investors.
177
178
7-1
Which of the following statements is true with regard to audit evidence?

a. Evidence obtained from sources external to the client is less reliable than those from sources internal to the client.
b. Evidence obtained from sources internal to the client is more reliable when its internal control is strong than weak.
c. Evidence supplied by the client is more reliable than those personally obtained by the auditor.
d. Evidence obtained through confirmation is less reliable than those obtained through observation.
7-2
Which of the following audit procedures would produce the least reliable audit evidence?
a. Test counts of inventory made by the auditor.
b. Notes on inquiry with the warehouse manager.
c. Correspondence with the suppliers of the inventory.
d. An analysis of the perpetual inventory records.
7-3
The auditor's analytical procedures will not be very effective in determining which of the following assertions?
a. Rights and obligations.
b. Completeness.
c. Valuation and allocation.
d. Presentation and disclosure.
7-4
Analytical procedures are best described as

a. tests of controls designed to evaluate the strength of internal controls.
b. tests of balances designed to substantiate financial information.
c. audit tests designed to evaluate the reasonableness of financial and non-financial information.
d. audit tests designed to investigate unrecorded accounting transactions.
7-5
Analytical procedure may be performed

a. at the planning and completion phases of an audit.
b. at the tests of controls and tests of balances phases of an audit.
c. at the tests of transactions and tests of balances phases of an audit.
d. at the planning, testing, and completion phases of an audit.
7-6
Which of the following ratios is an indicator of a client's ability to pay its long-term debt?
a. Debt to equity ratio.
b. Gross profit margin ratio.
c. Quick ratio.
d. Accounts receivable turnover ratio.
7-7
If accounts receivable turnover ratio for a client is 4 times in 20x0 and 2 times in 20x1, it is most likely that
a. there were fictitious credit sales in 20x1.
b. there was a better management of credit granting procedure in 20x0.
c. there were unrecorded credit sales in 20x0.
d. there was a poorer management of credit granting procedure in 20x0.
7-8
If inventory turnover ratio for a client is 5 times in 20x0 and 10 times in 20x1 , it is most likely that (Hint: obsolete inventory is
deducted from closing inventory)
a. there was an increase in the cost of goods sold in 20x0.
b. there was an increase in purchases in 20x0.
c. there was a decrease in obsolete inventory in 20x1.
d. there was an increase in obsolete inventory in 20x1.
7-9
When an auditor compares a set of financial data with a set of expected data computed by the auditor, which of the following
characteristics should the auditor pay most attention to?
a. The reliability of the original data from which the auditor computed the expected results.
b. The availability of the original data from which the auditor computed the expected results.
c. The size of the original data from which the auditor computed the expected results.
d. The realism of the original data from which the auditor computed the expected results.
7-10
Which of the following ratios is an indicator of a client's effectiveness in its operation?

a. Quick ratio.
b. Return on total assets.
c. Times interest earned.
d. Average inventory turnover ratio.
7-11
Which of the following ratios is least likely to be used in comparing clients in the same industry?
a. Average inventory turnover ratio.
b. Return on total assets ratio.
c. Current ratio.
d. Return on common equity ratio.
7-12
Which of the following ratios is least likely to be used in checking the liquidity position of a client?
a. Debt to equity ratio.
b. Gross profit margin ratio.
c. Current ratio.
d. Quick ratio.
7-13
Evidence is generally considered appropriate when

a. it has been obtained by a random selection.
b. there is enough of it to afford a reasonable basis for an opinion on financial statements.
c. it has the qualities of being relevant and reliable.
d. it consists of written statements made by managers of the audit client.
7-14
When the auditor examines the clients documents and records to substantiate the information on the financial statements,
it is commonly referred to as
a. inquiry.
b. confirmation.
c. vouching.
d. physical examination.
7-15
Evidence obtained directly by the auditor will not be reliable if

a. the auditor lacks the qualifications to evaluate the evidence.
b. it is provided by the clients attorney.
c. the client denies its veracity.
d. it is impossible for the auditor to obtain additional corroboratory evidence.
7-16
Which of the following factors would least influence an auditors consideration of the reliability of data for purposes of
analytical procedures?
a. Whether sources within the client were independent of those who are responsible for the amount being audited.
b. Whether the data were processed in an EDP system or in a manual accounting system.
c. Whether the data were subjected to audit testing in the current or prior year.
d. Whether the data were obtained from independent sources outside the entity or from sources within the entity.
7-17
Which of the following procedures would provide the most reliable audit evidence?
a. Inquiries of the clients internal audit staff held in private.
b. Inspection of prenumbered client purchase orders filed in the vouchers payable department.
c. Analytical procedures performed by the auditor on the entitys trial balance.
d. Examine of bank statements obtained directly from the clients financial institution.
7-18
Which of the following statements concerning audit evidence is correct?

a. To be appropriate, audit evidence should be either reliable or relevant, but need not be both.
b. The auditor exercises judgment in determining the reliability of audit evidence.
c. The difficulty and cost of obtaining audit evidence concerning an account balance is a valid basis for omitting the test.
d. A clients accounting data can be sufficient audit evidence to support the financial statements.
179
180
7-19
Which of the following presumptions is correct about the reliability of evidence?

a. Information obtained indirectly from outside sources is the most reliable evidence.
b. To be reliable, evidence should be convincing rather than persuasive.
c. Reliability of evidence refers to the amount of corroborative evidence obtained.
d. A strong internal control provides more assurance about the reliability of evidence.
7-20
In testing the existence or occurrence assertion for an asset, an auditor ordinarily vouches from the
a. financial statement s to the potentially unrecorded items.
b. potentially unrecorded items to the financial statements.
c. accounting records to the supporting documents.
d. supporting documents to the accounting records.
7-21
In determining whether transactions have been recorded (completeness objective), the direction (tracing versus vouching)
should be from the
a. general ledger balance.
b. adjusted trial balance.
c. original source documents.
d. general journal entries.
7-22
A clients income statements were misstated due to the recording of journal entries that involved debits and credits to an
unusual combination of expense and revenue accounts. The auditor would most likely detect these misstatements by
a. tracing a sample of source documents to the related general ledger.
b. evaluating the effectiveness of internal control policies and procedures.
c. investigating the reconciliations between controlling accounts and subsidiary records.
d. performing analytical procedures designed to disclose differences from expectations.
7-23
Which of the following non-financial information would an auditor most likely consider in performing analytical
procedures during the planning phase of an audit?
a. Work stoppages and labor difficulties.
b. Objectivity of audit committee member.
c. Square footage of selling space and market share.
d. Management plans to repurchase stock.
7-24
Analytical procedures performed at the completing the audit phase as part of the final review of the audited financial
statements suggest that several accounts have unexpected relationships. The results of these analytical procedures most
likely would indicate that
a. additional tests of balances are required.
b. fraud exists among the relevant account balances.
c. internal controls of the relevant account are not effective.
d. previous communication with the audit committee should be revised.
7-25
Which of the following would not be considered an analytical procedure?

a. Estimating payroll expense by multiplying the number of employee by the average hourly wage rate and the total hours
worked.
b. Estimating the maximum population misstatement rate of inventory based on the results of a statistical sample.
c. Computing accounts receivable turnover by dividing credit sales by the average net receivable.
d. Developing the expected current-year sales based on the sales trend of the prior five years.
7-26
Which of the following factors least affects the effectiveness and efficiency of an analytical procedure?
a. Segregation of obsolete inventory before the physical inventory count.
b. A standard cost system that produces variance reports.
c. Collection of data from sources with strong internal controls.
d. The level of detail in the data used to develop the expected relationships.
7-27
Analytical procedures used in the planning phase of an audit process should focus on
a. reducing the scope of tests of controls and tests of balances.
b. providing assurance that potential material misstatements will be identified.
c. enhancing the auditors understanding of the clients business.
d. assessing the sufficiency of the available evidential matter.
7-28
An auditors decision either to apply analytical procedures as tests of balances or to perform tests of balances usually is
determined by the
a. availability of the tests of balances procedures.
b. auditors familiarity with industry trend.
c. timing of performing the tests of balances procedures.
d. relative effectiveness and efficiency of the testing procedures.
7-29
Which of the following statements concerning analytical procedures is correct?

a. Analytical procedures should be used when there is no plausible relationships among non-financial information.
b. Analytical procedures used in planning the audit should not use non-financial information.
c. Analytical procedures usually are effective and efficient for tests of controls.
d. Analytical procedures alone may provide the appropriate level of assurance for some assertions.
7-30
Which of the following tends to be most predictable for purposes of analytical procedures applied as tests of balances?
a. Data subjected to auditing in the prior year.
b. Transactions subject to management discretion.
c. Relationships involving income statement accounts.
d. Relationships involving balance sheet accounts.
7-31
Which of the following comparisons is the most useful analytical procedure an auditor could make in evaluating a clients
expenses?
a. The current years accounts receivable with the prior years accounts receivable.
b. The current years payroll expense with the prior years payroll expense.
c. The current years budgeted sales with the prior years sales.
d. The current years budgeted contingent liabilities with prior years contingent liabilities.
7-32
Which of the following conditions or events most likely would cause an auditor to have substantial doubt about a clients
ability to continue as a going concern?
a. Significant related party transactions are pervasive.
b. Usual trade credit from suppliers is denied.
c. Arrearages in preferred stock dividends are paid.
d. Restrictions on the disposal of principal assets are present.
7-33
An auditor believes there is substantial doubt about the ability of a client to continue as a going concern for a reasonable
period of time. In evaluating the clients plans for dealing with the adverse effects of future conditions and events,
the auditor most likely would consider, as a mitigating factor, the clients plans to
a. discuss with lenders the terms of all debt and loan agreements.
b. strengthen internal controls over cash disbursements.
c. purchase production facilities currently being leased from a related party.
d. postpone expenditures for research and development projects.
7-34
An auditor believes there is substantial doubt about the ability of a client to continue as a going concern for a reasonable
period of time. In evaluating the clients plans for dealing with the adverse effects of future conditions and events,
the auditor most likely would consider, as a mitigating factor, the clients plans to
a. accelerate research and development projects related to future products.
b. accumulate treasury stock at prices favorable to the clients historic price range.
c. purchase equipment and production facilities currently being leased.
d. negotiate reductions in required dividends being paid on preferred stock.
7-35
Which of the following auditing procedures most likely would assist an auditor in identifying conditions and events that
may indicate substantial doubt about a clients ability to continue as a going concern?
a. Inspecting title documents to verify whether any assets are pledged as collateral.
b. Confirm with third parties the details of arrangements to maintain financial support.
c. Reconciling the cash balance per books with the cutoff bank statement and the bank reconciliation.
d. Comparing the clients depreciation and asset capitalization policies to other entities in the industry.
181
182
7-36
When an auditor concludes there is substantial doubt about a continuing clients ability to continue as a going concern for a reasonable
period of time, the auditors responsibility is to
a. express a qualified or adverse opinion, depending upon materiality, due to the possible effects on the financial
statements.
b. consider the adequacy of disclosure about the clients possible inability to continue as a going concern.
c. report to the clients audit committee that managements accounting estimates may need to be adjusted.
d. reissue the prior years auditors report and add an explanatory paragraph that specially refers to substantial doubt and
going concern.
7-37
The third standard of field work requires the auditor to collect sufficient appropriate evidential matter in support of the
opinion. Which procedure for collecting evidential matter is not identified in this standard?
a. Inspection.
b. Inquiries.
c. Observation.
d. Rechecks.
7-38
AU 500 Audit Evidential, states that management makes certain assertions that are embodied in financial
statement components; for example, two such categories of assertions are completeness and valuation or allocation. Which of the
following is not a broad category of management assertions according to the auditing standards?
a. Rights and obligations.
b. Presentation and disclosure.
c. Existence or occurrence.
d. Errors or fraud.
7-39
Which of the following is an example of corroborating information (note: versus underlying information) that could be used by an
auditor as evidential matter supporting the financial statements?
a. Worksheets supporting cost allocations.
b. Confirmation of accounts receivable.
c. General and subsidiary ledgers.
d. Accounting manuals.
7-40
Audit evidence can come in different forms with different degrees of persuasiveness. Which of the following is the least
persuasive type of evidence?
a. Bank statement obtained from the client.
b. Test counts of inventory made by the auditor.
c. Prenumbered purchase order forms.
d. Correspondence from the clients attorney about litigation.
7-41
Audit evidence can come in different forms with different degrees of persuasiveness. Which of the following is the most
persuasive type of evidence?
a. Prenumbered client purchase order forms.
b. Client work sheets supporting cost allocations.
c. Bank statements obtained from the client.
d. Client representation letter.
7-42
Which of the following presumptions does not relate to the appropriateness (note: versus sufficiency) of audit evidence?
a. The more effective internal control, the more assurance it provides about the accounting data and financial statements.
b. An auditors opinion, to be economically useful, is formed within reasonable time and based on evidence obtained at a
reasonable cost.
c. Evidence obtained from independent sources outside the entity is more reliable than evidence secured solely within the
client.
d. The independent auditors direct personal knowledge, obtained through observation and inspection, is more persuasive
than information obtained indirectly.
7-43
A basic premise underlying analytical procedures is that

a. these procedures cannot replace tests of balances and transactions.
b. statistical tests of financial information may lead to the discovery of material misstatements in the financial statements.
c. the study of financial ratios is the only alternative to the investigation of unusual fluctuation.
d. plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions
to the contrary.
7-44
An objective of performing analytical procedures in planning an audit is to identify the existence of

a. unusual transactions and events.
b. illegal acts that went undetected because of internal control weaknesses.
c. related party transactions.
d. recorded transactions that were not properly authorized.
7-45
For audits of financial statements made in accordance with generally accepted auditing standards (GAAS), the use of
analytical procedures is required (mandatory) to some extent
a.
b.
c.
d.
7-46
In Planning
No
Yes
Yes
No
In Tests of Balances
Yes
Yes
No
No
In Completing the Audit

Yes
No
Yes
No
A primary objective of analytical procedures used in the final review stage of completing the audit is to
a. obtain evidence from details testing to corroborate particular assertions.
b. identify areas that represent specific risks relevant to the audit.
c. assist the auditor in assessing the validity of the conclusions reached.
d. satisfy doubts when questions arise about a clients ability to continue in existence.
7-47
Analytical procedures used in the final review stage of completing the audit generally include
a. considering unusual or unexpected account balances that were not previously identified.
b. performing tests of transactions to corroborate managements financial statement assertions.
c. gathering evidence concerning account balances that have not changed from the prior year.
d. retesting controls that appeared to be ineffective during the assessment of control.
7-48
If an auditor were concerned that a client was failing to bill customers for shipments (i.e., completeness objective), the
auditor would
a. select a sample of sales transactions from the sales journal and vouched each to shipping documents to determine
whether sales are supported by adequate documentations.
b. select a sample of shipping documents and traced each to recorded sales transactions in the sales journal to determine
whether shipments have been billed.
c. select a sample of sales account balances and observed the inventory count for shipments to examine existence.
d. select a sample of sales transactions and recomputed the costs of shipments to determine accuracy.
7-49
If an auditor selects a sample of sales transactions from the sales journal and vouches each to shipping documents to
determine whether sales are supported by adequate documentations, the auditor is most likely testing for the specific audit
objective of
a. Completeness
b. Rights and Obligations
c. Accuracy and Valuation
d. Occurrence
183
184

7-1 b. 7-2 b. 7-3 a.
7-4 c. 7-5 d. 7-6 a. 7-7 b. 7-8 d. 7-9 a. 7-10 b. 7-11 d.
7-12 b. 7-13 c. 7-14 c. 7-15 a. 7-16 b. 7-17 d. 7-18 b. 7-19 d. 7-20 c. 7-21 c.
7-22 d. 7-23 c. 7-24 a. 7-25 b. 7-26 a. 7-27 c. 7-28 d. 7-29 d. 7-30 c. 7-31 b.
7-32 b. 7-33 d. 7-34 d. 7-35 b. 7-36 b. 7-37 d. 7-38 d. 7-39 b. 7-40 c. 7-41 c.
7-42 b. 7-43 d. 7-44 a. 7-45 c. 7-46 c. 7-47 a.
7-48 b. 7-49 d.

Simulation Question 7-1 is an adaptation with permission from an article by Lanza, R. B. in the The White Paper , a publication of the Association
of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and places have
been changed.
Bruce Lee was a member of an audit team who was assigned to investigate possible embezzlement at one retail store. Bruces
responsibility was to examine the questionable actions of one of the cashiers named Helen Uddin. The regional manager of that retail store
informed Bruce that he knew Helen was up to no good. Maybe she is playing with her refunds or discounts, but something fishy is going on! he
lamented.
Helen knew the store cameras and informants were watching her and that management regularly counted the cash. Therefore, Bruce
determined that he would not be able to detect any unrecorded cash skimming schemes because, obviously, if there were no recorded sales then
there were no sales transaction data. But Bruce knew that he could look for register adjustment schemes such as phony discounts, refunds, and
sales voids. For example, Helen might say to a customer that her computer was down, wrote a manual receipt at the full price, and accepted cash
for the sale. Then, after the customer left, she would book the sale with a large discount and take the difference in cash. Another scenario was
Helen might book the sale with the large discount but never gave the receipt to the customer. Finally, Helen could fake a large number of refunds
and sales voids.
Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 7-1 in
iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file, Bruce planned to
analyze the data to find out if Helen was in fact posting large number of phony discounts, sales voids and refunds. He planned to:
Extract sales with discounts over 90% and summarize by employee;
Identify employees that have produced register adjustments (discounts, refunds, and sales voids) over 300 % more than the average
employee; and
List the top 10 employees by register adjustments (discounts, refunds, and sales voids).
Bruce was confident that the data analyses would identify Helen as the number one suspect in the retail store.
Required
Access Data File 7-1 in iLearn for the sales register data file, which contains 10,240 sales transactions.
1. Analyze the sales register data file to produce the following three reports:
i. Report No.1 Extract sales with discounts over 90% and summarize by employee.
ii. Report No.2 List the top 10 employees by register adjustments (discounts, refunds, and sales voids).
iii. Report No.3 Identify employees that have produced register adjustments over 300% more than the average employee.
2. Review the three reports in 1 above and explain why you think whether Helen should or should not be the number one suspect.
Note: State your assumption, if any, about Helens employee number.

Simulation Question 7-2 is an adaptation with permission from a case by Coulter, J.M. and T.J. Vogel in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
Pets.com, Inc.
During the 1990s, the establishment and growth of the Internet created a dot-com euphoria. Venture capitalists were eager to invest
their funds in Internet start-ups that offered the potential to provide large returns with the growth of the Internet. Among the most popular new
dot-com companies were online retailers, or e-tailers. Because there was no required investment in brick and mortar needed for these etailers, the common perception was that e-tailers could sell their products for less. The lower prices and customer convenience of shopping from a
computer made these business very attractive investments.
One such company that was established during the period was Pets.com, Inc. (hereafter, P). P incorporated in February 1999 as an
online retailer of pet products. The corporate headquarters were located in San Francisco. Ps online store was designed to service the needs of
the owners of many pets including dogs, cats, birds, fish, reptiles, and ferrets, among others. Approximately 12,000 products were available. P
also integrated this broad product selection with extensive pet-related information and resources designed to help customers make informed
purchasing decisions. Ps strategy included the following key components:
a. Building enduring brand equity through an advertising strategy that included its Ps sock puppet brand icon, relationships with selected online
companies, and support for national events and pet-related local market activities.
b. Offering the broadest possible pet product selection available to its customers at competitive prices.
c. Establishing its private label brands for pet products marketed under the Petsplete and Pets brand names.
d. Providing increasingly comprehensive and relevant content in conjunction with a range of consumer and veterinary care partners.
e. Delivering superior customer service and promoting repeat purchases through investments in people, technology, and distribution facilities.
f. Continuing to maintain and expand its relationships with Amazon.com, which was its largest shareholder, and Go.com.
g. Expanding internationally in order to capitalize on the global market.
185
186
Like all business start-ups, the main challenge to achieving these ambitious goals was to gain market share. P set out to establish and
grow a customer base with an aggressive marketing campaign and discounted prices. The marketing campaign included the creation of its sock
puppet and extensive advertising at national events. With product pricing, company officials decided to offer severe discounts to attract
customers. They were successful in gaining market share, but their strategy resulted in a negative gross margin over the first year of operations. .
You should access Data File 7-2 in iLearn for Exhibits 1, 2, and 3 that contain the financial statements for Ps first year of operations.
The income statement in Exhibit 2 demonstrates Ps increasing customer base. Sales grew from a mere $39k in its first quarter of operations to
nearly $5.2m in the final quarter of 1999. Unfortunately, P was experiencing the financial hardships encountered by many start-ups. As the
MD&A in Exhibit 4 indicates, extensive marketing costs and severe price discounts created a large operating loss for the period. You should
access Data File 7-2 in iLearn for Exhibits 4 that contains Ps Managements Discussion and Analysis. The balance sheet in Exhibit 2
reports available cash of $30.2 million, but company officials knew that this was not enough to support the growth planned for subsequent
periods. The statement of cash flows in Exhibit 3 shows that P used $65.3 million in its 1999 operations. Certainly this use would grow in 2000 as
the company extended its customer base. Additional funding would have to be acquired to support this growth. Despite the companys brief time
in existence to that point, company officials determined it was time to go forward with its initial public offering (IPO) of common stock.
The Planned IPO
P planned to go public in February 2000. The principal purposes of the offering were to fund operating losses, increase working
capital, fund capital expenditures, create a public market for Ps common stock, and facilitate future access to the public capital markets. The net
proceeds of the offering would be used primarily for working capital and general corporate purposes, including marketing and brand building
efforts, capital expenditures associated with the expansion and building of distribution centers, and technology and system upgrades.
Pets executives believed that their extensive product offering along with an efficient and convenient web shopping store would enable
it to attract an increasing share of the pet product retail industry. The most recent data on this industry showed an annual growth rate of 9 percent
between 1993 and 1997. Total industry sales for 1997 exceeded $22 billion. It was believed that if P could establish itself as a market leader for
the online purchase of pet products, it could capture an increasing share of the growing market. Unfortunately, because P was such a young
company, many business risks existed. Together with the interested underwriters, P executives evaluated the risks that potential investors would
encounter with the purchase of Ps common stock. You should access Data File 7-2 in iLearn for Exhibits 5 that contains a summary of the
risks disclosed in Ps prospectus.
After evaluating the risks and the potential payoffs to investors, four companies agreed to underwrite the issue: Merrill Lynch $ Co.,
Bear, Stearns & Co. Inc., Thomas Weisel Partners LLC, and Warbury Dillon Read LLC. Ps initial offering of 7.5 million shares at an offering
price of $11 per share was scheduled for February 16, 1999. The shares were approved for listing on the NASDAQ national Market under the
symbol IPET. The offering was expected to provide net proceeds to Pets of $76.725 million as follows:
Gross Proceeds (7.5 million shares at $11)

Less: Underwriting discount ($0.77 per share)
Net proceeds to P
$82,500,000
5,775,000
$76,725,000
=========
The Audit
P hired Ernst & Young LLP (hereafter, E&Y) to audit the 1999 financial statements summarized in Exhibits 2 through 4. As part of
the opinion formulation process, E&Y needed to consider the companys poor operating performance. After all, the companys strategies had thus
far led to a substantial loss in its first year of existence, including a negative gross profit. It is questionable whether a company with this type of
performance can be reasonably expected to survive financially in the foreseeable future. If E&Y has substantial doubt about Ps ability to
continue as a going concern, they would have to indicate this in an explanatory paragraph accompanying their audit opinion. However, such an
opinion would certainly hinder any chance for a successful public offering of stock. E&Ys auditors would certainly have to examine the situation
thoroughly before making this critical decision.
In order to guide them in this decision, the auditors would utilize AU 570 Going Concern. This standard requires the auditors to obtain
additional information about conditions and events that could create substantial doubt about the entitys ability to continue as a going concern.
You should refer to Table 7-11 Conditions and Events that Indicate a Substantial Doubt in Chapter 7. Certainly, the financial performance
of P, along with the information on business risks contained in Exhibit 5, suggests that some of the conditions and events did indeed exist for P.
In addition to the information above, auditors often utilize bankruptcy prediction models to assist in the going concern analysis. These
models are designed to predict financial distress within one year. Studies suggest that the key factors in determining the likelihood of financial
distress are profitability, the volatility of that profitability, and the companys degree of financial leverage (solvency). Interestingly, liquidity
measures turn out to be of less importance. You should access Data File 7-2 in iLearn for Exhibits 6 that contains the most popular of the
bankruptcy prediction models the Altman Z-score model.
The auditors also should evaluate their clients industry for any macro-economic impact from the external environment. P operated in
the e-tailing industry where companies were relatively young and characterized by fast growth and cash shortages. In fact, operating losses and
cash shortages are the norm for the industry. These are necessary in the short run to gain the market share that hopefully provides a large payoff
in the long run. You should access Data File 7-2 in iLearn for Exhibits 7 that provides selected financial information for three other etailers: Amazon.com Inc., eToys Inc., and priceline.com Inc. These companies were characterized by increasing losses, even as they gained
market share, and negative cash flows from operations. Despite this normally poor operating performance, e-tailers had established favor among
the investing community. eToys and priceline.com each had a fairly large share price in their first year as a publicly traded company despite the
large operating losses. Amazon.com had really become a market favorite. Despite mounting operating losses, its stock price had jumped from a
split-adjusted $17.85 at the end of 1998 to $76.13 at the end of 1999. It certainly appeared that the market was confident of the future success of
these e-tailers. Thus e-tailers in need of additional funding to support their short-term operating losses had reasonable expectations of being able
to obtain the funds through subsequent stock issuances.
E&Ys auditors had a tremendous amount of information to digest regarding the risks facing P. The anticipated date for the IPO was
soon approaching. Without a standard unqualified audit opinion, questions would arise regarding the viability of P as a viable investment
alternative, and the initial public offering would most likely fail. A decision had to be made regarding the type of opinion that E&Y would
provide in the IPO prospectus.
Required
To answer the following questions, in addition to the information provided in Exhibits 1 through to 7 in iLearn, you are encourage to use other
information available in SEC reports such as Ps prospectus, proxy statements, and the 10-Ks for other e-commerce companies. These reports are
available at the SECs EDGAR database http://www.sec.gov/cgi_bin/srch-edgar
1. Refer to the four categories of common ratios used for ratio analysis in Table 7-8 of Chapter 7.
a. Compute the financial ratios of P that you believe are relevant to evaluate the ability of the company to continue as a going concern.
b. In your opinion, will P continue as a going concern based on the results of 1a? Explain your opinion.
2. Refer to the Altman Z-score model in Table 7-10 of Chapter 7 and Exhibit 6 in iLearn.
a. Compute Model 1 (1968) of Altman Z-score for P as a public company. Assume P was publicly traded at a stock price of $411 (i.e., the IPO
price in February 2000) and that all preferred stock outstanding had been converted into common stock. The conversion rate is one share of
common for each share of preferred.
b. Compute Model 2 (1983) of Altman Z score for P as a private company.
c. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, and 2b? Explain your opinion.
3. Refer to selected financial information from other e-tailers in Exhibit 7 in iLearn.
a. Compare your financial analysis in 1a, 2a, and 2b for P with the financial information provided for other e-tailers in Exhibit 7 in iLearn.
b. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, 2b, and 3a? Explain your opinion.
4. Considering all your work done in 1, 2, and 3 above, and assume you are E&Ys auditor, which of the following opinions would you issue?
Provide justification for your chosen opinion.
a. A standard unqualified opinion.
b. An unqualified opinion with an additional paragraph about P will not continue as a going concern.
c. A qualified opinion.
d. A qualified opinion with an additional paragraph about P will not continue as a going concern.

Simulation Question 7-3 is an adaptation with permission from a case by Coulter, J.M. and T.J. Vogel in the Issues in Accounting Education , a
Pets.com, Inc.
During the 1990s, the establishment and growth of the Internet created a dot-com euphoria. Venture capitalists were eager to invest
their funds in Internet start-ups that offered the potential to provide large returns with the growth of the Internet. Among the most popular new
dot-com companies were online retailers, or e-tailers. Because there was no required investment in brick and mortar needed for these etailers, the common perception was that e-tailers could sell their products for less. The lower prices and customer convenience of shopping from a
computer made these business very attractive investments.
One such company that was established during the period was Pets.com, Inc. (hereafter, P). P incorporated in February 1999 as an
online retailer of pet products. The corporate headquarters were located in San Francisco. Ps online store was designed to service the needs of
the owners of many pets including dogs, cats, birds, fish, reptiles, and ferrets, among others. Approximately 12,000 products were available. P
also integrated this broad product selection with extensive pet-related information and resources designed to help customers make informed
purchasing decisions. Ps strategy included the following key components:
a. Building enduring brand equity through an advertising strategy that included its Ps sock puppet brand icon, relationships with selected online
companies, and support for national events and pet-related local market activities.
b. Offering the broadest possible pet product selection available to its customers at competitive prices.
c. Establishing its private label brands for pet products marketed under the Petsplete and Pets brand names.
d. Providing increasingly comprehensive and relevant content in conjunction with a range of consumer and veterinary care partners.
e. Delivering superior customer service and promoting repeat purchases through investments in people, technology, and distribution facilities.
f. Continuing to maintain and expand its relationships with Amazon.com, which was its largest shareholder, and Go.com.
g. Expanding internationally in order to capitalize on the global market.
Like all business start-ups, the main challenge to achieving these ambitious goals was to gain market share. P set out to establish and
grow a customer base with an aggressive marketing campaign and discounted prices. The marketing campaign included the creation of its sock
puppet and extensive advertising at national events. With product pricing, company officials decided to offer severe discounts to attract
customers. They were successful in gaining market share, but their strategy resulted in a negative gross margin over the first year of operations. .
You should access Data File 7-3 in iLearn for Exhibits 1, 2, and 3 that contain the financial statements for Ps first year of operations.
The income statement in Exhibit 2 demonstrates Ps increasing customer base. Sales grew from a mere $39k in its first quarter of operations to
nearly $5.2m in the final quarter of 1999. Unfortunately, P was experiencing the financial hardships encountered by many start-ups. As the
MD&A in Exhibit 4 indicates, extensive marketing costs and severe price discounts created a large operating loss for the period. You should
access Data File 7-3 in iLearn for Exhibits 4 that contains Ps Managements Discussion and Analysis. The balance sheet in Exhibit 2
reports available cash of $30.2 million, but company officials knew that this was not enough to support the growth planned for subsequent
periods. The statement of cash flows in Exhibit 3 shows that P used $65.3 million in its 1999 operations. Certainly this use would grow in 2000 as
the company extended its customer base. Additional funding would have to be acquired to support this growth. Despite the companys brief time
in existence to that point, company officials determined it was time to go forward with its initial public offering (IPO) of common stock.
The Planned IPO
187
188
P planned to go public in February 2000. The principal purposes of the offering were to fund operating losses, increase working
capital, fund capital expenditures, create a public market for Ps common stock, and facilitate future access to the public capital markets. The net
proceeds of the offering would be used primarily for working capital and general corporate purposes, including marketing and brand building
efforts, capital expenditures associated with the expansion and building of distribution centers, and technology and system upgrades.
Pets executives believed that their extensive product offering along with an efficient and convenient web shopping store would enable
it to attract an increasing share of the pet product retail industry. The most recent data on this industry showed an annual growth rate of 9 percent
between 1993 and 1997. Total industry sales for 1997 exceeded $22 billion. It was believed that if P could establish itself as a market leader for
the online purchase of pet products, it could capture an increasing share of the growing market. Unfortunately, because P was such a young
company, many business risks existed. Together with the interested underwriters, P executives evaluated the risks that potential investors would
encounter with the purchase of Ps common stock. You should access Data File 7-3 in iLearn for Exhibits 5 that contains a summary of the
risks disclosed in Ps prospectus.
After evaluating the risks and the potential payoffs to investors, four companies agreed to underwrite the issue: Merrill Lynch $ Co.,
Bear, Stearns & Co. Inc., Thomas Weisel Partners LLC, and Warbury Dillon Read LLC. Ps initial offering of 7.5 million shares at an offering
price of $11 per share was scheduled for February 16, 1999. The shares were approved for listing on the NASDAQ national Market under the
symbol IPET. The offering was expected to provide net proceeds to Pets of $76.725 million as follows:
Gross Proceeds (7.5 million shares at $11)

Less: Underwriting discount ($0.77 per share)
Net proceeds to P
$82,500,000
5,775,000
$76,725,000
=========
The Audit
P hired Ernst & Young LLP (hereafter, E&Y) to audit the 1999 financial statements summarized in Exhibits 2 through 4. As part of
the opinion formulation process, E&Y needed to consider the companys poor operating performance. After all, the companys strategies had thus
far led to a substantial loss in its first year of existence, including a negative gross profit. It is questionable whether a company with this type of
performance can be reasonably expected to survive financially in the foreseeable future. If E&Y has substantial doubt about Ps ability to
continue as a going concern, they would have to indicate this in an explanatory paragraph accompanying their audit opinion. However, such an
opinion would certainly hinder any chance for a successful public offering of stock. E&Ys auditors would certainly have to examine the situation
thoroughly before making this critical decision.
In order to guide them in this decision, the auditors would utilize AU 570 Going Concern. This standard requires the auditors to obtain
additional information about conditions and events that could create substantial doubt about the entitys ability to continue as a going concern.
You should refer to Table 7-11 Conditions and Events that Indicate a Substantial Doubt in Chapter 7. Certainly, the financial performance
of P, along with the information on business risks contained in Exhibit 5, suggests that some of the conditions and events did indeed exist for P.
In addition to the information above, auditors often utilize bankruptcy prediction models to assist in the going concern analysis. These
models are designed to predict financial distress within one year. Studies suggest that the key factors in determining the likelihood of financial
distress are profitability, the volatility of that profitability, and the companys degree of financial leverage (solvency). Interestingly, liquidity
measures turn out to be of less importance. You should access Data File 7-3 in iLearn for Exhibits 6 that contains the most popular of the
bankruptcy prediction models the Altman Z-score model.
The auditors also should evaluate their clients industry for any macro-economic impact from the external environment. P operated in
the e-tailing industry where companies were relatively young and characterized by fast growth and cash shortages. In fact, operating losses and
cash shortages are the norm for the industry. These are necessary in the short run to gain the market share that hopefully provides a large payoff
in the long run. You should access Data File 7-3 in iLearn for Exhibits 7 that provides selected financial information for three other etailers: Amazon.com Inc., eToys Inc., and priceline.com Inc. These companies were characterized by increasing losses, even as they gained
market share, and negative cash flows from operations. Despite this normally poor operating performance, e-tailers had established favor among
the investing community. eToys and priceline.com each had a fairly large share price in their first year as a publicly traded company despite the
large operating losses. Amazon.com had really become a market favorite. Despite mounting operating losses, its stock price had jumped from a
split-adjusted $17.85 at the end of 1998 to $76.13 at the end of 1999. It certainly appeared that the market was confident of the future success of
these e-tailers. Thus e-tailers in need of additional funding to support their short-term operating losses had reasonable expectations of being able
to obtain the funds through subsequent stock issuances.
E&Ys auditors had a tremendous amount of information to digest regarding the risks facing P. The anticipated date for the IPO was
soon approaching. Without a standard unqualified audit opinion, questions would arise regarding the viability of P as a viable investment
alternative, and the initial public offering would most likely fail. A decision had to be made regarding the type of opinion that E&Y would
provide in the IPO prospectus.
Required
To answer the following questions, in addition to the information provided in Exhibits 1 through to 7 in iLearn, you are encourage to use other
information available in SEC reports such as Ps prospectus, proxy statements, and the 10-Ks for other e-commerce companies. These reports are
available at the SECs EDGAR database http://www.sec.gov/cgi_bin/srch-edgar
1. Refer to the four categories of common ratios used for ratio analysis in Table 7-8 of Chapter 7.
a. Compute the financial ratios of P that you believe are relevant to evaluate the ability of the company to continue as a going concern.
b. In your opinion, will P continue as a going concern based on the results of 1a? Explain your opinion.
2. Refer to selected financial information from other e-tailers in Exhibit 7 in iLearn.
a. Compare your financial analysis in 1a for P with the financial information provided for other e-tailers in Exhibit 7 in iLearn.
b. In your opinion, will P continue as a going concern based on the combined results of 1a and 2a? Explain your opinion.
3. Refer to the four categories of conditions and events that indicate a substantial doubt about going concern in Table 7-11 of Chapter 7.
a. Access Exhibit 5 in iLearn and sort the 39 risk factors in Exhibit 5 into the four categories of conditions and events in Table 7-11. List them
under four headings: 1. Negative financial trend, 2. Non-financial indicator, 3. Internal factors, and 4. External factors.
b. Review the risk factors in each of the four categories in 3a. Identify and state those risk factors in each of the four categories that you believe
are relevant for forming an opinion on whether P will continue as a going concern.
c. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, and 3b? Explain your opinion.
4. Considering all your work done in 1, 2, and 3 above, and assume you are E&Ys auditor, which of the following opinions would you issue?
Provide justification for your chosen opinion.
a. A standard unqualified opinion.
b. An unqualified opinion with an additional paragraph about P will not continue as a going concern.
c. A qualified opinion.
d. A qualified opinion with an additional paragraph about P will not continue as a going concern.
189
190
Chapter 8
Audit Plan Internal Control
LO8-1 Understand the 5 components of internal control.
LO8-2 Distinguish among the 3 methods of documenting internal control.
LO8-3 Explain how the auditor assesses control risk (CR).
LO8-4 Understand the definition of a material weakness according to AICPAs
AU 265 and PCAOBs AS 5.
LO8-5 Describe how the auditor communicates internal control-related matters.
LO8-6 Describe the managements responsibilities on Internal Control over Financial
Reporting (ICFR) under Section 404 of the Sarbanes-Oxley Act of 2002 and
guided by the PCAOBs AS 5.
LO8-7 Describe the auditors responsibilities on Internal Control over Financial
Reporting (ICFR) under Section 404 of the Sarbanes-Oxley Act of 2002 and
guided by the PCAOBs AS 5.
LO8-8 Describe the Top-Down approach for obtaining an understanding of ICFR and
identifying controls to test.
LO8-9 Describe how the auditor form an opinion on the effectiveness of ICFR under
Section 404 of the Sarbanes-Oxley Act of 2002 and guided by the PCAOBs
AS 5 and AS 4.
LO8-10 Compare internal control of an integrated audit with internal control of a
financial audit.
191
192
Chapter 8 Audit Plan Internal Control

Figure 8-1 shows the sequential steps in which an auditor considers a clients internal control.
Figure 8-1 Steps in Internal Control Consideration
The Audit Process
Audit Plan
Preplan CH 5
Tests of Controls
Tests of Balances
Financial Audit
Audit Report
Integrated Audit
Objectives CH 6
1. Understanding of Internal
Control
1. Plan the Audit of ICFR
2. Document the Understanding

of Internal Control
2. Obtaining an Understanding of
ICFR and Identifying Controls to
Test
3. Assess Control Risk (CR)
3. Test and Evaluate Design

Effectiveness of Controls
4. Perform Tests of Controls

Procedures
4. Test and Evaluate Operating

Effectiveness of Controls
5. Communicate Internal ControlRelated Matters
4. Form an Opinion on the

Effectiveness of ICFR
Evidence CH 7

(Chapter 9)
Program and
Technology CH 10
Financial Audit of Internal Control

AU 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement defines
internal control as The policies and procedures established by management to provide reasonable assurance that
specific objectives of the entity will be achieved. According to the definition, an audit should only expect
reasonably assurance, not absolute assurance, that a client's control objectives will be accomplished. This is because
there are two inherent limitations of a clients internal control: 1. Human errors. For example, an effective internal
control may be undermined by employee's unintentional errors or management's intentional acts of overriding the
control. 2. Changing circumstances. For example, controls over a manual data processing system may not be
appropriate for a new computerized data processing system. An auditor should also recognize that the cost of a
client's internal control should not exceed the expected benefit derived from its implementation. This adds another
limitation to the client's internal control. Finally an auditor should understand a clients internal control according to
the AICPAs third fundamental Performance principle, which states, [T]he auditor identifies and assesses risks of
material misstatement, whether due to due to fraud or error, based on an understanding of the entity and the
environment, including the entitys internal control.
Understanding of Internal Control
The auditor should understand five components of a clients internal control based on the Committee of Sponsoring
Organizations of the Treadway Commission - COSOs Internal Control-Integrated Framework. Table 8-1 describes
these five components and the auditors understanding of them
Table 8-1 Understanding the Five Components of Internal Control
Components of Internal Control
Understanding the Components
1. Control Environment
This consists of actions, policies, and procedures that reflect the
overall attitude of the top management, directors, and owners of a
client about internal control and its importance. Seven key factors
that affect the control environment are:
The auditor should learn enough about the control environment to

understand the managements and board of directors attitude,
awareness, and actions concerning the control environment. In addition,
the auditor should focus on the substance of controls rather than on their
form because controls may be established but not acted on. Thus, the
most important aspect of any internal control is having competent and
trustworthy personnel who follow internal control policies and
procedures.
Integrity and ethical values.

Commitment to competence.
Participation of those charged with governance (e.g., board of

directors or audit committee).
Management philosophy and operating style.

Organizational structure.
Assignment of authority and responsibility.
Human resource policies and practices.

2. Risk Assessment
This consists of managements identification and analysis of risks
relevant to the preparation of financial statements in accordance with
GAAP. The managements risk assessment process should consider
external and internal events and circumstances that may arise and
adversely affect the companys ability to record, process, summarize,
and report financial data consistent with the assertions of the
management in the financial statements. Five basic assertions that
must be met by the managements risk assessment are:
The auditor should obtain sufficient information about a clients risk

assessment process to understand how the management considers risks
relevant to financial reporting objectives and decides what to do to
address those risks.
Existence or occurrence.
Completeness.
Valuation or allocation.
Rights and obligations.
Presentation and disclosure.

3. Control Activities
This consists of policies and procedures that the management has
established to meet its objectives for financial reporting. Five basic
control activities that the management must establish are:
The auditors understanding of control activities is a function of the

audit plan adopted. If the auditor plans to conduct only TOB, then little
or no work is done on understanding control activities. If the auditor
plans to conduct both TOC and TOB, then s/he needs to understand the
control activities relating to specific audit objectives and for the purpose
193
194
Components of Internal Control
Adequate Separation of Duties
Proper Authorization of Transactions and Activities (or

Information Process Controls)
Adequate Documentations and Records.
Physical Control over Assets and Records (or Physical

Controls)
Independent checks on performance (or Performance

Reviews)
4. Information and communication

The information system consists of methods used to identify,
assemble, classify, record, and report a companys transactions and to
maintain accountability for related assets and liabilities. An effective
accounting system should:
Understanding the Components

of assessing control risk (CR).
Identify and record all valid transactions.
Describe on a timely basis the transactions in sufficient

detail to permit proper classification of transactions for financial
reporting.
Measure the value of transactions in a manner that permits

recording their proper monetary value in the financial statements.
Determine the time period in which transactions occurred to

permit recording of transactions in the proper accounting period.
Present properly the transactions and related disclosures in

Communication involves providing an understanding of individual
roles and responsibilities so that the personnel understand how their
financial reporting activities are related to the work of others and the
means of reporting exceptions to an appropriate higher level within
the company.
5. Monitoring
This consists of the managements ongoing and periodic assessment
of the performance of internal control. The Management may use
internal auditors to monitor the operating effectiveness and efficiency
of internal control.
Documenting the Understanding of Internal Control
Separation of duties controls include (1) Separation of the custody of

assets from accounting. (2) Separation of the authorization of
transactions from the custody of related assets. (3) Separation of
operational responsibility from record-keeping responsibility. (4)
Separation of IT duties from user departments.
Proper authorization controls include (1) General authorization in that
management establishes polices and subordinates are instructed to
implement these general authorizations by approving all transactions
within the limits set by the policy. (2) Specific authorization in that
management authorizes a specific transaction. In an information
processing system, information processing controls are performed to
check accuracy, completeness, and authorization of transactions. They
include (1) General controls, which relate to the overall information
processing environment such as controls over data center and network
operations; system software acquisition, change, and maintenance. (2)
Application controls, which apply to the processing of individual
applications and help ensure the occurrence, completeness, and
accuracy of transaction processing.
Adequate documentations and records include (1) Prenumbered
documents to facilitate the control of, and accountability for,
transactions for the completeness assertion. (2) Prepared documents on
a timely basis to minimize timing errors. (3) Designed documents for
multiple use, when possible, to minimize the number of different form.
(4) Constructed documents in a manner that encourages self-input
correction and verification.
Physical controls include (1) Physical security of assets, including
adequate safeguards, such as secured facilities over access to assets and
records. (2) Authorization for access to computer programs and data
files. (3) Periodic counting and comparison with amounts shown on
control records such as comparing the results of inventory counts with
inventory records.
Performance reviews controls include (1) Managements independent
checks on the performance of individuals. (2) Managements active
participation in the supervision of operations. (3) Managements study
of budget variances with follow-up action.
The auditor must obtain sufficient knowledge of a clients information
system:
I. To understand (1) the classes of significant transactions, (2) the ways
those transactions are initiated, (3) the accounting records and
supporting documents for those transactions, (4) the accounting
processing involved, and (5) the financial reporting process, including
significant accounting estimates and disclosures.
II. To ensure that the TOC and TOB procedures meet the following
types of specific audit objectives (recall Chapter 6):
(1) Existence or Occurrence
(2) Completeness.
(3) Rights and Obligations.
(4) Valuation and Allocation.
(5) Classification.
(6) Cutoff.
(7) Accuracy.
(8) Understandability.
In addition, the auditor should obtain sufficient knowledge of how the
client communicates financial reporting roles and responsibilities and
significant matters relating to financial reporting.
The auditor should know how a client monitors the performance of

internal control over time, including how corrective action is initiated.
AU 230 Audit Documentation requires auditors to document their understanding of a clients internal control. The
form and extent of this documentation are influenced by the size and complexity of the client, as well as the nature
of the client's internal control. The three most common methods used by the auditors to document their
understanding of the client's internal control are described in Table 8-2.
Table 8-2 Three Methods of Documenting Internal Control
Narrative Description
Internal Control Questionnaires
Flow Chart
A narrative description is a written

memorandum
of
the
auditor's
understanding of the client's internal
control. Narrative descriptions generally
are more appropriate for documenting the
internal control of a small client. They
can be cumbersome to use as the size of
the client increases.
Figure 8-2 shows an example of using a
narrative description to document the
auditors understanding of a clients
control environment.
An internal control questionnaire is a checklist of

questions designed to detect internal control
deficiencies. The questionnaires typically require
a "yes," "no," or "not applicable (n/a)," response.
"Yes" responses suggest strong or satisfactory
internal controls, and "no" responses suggest
weak or no internal controls.
The internal control questionnaires may not be
efficient in documenting a client's internal control
for various reasons:
A flow chart is a symbolic, diagrammatic

representation of a client's internal control.
A flow chart is especially useful in
documenting the internal control of a large
and complex client. Separate flowcharts are
prepared for each major transaction cycle.
Typically, the departmental units are shown
in columns across the top of the chart, and
the flow of documents is from left to right.
Figure 8-4 shows an example of using a
flowchart to document the auditors
understanding of a clients information and
communication.
Figure 8-5 shows some common symbols
used in flowcharting a clients information
and communication.
They can lack flexibility. For example,

they may contain many questions that are "not
applicable" to a specific client.
Compensatory controls are not obvious.

The situation where a strong internal control
may compensate for a weak internal control
elsewhere is not obvious from examining the
completed set of questionnaires.
Client
employees
may
respond
inaccurately to internal control questions asked
by the auditor.
Figure 8-3 shows an example of using an internal
control questionnaire to document the auditors
understanding of a clients risk assessment.
The auditors may use a combination of narrative descriptions, flowcharts, and questionnaires to document their
understanding of the internal controls, thereby maximizing the advantages of each. After the auditors have
documented their understanding of the client's internal control, they generally verify that the client's internal control
in actual operation matches with the documented internal control by performing a walk-through test. In this walkthrough test, the auditors trace a few transactions through each step, from beginning to end, of the documented
internal control to familiarize the auditors with the audit trail and to identify differences between internal control in
operation and internal control as documented in the working papers.
Figure 8-2 An Example of Using a Narrative Description to Document the Auditors Understanding of a
Clients Control Environment
Audit Memo Control Environment
Client: XYZ Company
Completed by __________________
Reviewed by ___________________
Date ________________
Date ________________
The company manufactures sophisticated computer components. There is one location in Silicon Valley, San Jose. Mr. A is the chairman of the
board and chief executive officer. His son, Mr. B, is the chief operating officer. The family controls 80 percent of the common stock. The board
of directors is composed of family members, but Mr. A and Mr. B monitor the business and make most of the business decisions.
Mr. C, the controller, and Mrs. D, the bookkeeper, handle most of the significant accounting functions. Both Mr. C and Mr. D are competent and
committed to the company. Mr. B reviews cash receipts and cash disbursements. Both Mr. A and Mr. B have conservative attitudes towards
accounting, and they consider lower taxes to be important. Our CPA firm is consulted on the accounting for unusual transactions, and there are
rarely any adjustments for errors from routine transaction processing.
The company uses a standard accounting software package. Access to the computer files is limited to Mr. B, Mr. C, and Mrs. D. Mr. A and Mr. B
monitor revenues and expenses by comparing them to the budget and prior-year results.
195
196
Figure 8-3 An Example of Using an Internal Control Questionnaire to Document the Auditors
Understanding of a Clients Risk Assessment
Internal Control Questionnaire Risk Assessment
Client: XYZ Company
Completed by __________________
Date ________________
Reviewed by ___________________
Date ________________
Does the client set broad objectives that state what the client
desires to achieve, and are they supported by strategic plans?
Does the client have a risk analysis process that includes
estimating the significance of the risks, assessing the
likelihood of their occurring, and determining the actions
needed to respond to the risks?
Does the client have mechanisms to identify and react to
changes that may dramatically and pervasively affect the
client?
Yes, No, N/A

Yes
Yes
Yes
Comments
Management has prepared a five-year business plan that
includes goals for the companys products, responsibilities,
and growth plan.
The companys business plan and budgeting process
include analyzing risks that might affect the company.
Senior management meets monthly to discuss recent events
and how they may affect the company.
Management has a number of mechanisms to identify risks
that may affect the company. These include review of
business and industry publications, participation in industry
trade groups, and a strategic analysis group.
Assessing Control Risk (CR)

After obtaining an understanding and documentation of the client's internal control, the auditor assesses the control
risk (CR). AU 315 defines control risk as "the risk that a material misstatement that could occur in an assertion will
not be prevented or detected on a timely basis by the entity's internal controls. In practice, an auditor regards a
client's CR as the risk of material misstatement of assertions relating to an individual account-balance or class of
transactions that is not prevented or detected by a client's internal control. In addition, as noted previously, CR exists
independent of the audit of a client's financial statements. Thus, the auditor cannot change the actual level of CR.
Finally, there is no authoritative guideline for assessing the level of CR. In practice, a percentage between 0% and
100%, with 0% as the minimum and 100% as the maximum control risk, is commonly used to indicate the level of
CR. Based on the auditor's understanding and documentation of a client's internal controls, the auditor assesses the
level of CR in two ways as described in Table 8-3.
On occasion, an auditor may desire to fine-tune (i.e., to further reduce) the assessed level of CR below the
maximum of 100% by conducting some TOC at the audit plan phase. In such a case, the auditor considers (a)
whether additional evidential matter is available to support the fine-tuning, and (b) whether the expected effort to
perform some TOC is likely to result in less effort in TOB.
After assessing the level of CR at the audit plan phase, and together with the assessment of inherent risk
(IR), the auditor derives the level of detect risk (DR) based on an audit risk model, AR = IR X CR X DR (discussed
in Chapter 9) and determines the nature, timing, and extent of TOB that are needed to achieve the derived level of
DR, given a pre-specified level of audit risk (AR).
Although the inverse relationship between CR and DR permits the auditor to alter the nature, timing, and
extent of the TOB, the assessed level of CR cannot be so low (e.g., close to zero) as to eliminate the need to perform
any TOB. In addition, the auditor's understanding and documentation of the client's internal control and the
assessment of CR provide the basis for communicating internal control-related matters to those charged with
governance (e.g., audit committee or board of directors), a requirement of AU 265 Communication of Internal
Control Related Matters Identified in an Audit .
Figure 8-4 An Example of Using a Flowchart to Document the Auditors Understanding of a Clients
Information and Communication
______________________________________________________________________________________
Flow Chart Information and Communication
Client: XYZ Company
Completed by __________________
Reviewed by ___________________
Date ________________
Date ________________
Order Entry Portion of the Revenue Cycle

______________________________________________________________________________________
Order Entry Department
IT Department
Shipping Department
____________________________________________________________________________________________________________
By phone/mail/internet or from
sales representative
Customer
Approved
shipping
order
Price
Inventory
Inventory
Open
orders
Open
orders
Ship
goods
Customer
order
Correct
error
Data validation
program
Input
Filed by
date
Error
report
Shipping
program
Order
acknowledgement
Approved
shipping
order
To
customer
To
customer
Filed
in numeric
order
Figure 8-5 Some Common Symbols Used in Flowchart

Symbol
Description
Document
Paper documents and reports of all kinds, e.g., customer orders, sales invoices, purchase orders, error
report, shipping documents, and paychecks.
Manual Input
Input entered manually at the time of processing, e.g., using keyboard.
197
198
Symbol
Description
Manual Operation or
Activity
Any manual operation or activity, e.g., preparation of a sales invoice, bank reconciliation, posting of
accounts receivable, and correcting errors.
Computer Process
Computer executed process, e.g., execution of data validation program or checking of customers
credit limit.
Data Inputted or
Outputted
Data inputted from or outputted to another part of the flowchart, e.g., cash received from customer is
inputted to cash receipts journal which in turn is outputted to accounts receivable ledger.
Off-page Connector
Off-page connector that indicates source or destination of items entering or exiting the flowchart, e.g.,
sending a copy of an invoice to an outside customer that exits the flowchart.
Computer off-page
Connecting Node
Computer connecting node that indicates source or destination of items entering or exiting the
flowchart, e.g., the connecting node from mail room indicates cash receipt entering the flowchart from
the mail room.
Paper Document or
Record File
Paper document or record storage, e.g., filing of bank deposit slips. An A indicates a file organized
in an alphabetic order, a N indicates a numeric order file, and a D indicates a file organized by
date.
Filed
by Annotation
Date
Flow-line
Annotation used for explanatory comments, e.g., filing of sales invoices by date, alphabetical, or
category of merchandises.
Lines indicating the directional flow of documents. Lines are typically downward or to the right unless
otherwise indicated by arrowheads.
Decision indicates alternative course of action resulting from a yes or no decision.
No
Yes
Computer Card
Computer input medium which is a punched card, e.g., payroll earning cards.
Computer Tape
Computer input medium which is a punched tape, e.g., inventory tapes.
Computer Data
Inputted or
outputted
Computer data inputted from or outputted to another part of the flowchart, e.g., payroll data is inputted
from payroll records which in turn is outputted to store in magnetic tape.
Computer Magnetic
Disk or Drum
Computer storage medium which is a magnetic disk or drum, e.g., customers names and addresses are
stored in a magnetic disk.
Computer Magnetic
Tape
Computer storage medium which is a magnetic tape, e.g., payroll data are stored in a master payroll
magnetic tape.
Computer Display
Computer input or output device in which the information is displayed at the time of process, e.g.,
display of customer accounts on a computer monitor.
Table 8-3 Two Ways in Assessing CR

(1) CR at the maximum of 100%
For assertions relating to some account-balances or classes of transactions, the auditor's initial understanding and documentation of the internal
controls may cause him/her to conclude that the internal controls are unlikely to be effective, or effort required to evaluate their effectiveness
would be inefficient. For these assertions, the auditor typically assesses CR at the maximum of 100% at the audit plan phase in the past.
However, under AU315, it is no longer acceptable to assess CR at the maximum of 100% based on the auditors initial understanding and
documentation of the internal controls. The auditor must now develop a greater understanding of the internal controls, which includes testing and
evaluating the design and operation of the internal controls in order to assess CR at the maximum of 100%. When assessed CR is at the
maximum (a) the auditor needs only to document the assessment but not the basis for the assessment, (b) the auditor would not plan to rely on the
internal controls, and (c) the auditor would not plan to perform TOC but to only perform TOB.
(2) CR below the maximum of 100%

For other assertions relating to some account-balances or classes of transactions, the auditor's understanding and documentation of the internal
controls may cause the auditor to assess CR at below the maximum of 100%. When assessed CR is below the maximum (a) the auditor should
document the assessment and the basis for the assessment, (b) the auditor would plan to rely on the internal controls, and (c) the audit would plan
to perform both the TOC and TOB.
When the auditor plan to rely on the internal controls, s/he must:
Identify the control activities (see Table 8-1) that are relevant to a financial statement assertion. The relevance of a control activity to an
assertion is judged in terms of:
(a) Its pervasive effect on an assertion.
A control activity can be relevant to an assertion either because it has a pervasive effect on many assertions or because it has a specific
effect on an individual assertion. A control activity that affects more than one assertion is usually more pervasive than one that affects only a
single assertion. For example, a credit managers follow-up on customers complaints in a monthly statement - a control activity of independent
checks that affects both the valuation and allocation, and completeness assertions - is a more pervasive control activity than the credit managers
approval of credit for customers a control activity of proper authorization that affects only the valuation and allocation assertion. In general,
the more pervasive is the effect, the more relevant is the control activity, the stronger is the overall internal controls, and the lower is the assessed
CR.
(b) Its direct relationship to an assertion.
The more directly related a control activity is to an assertion, the more effective it is in preventing or detecting material misstatements in
that assertion. For example, a sales managers tracing of shipping documents to billing documents - a control activity of adequate documentation
that affects the completeness of sales revenue - is more directly related to the completeness assertion than the sales managers reviews of sales
activities at various stores a control activity of independent checks that is less directly related to the completeness of sales revenue. In general,
the more direct is the relationship, the more relevant is the control activity, the stronger is the overall internal controls, and the lower is the
assessed CR.
Evaluate the effectiveness of the control activities in preventing and detecting material misstatements in an assertion.
After a control activity that is relevant to an assertion has been identified, the auditor evaluates its effectiveness in preventing and detecting
material misstatements in the assertion. To evaluate its effectiveness, the auditor obtains evidence (recall Chapter 7) about the design and
operation of the control activity by performing TOC. TOC directed at the effectiveness of the design of the control activity are concerned with
whether it is suitably designed to prevent or detect material misstatements. On the other hand, TOC directed at the operation effectiveness of the
control activity are concerned with how it is suitably applied to prevent or detect material misstatements. Recall some of the common TOC
procedures used by the auditor in Chapter 7. No one specific procedure is always necessary, applicable, or equally effective in every
circumstance. The auditor selects a variety of TOC procedures, for example, inquiry, observation, and inspection to evaluate the effectiveness of
the design and operation of a control activity.
Communicating Internal Control-Related Matters

Consistent with the PCAOBs AS 5 definition, the AICPAs AU 265 defines a material weakness as a material
weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial
reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the companys annual or
interim financial statements will not be prevented or detected on a timely basis (emphasis added). AU 265 further
defines:
1. Control deficiency. A control deficiency exists if the design or operation of controls does not permit company
personnel to prevent or detect misstatements on a timely basis in the normal course of performing their assigned
functions. A design deficiency exists if a necessary control is missing or not properly designed. An operation
deficiency exists if a well-designed control does not operate as designed or if the person performing the control is
insufficiently qualified or authorized. Table 8-4 shows some examples of control deficiency in the design or
operation of controls in AU 265.
2. Significant deficiency. A significant deficiency exists if one or more control deficiencies exist that is less severe
than a material weakness (defined below), but important enough to merit attention by those responsible for oversight
of the companys financial reporting.
199
200
3. Material weakness. A material weakness exists if a significant deficiency, by itself or in combination with other
significant deficiencies, results in a reasonable possibility that internal control will not prevent or detect material
financial statement misstatements on a timely basis.
4. Reasonable possibility and Materiality. To determine a material weakness, the auditor must consider two
dimensions: Reasonable possibility and Materiality. Reasonable possibility refers to reasonably possible or probable
that a misstatement resulting from a significant deficiency or a combination of significant deficiencies. Materiality
refers to the same concept of materiality that is used in determining financial statement materiality (discussed in
Chapter 9).
Table 8-5 shows the auditors consideration of reasonable possibility and materiality, and communication
of material weakness, significant deficiency, and insignificant deficiency. Note that if reasonable possibility is
remote, an identified control issue will not be reported. However, if reasonable possibility is reasonably possible or
probable, an identified control issue will be reported as a material weakness, a significant deficiency, or an
insignificant deficiency depending on the materiality of misstatement in the financial statements.
The auditor must communicate material weaknesses and significant deficiencies in writing (refer to as a
material weakness report) and such communication must be documented in the auditor's working papers. There is no
specific guideline for the format of the written report, for example, a memo is acceptable, but the content of the
written report should at least include: 1. An indication that the purpose of the audit is to report on the financial
statements and not to provide assurance on the internal controls. 2. A definition of material weakness. 3. A statement
that the report is intended solely for the information of the audit committee, management, and others within the
organization, and when applicable, specific regulatory agencies that have requested a copies of the report. 4. A
description of the material weakness and significant deficiency noted. The material weakness and significant
deficiency report should be addressed to those charged with governance (e.g., audit committee or its board of
directors) and the management. Figure 8-6 shows an example of a material weakness report.
AU 265 requires the auditor to communicate material weaknesses or significant deficiencies to those
charged with governance even if the management has addressed the material weaknesses or significant deficiencies
and has implemented new controls that improve the effectiveness of internal control. However, AU 265 does not
require the auditor to communicate material weaknesses and significant deficiencies if (1) the management has
already made them known to those charged with governance, and (2) those charged with governance has accepted
the management's conscious effort to trade off the cost against the risk associated with the material weaknesses and
significant deficiencies.
Ordinarily, a previously communicated material weakness or significant deficiency that has not been
corrected would not need to be communicated again by the auditor. However, the auditor should periodically
consider whether the passage of time or changes in the management, the board of directors, or the audit committee
would require the material weakness or deficiency to be communicated again. Finally, the auditor may choose to
communicate all material weaknesses and significant deficiencies either during the course of the audit or after the
audit is concluded.
In addition to communicating material weaknesses and significant deficiencies that is required under AU
265, the auditor may also send an optional clients advisory comments letter (also known as a management letter)
that: 1. Communicates insignificant control deficiencies. 2. Makes recommendations for improving the client's
business. 3. Promotes a better relationship between the CPA firm and the client. 4. Suggests additional tax and
management services available to the client. This clients advisory comments letter should be addressed to the
client's management (AU 265). However, many auditors combine the clients advisory comments letter and the
material weakness report into one report and report it to the audit committee. Figure 8-7 shows an example of a
clients advisory comment letter (management letter).
Note that an auditor should never issue a written report stating that no-material-weaknesses were noted in
the course of the audit because of the potential for a reader misinterpreting the limited assurance associated with the
auditor issuing such a no-material-weakness report.
Lastly, sometime an auditor may be specially engaged to express an opinion on a client's internal control as
a special attestation service under the AICPAs SSAE No.10 AT 501 Reporting on an Entitys Internal Control
Over Financial Reporting, that is separate from the normal audit engagement. In this special type of service, the
auditor issues a special internal control report that also reports material weaknesses ad significant deficiencies to the
audit committee. This type of special service is similar to PCAOBs requirement that auditors attest to
managements report on internal control over financial reporting (ICFR) under Section 404 of the SarbanesOxley
Act of 2002. Chapter 22 provides more discussion on this special attestation service.
Table 8-4 Some Examples of Control Deficiency in the Design or Operation of Controls in AU 265
Examples of Control Deficiency in the Design or Operation of Controls
Deficiencies in the Design of Controls
Inadequate design of internal control over the preparation of the financial statements being audited.
Inadequate design of internal control over a significant account or process.
Inadequate documentation of the components of internal control.
Insufficient control consciousness within the organization, for example, the tone at the tip and the control environment.
Absence or inadequate segregation of duties within a significant account or process.
Absence or inadequate controls over the safeguarding of assets.
Inadequate design of information technology (IT) general and application controls.
Employees or management who lack the qualifications and training to fulfill their assigned functions.
Inadequate design of monitoring controls.
The absence of an internal process to report deficiencies in internal control to management on a timely basis.
Failures in the Operation of Internal Control
Failure in the operation of effectively designed controls over a significant account or process.
Failure of the information and communication component of internal control to provide complete and accurate output because of
deficiencies in timeliness, completeness, or accuracy.
Failure of controls designed to safeguard assets from loss, damage, or misappropriation.
Failure to perform reconciliations of significant accounts.
Undue bias or lack of objectivity by those responsible for accounting decisions.
Misrepresentation by client personnel to the auditor (an indicator of fraud).
Management override of controls.
Failure of an application control caused by a deficiency in the design or operation of an IT general control.
An observed deviation rate that exceeds the number of deviations expected by the auditor in a test of operating effectiveness of a control.
Table 8-5 Auditors Consideration of Reasonable Possibility and Materiality, and Communication of
Material Weakness, Significant Deficiency, and Insignificant Deficiency
Materiality
Material
and
Significant
deficiency
Not Material
but
Significant
deficiency
Not Material
and
Insignificant
Deficiency
Remote
Reasonable Possibility
Reasonably Possible or Probable
Communicate Material weakness
No Report
Report material weakness to
audit committee and to management
Communicate Significant Deficiency

No Report
Report significant deficiency to
Communicate Insignificant Deficiency

No Report
Send clients advisory comment letter to management
201
202
Figure 8-6 An Example of a Material Weakness Report
XYZ CPA, LLP

P.O.Box 888
San Francisco
February 8, 20xx
Board of Directors and Those Charged with Governance

ABC Company
1st Street, San Francisco
In planning and performing our audit of the financial statements of ABC Company for the year ended December 31, 20xx, we considered its
internal controls in order to determine our auditing procedures for the purpose of expressing our opinion on the financial statements and not to
provide assurance on internal controls. However, we noted certain matters involving internal controls and its operation that we considered to be a
material weakness in accordance with the standards of the Public Company Accounting Oversight Board (United States). A material weakness is
a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a
reasonable possibility that a material misstatement of the companys annual or interim financial statements will not be prevented or detected on a
timely basis. The matter noted is that there is a lack of independent verification of the key entry of the customers name, product number,
quantity shipped, prices used, and the related mathematical extensions on sales invoices and credit memos. As a consequence, errors in these
activities could occur and remain uncorrected, adversely affecting both recorded net sales and accounts receivable. This deficiency is significant
because of the large size of the average sales of ABC Company.
This report is intended solely for the information and use of the board of directors and those charged with governance in ABC Company.
Sincerely,
_________________________________
XYZ CPA, LLP
Figure 8-7 An Example of a Clients Advisory Comment Letter (Management Letter)

XYZ CPA, LLP
P.O.Box 888
San Francisco
April 28, 20xx
Mr. A
Chief Executive Officer
ABC Company
Dear Mr. A:
We have audited the financial statements of ABC Company for the year ended December 31, 20xx, and have issued our report thereon dated
March 31, 200x. As part of our audit, we studied internal controls only to the extent that we considered necessary to determine the nature, timing,
and extent of auditing procedures.
Summarized below are suggestions of importance that we believe warrant your attention. Our recommendations were discussed with personnel
responsible for the various areas, and many of these recommendations are currently being implemented.
Equipment Returned to Vendor for Repair
The company does not maintain shipping and receiving logs for all equipments sent to and received from vendor for repair. The
shipping/receiving log, listing the serial numbers of equipments sent and the dates the equipments were sent and received back, should be used to
track and monitor the status of repairs and to ensure that the equipments are returned from vendor promptly.
We appreciate the opportunity to present these comments for your consideration, and we are prepared to discuss them at your convenience.
Sincerely,
______________________
XYZ CPA, LLP
Integrated Audit of Internal Control

Managements Responsibilities on ICFR
responsibilities are to oversee the audits of public companies that are subjected to the securities laws. These
responsibilities include overseeing the corporate responsibilities rules on internal controls under the Act. If the
PCAOB determines that any public company has engaged in practices in violation of the rules, the Board may
impose sanctions, including fine of not more than $5 million and/or imprisonment of up to 20 years. A section of the
corporate responsibilities rules on internal controls is as follows:
Section 404 Management Assessment of Internal Controls

Requires the annual report of each public company to include an internal control report which shall:
(1) state the responsibility of management for establishing and maintaining an adequate internal controls and procedures for financial reporting;
and
(2) contain an assessment, as of the end of the public companys fiscal year, of the effectiveness of the internal controls and procedures of the
company for financial reporting.
The management must develop a control framework, based on a recognized control framework such as the
Internal controlIntegrated Framework developed by the Committee of Sponsoring Organizations (COSO) of the
Treadway Commission, to identify important controls, document their existence, and test their operation as a basis
for developing its report on internal controls. The management is required to include its assessment of the
effectiveness of the companys internal control over financial reporting as an addition to the annual financial
statements. The managements report on internal control over financial reporting is required to include the
following:
1. A statement of managements responsibility for establishing and maintaining effective internal controls over
financial reporting.
2. A statement identifying the framework used by management to evaluate internal control such as the COSO
framework.
3. An assessment of the effectiveness of the companys internal control as of the end of the period reported on,
including an explicit statement as to whether internal control over financial reporting (ICFR) is effective.
4. A statement that the managements report has been audited and that the audit report is contained in the annual
financial report.
Figure 8-8 provides an example of the managements integrated report on a companys internal control and financial
information.
Figure 8-8 Managements Integrated Report on Internal Control and Financial Information
XYZ COMPANY STATEMENT ON FINANCIAL INFORMATION
XYZ company is responsible for the information presented in this Annual Report. The consolidated financial statements have been prepared in
accordance with generally accepted accounting principles and present fairly, in all material respects, the companys results of operations,
financial position, and cash flows. Certain amounts included in the consolidated financial statements are estimated based on currently available
information and judgment as to the outcome of future conditions and circumstances. Financial information elsewhere in this Annual Report is
consistent with that in the consolidated financial statements.
XYZ companys management is responsible for the design and operation of an effective system using the framework developed by COSO
in the Internal Control-Integrated Framework. This system is designed to provide reasonable assurance, at suitable costs, that assets are
safeguarded and that transactions are executed in accordance with appropriate authorization and are recorded and reported properly. The XYZ
companys system of internal controls is supported by written policies and procedures and is supplemented by a staff of internal auditors.
During the past year, the XYZ company evaluated both the design and the operation of the internal control system, including tests of the
controls, where applicable. Our assessment is that the internal controls over financial reporting as of December 31, 20xx are effective in
preventing or detecting material misstatements in our financial reports . The system is continually reviewed, evaluated and where appropriate,
modified to accommodate current conditions. Emphasis is placed on the careful selection, training and development of professional managers.
An organizational alignment that is premised upon appropriate delegation of authority and division of responsibility is fundamental to this
system. Communication programs are aimed at assuring that established policies and procedures are disseminated and understood throughout
the XYZ company.
The consolidated financial statements and our report on internal control over financial reporting have been audited by independent auditors
whose report appears below. Their audit was conducted in accordance with generally accepted auditing standards established by the Public
Company Accounting Oversight Board, which include testing and evaluation of the XYZ companys internal controls and gathering of
independent evidence to form an opinion on the fairness of the XYZ companys financial and control reports.
The Audit Committee of the Board of Directors is composed solely of directors who are not officers or employees of the XYZ company and
who have financial expertise. The Audit Committees responsibilities include recommending to the Board for stockholder approval the
independent auditors for the annual audit of the XYZ companys consolidated financial statements. The Committee also reviews the
203
204
independent auditors audit strategy and plan, scope, fees, audit results, and non-audit services and related fees; internal audit reports on the
adequacy of internal controls; the XYZ companys ethic program; status of significant legal matters; the scope of the internal auditors plans
and budget and results of their audits; and the effectiveness of the XYZ companys program for correcting audit findings. The independent
auditors and XYZ company personnel, including internal auditors, meet periodically with the Audit Committee to discuss auditing and financial
reporting matters.
_____________________
Mr. A MBA, CPA
Chief Executive Officer
Auditors Responsibilities on ICFR

To provide guidance for audits in accordance to Section 404, the PCAOB issued Auditing Standard No.5 (AS 5) An
Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements. AS 5
states that the auditor must conduct an integrated audit of the clients internal control over financial reporting
(ICFR) and its financial statements. The auditor must conduct the audits ICFR and financial statements in an
integrated way because each provides the auditor with information relevant to the evaluation of the results of the
other. In addition, AS 5 makes it clear that while the two audits are to be integrated, they have different objectives.
The auditors objective in an audit of ICFR is to express an opinion on the effectiveness of the clients internal
control over financial reporting, while the objective in a financial statement audit is to express an opinion on
whether the financial statements are fairly stated in accordance with generally accepted accounting principles.
Plan the Audit of ICFR
Planning in an audit of ICFR is coordinated with the planning in a financial audit. For both audits, the auditor
considers matters related to the clients industry, business, and regulatory environment and so on. Planning matters
specific to an audit of ICFR include: 1. Knowledge of the entitys internal control over financial reporting (ICFR)
obtained during other engagements. 2. Matters affecting the industry in which the client operates, such as financial
reporting practices, economic conditions, laws and regulations, and technological changes. 3. Matters relating to the
clients business, including its organization, operating characteristics, and capital structure. 4. The extent of recent
changes in the client, its operations, or its ICFR. 5. Preliminary judgments about materiality, risk, and other factors
relating the determination of material weaknesses. 6. Control deficiencies previously communicated to the audit
committee or management. 7. Legal or regulatory matters of which the client is aware. 8. The type and extent of
available evidence related to the effectiveness of the clients ICFR. 9. Preliminary judgments about the effectiveness
of ICFR. 10. Public information about the client relevant to the evaluation of other likelihood of material financial
statement misstatements and the effectiveness of the clients ICFR. 11. Knowledge about risks related to the clients
evaluated as part of the audits client acceptance and retention evaluation. 12. The relative complexity of the clients
operations.
In addition, planning matters specific to the risk of fraud and the risk of management override of controls in
an audit of ICFR include: 1. Controls over significant, unusual transactions, particularly those that result in late or
unusual journal entries. 2. Controls over journal entries and adjustments made in the period-end financial reporting
process. 3. Controls over related-party transactions. 4. Controls related to significant management estimates. 5.
Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately manage financial
results.
Lastly, to effectively plan an audit of ICFR, PCAOBs AS 5 recommends 1. Scaling the audit which
means the auditor takes into consideration the size and complexity of the client, its business processes, and business
units that affect the way in which the client achieves effective internal control objectives. 2. Using the work of
others which means the auditor uses the work performed by, or receives direct assistance from, internal auditors
(consistent with AU 610), company personnel, and third parties working for management (e.g. valuation specialist
discussed in Chapter 19) or the audit committee.
Obtaining an Understanding of ICFR and Identifying Controls to Test
In the U.S., most management based on a control framework, Internal controlIntegrated Framework, developed by
the Committee of Sponsoring Organizations (COSO) of the Treadway Commission to identify important controls,
document their existence, and test their operation as a basis for developing its report on internal controls. Likewise,
most auditors use a Top-Down Approach for obtaining an understanding of ICFR and identifying controls to test
based on the same control framework developed by the COSO. As shown in Figure 8-9, a Top-Down approach
starts at the top, the financial statements elements and entity-level controls, and links the financial statement
elements and entity-level controls to significant accounts, relevant assertions, and to the major classes of
transactions. Table 8-6 provides brief comments on the top-down approach for obtaining an understanding of ICFR
and identifying controls to test.
Figure 8-9 A Top-Down Approach for Obtaining an Understanding of ICFR and Identifying Controls to Test
Identify Entity-Level Control
\
Identify Significant Accounts and
Disclosures and their Relevant
Assertions
Understand Likely Sources of

Misstatement
\
Select Controls to Test
Table 8-6 Brief Comments on the Top-Down approach for Obtaining an Understanding of ICFR and
Identifying Controls to Test
A Top-Down Approach
Identify Entity-Level Controls
Identify Significant Accounts

and Disclosures and their
Relevant Assertions
Brief Comments
To identify entity-level controls, AS 5 emphasizes identifying two categories of entity-level controls:
(1) The control environment in addition to understand the control environment component in the
financial audit (audit of financial statements), the auditor should also understand whether (a)
Managements philosophy and operating style promote effective ICFR. (b) Sound integrity and ethical
values, particularly of top management, are developed and understood. (c) The Board or audit committee
understands and exercises oversight responsibility over financial reporting and internal control.
(2) The period-end financial reporting process in addition to understand the information and
communication component in the audit of financial statements, the auditor should also understand (a) the
procedures used to enter transaction totals into the general ledger; select and apply accounting policies;
initiate, authorize, record, and process period-end journal entries in the general ledger; record recurring
and nonrecurring adjustments to the annual and quarterly financial statements, and prepare annual and
quarterly financial statements and related disclosures, and (b) The extent of IT (information technology)
involvement in each period-end financial reporting process; who participated from management; the
number of locations involved; types of adjusting and consolidating entries, and the nature and extent of
the oversight of the process by management, the board of directors, and the audit committee.
In an integrated audit, the auditor should identify significant accounts and disclosures that have a
reasonable possibility of containing a misstatement that would cause the financial statement to be
materially misstated. Factors that the auditor should consider for identifying significant accounts and
disclosures include (1) Size and composition. (2) Susceptibility of loss due to errors or fraud. (3) Volume
of activity, complexity, and homogeneity of individual transactions. (4) Nature of the account. (5)
Accounting and reporting complexity. (6) Exposure to losses. (7) Possibility of significant contingent
liabilities. (8) Existence of related party transactions. (9) Changes from the prior period.
Once significant accounts and disclosures are identified, the auditor identifies which financial statement
assertions are relevant to the significant accounts and disclosures. The relevant assertions are then
translates into specific audit objectives. For example, a relevant existence or occurrence assertion to a
significant accounts receivable transaction during the period under audit is translated into the specific
audit objective of occurrence that is to be accomplished by performing certain tests of controls (Recall
205
206
A Top-Down Approach
Understand Likely Sources of

Misstatements
Select Controls to Test
Brief Comments
Table 6-7 in Chapter 6).
In an integrated audit, in order to understand likely sources of misstatements, and to assist in selecting
controls to test, the auditor should (1) Understand the flow of transactions. (2) Verify points within the
clients processes at which a misstatement could arise that could be material. (3) Identify the controls
management has implemented to address these potential misstatements. (4) Identify the controls
management has implemented to prevent or detect on a timely basis unauthorized acquisition, use, or
disposition of the clients assets that could result in a material misstatement.
Ordinarily, the auditor accomplishes the above four objectives by performing a walk-through . In a walkthrough, the auditor traces a transaction from origination through the clients processes and information
system until it is reflected in the clients financial reports. It should encompass the entire information flow
through the sub-processes of initiating, authorizing, recording, processing, and reporting individual
transactions for each of the significant processes identified. A walk-through helps the auditor in (a)
confirming his/her understanding of control design and transaction process flow, (b) determining whether
all points at which misstatements could occur have been identified, (c) evaluating the effectiveness of the
design of controls, and (d) confirming whether controls have been placed in operation.
In an integrated audit, it is not necessary to design test of all controls. The auditor only tests those controls
that are important to his/her conclusion about whether the clients controls sufficiently address the risk of
misstatement for each relevant assertion identified. Factors that the auditor should consider in selecting
controls to test include (1) Points at which errors or fraud could occur. (2) The nature of the controls
implemented by management. (3) The design of the controls in relation to management assertions and
specific audit objectives. (4) The risk that the controls might not be operating effectively.
Test and Evaluate Design Effectiveness of Controls

Controls are effectively designed when they prevent or detect errors or fraud that could result in material
misstatements in the financial statements. As mentioned above, in the U.S., most management based on a control
framework, Internal controlIntegrated Framework, developed by the COSO to identify important controls,
document their existence, and test their operation as a basis for developing its report on internal controls. Thus, the
auditor first identifies the managements relevant controls that are set up according to the COSO framework, then
the auditor tests and evaluates design effectiveness of the relevant controls through inquiry, observation,
walkthroughs, inspection of relevant documentation, and subjective evaluation of whether they are likely to prevent
or detect misstatements. Similar to Table 8-4, AS 5 also provides some examples of control deficiency in the design
or operation of controls in Table 8-7.
Table 8-7 Some Examples of Control Deficiency in the Design or Operation of Controls in AS 5
Deficiencies in the Design of Controls
Inadequate overall internal control design.

Absence of appropriate segregation of duties.
Absence of appropriate reviews and approvals of accounting transactions and entries.
Inadequate procedures for applying accounting principles.
Inadequate procedures for safeguarding assets.
Absence of other appropriate control techniques.
Evidence of other accounting (computer) system design flaws.
Failures in the Operation of Internal Control

Evidence of failure of internal controls to prevent or detect misstatement.
Misapplication of control procedures.
Failure to safeguard assets from loss, damage or misappropriation.
Evidence of intentional override of internal controls.
Failure to perform part of the internal controls.
Evidence of willful wrong doing by employees or management.
Evidence of manipulation, falsification, or alteration of accounting records.
Evidence of intentional misapplication of accounting principles.
Evidence of misrepresentation by client personnel to the auditor.

Evidence of employees or management lack the qualifications and training to fulfill their assigned functions.
Others
Absence of a sufficient level of control consciousness within the organization.
Failure to follow up and correct previously identified internal control weaknesses.
Evidence of significant or extensive undisclosed related party transactions.
Evidence of undue bias or lack of objectivity by those responsible for accounting decisions.
Test and Evaluate Operating Effectiveness of Controls

The auditor tests and evaluates the operating effectiveness of a control by determining whether the control is
operating as designed and whether the person performing the control possesses the necessary authority and
competence to perform the control effectively. The PCAOBs AS 5 provides the following guidelines for auditor to
consider the nature, timing , and extent of testing and evaluating the operating effectiveness of controls:
1. Nature - Tests of operating effectiveness usually include such type (nature) of procedures as inquiry of
management, inspection of relevant documentation, observation of the clients operations, and re-performance of the
application of the control. When the procedure of inquiry is used to test and evaluate operating effectiveness of a
control, the auditor should perform additional procedures because inquire alone does not provide sufficient evidence
to support operating effectiveness of a control.
2. Timing - The auditor should perform tests of operating effectiveness of controls over a period of time that is
adequate to determine whether the controls are operating as of the date indicated in managements internal control
report. The period of time over which the auditor performs tests of controls will vary with the frequency with which
they are applied. For example, some controls operate continuously such as controls over the processing of routine
sales transactions, while other controls operate only periodically such as monthly bank reconciliation. AS 5 provides
the following guidelines regarding the timing of testing and evaluating the operating effectiveness of controls:
(a) Controls that operate periodically - For example, payroll controls that operate once a month. The auditor can
examine the effectiveness of the control near year-end.
(b) Computerized controls: The auditor must test the effectiveness of the computer process. If there are strong
controls over program changes and access to data, the auditor may test the controls by running a series of
transactions through the system and determining that there have not been significant changes to the computer
application.
(c) Continuous manual-based controls - For example, credit approvals, order entry, and preparation of shipping
documents. The auditor must test a sample that is representative of the manual-based processing throughout the
period.
(d) Controls that operate after the as of date specified in managements report - For example, controls over a
December 31 period-end financial reporting process usually operate in January of the following year. In this case,
the auditor can only perform tests at the time the controls are operating, that is, after the as of date.
(e) Management has implemented new controls during the year - The auditor must evaluate whether there has been
sufficient time to determine whether the new controls have been effectively implemented. If there has not been
sufficient time to evaluate the operating effectiveness of a new control (e.g., the new control was just implemented
on December 30 for a December 31 year-end), the auditor should indicate that the control has not been implemented
for a period of time that would be sufficient to evaluate its effectiveness.
3. Extent - AS 5 does not provide any detailed guidance on what constitutes a sufficient sample for testing the
operating effectiveness of the control. This is left to the auditor as a matter of professional judgment. As a rule of
thumb, the auditor should consider the following factors when judging the extent of testing the operating effectives
the control (a) Nature of control - Manual controls should be subjected to more extensive testing than automated
controls involving people. (b) Frequency of operation - The more frequently a manual control operates; the greater
the number of operations of the control the auditor should test. (c) Importance of the control - The more important
the control, the more extensively it should be tested. In contrast to the PCAOB, most CPA firms have developed
detailed guidance on what constitutes a sufficient sample for testing and evaluating the operating effectiveness of
controls (Discussed in Chapter 11 and Chapter 12).
Lastly, AS 5 recommends incorporating knowledge obtained from prior years audits into the judgment
process for determining the nature, timing , and extent of testing for the current year audit. This knowledge includes:
1. The nature, timing, and extent of procedures performed in previous audits, 2. The results of the previous years
207
208
testing of the control, and 3. Whether there have been changes in the control or the process in which it operates since
the previous audit.
Form an Opinion on the Effectiveness of ICFR
The auditor should evaluate all evidence obtained before forming an opinion on the effectiveness of ICFR,
including: 1. Items that the management is required to present in its report under AS 5. 2. The results of the auditors
tests and evaluations of the design and operating effectiveness of controls. 3. Any negative results of substantive
procedures (tests of balances) performed during the financial statement audit. 4. Any identified control deficiencies.
5. Review all reports issued during the year by the internal audit function that address controls and evaluate any
control deficiencies identified in those reports.
The auditor communicates in writing to management all control deficiencies, regardless of severity this
includes material weaknesses, significant deficiencies, and insignificant deficiencies. The auditor also communicates
in writing to the audit committee all material weaknesses and significant deficiencies, and an indication that all
deficiencies have been communicated to management. The written communication on weaknesses to both
management and the audit committee should be made prior to issuance of the audit opinion on the effectiveness of
ICFR. In addition, AS 5 requires the auditor to communicate material weaknesses or significant deficiencies to the
audit committee even if the management has addressed the material weaknesses or significant deficiencies and has
implemented new controls that improve the effectiveness of internal control.
Consistent with the AICPAs AU 265 definition, the PCAOBs AS 5 defines a material weakness as a
material weakness is a control deficiency, or a combination of significant deficiencies , in internal control over
financial reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the companys
annual or interim financial statements will not be prevented or detected on a timely basis (emphasis added). Table
8-8 shows the auditors consideration of reasonable possibility and materiality, communication of material
weakness, significant deficiency and insignificant deficiency, and forming an opinion on the effectiveness of ICFR.
Note that if reasonable possibility is remote, an unqualified opinion will be issued irrespective of materiality of
misstatement in the financial statements. However, if reasonable possibility is reasonably possible or probable: 1.
An adverse opinion will be issued for a material weakness. 2. (a) An unqualified opinion will be issued for a
significant deficiency in minor scope limitation. (b) A qualified opinion will be issued for a significant deficiency in
more than minor scope limitation. (c) A disclaim opinion or withdraw will be issued for a significant deficiency in
serious scope limitation. 3. An unqualified opinion will be issued for an insignificant deficiency.
In a financial audit, AU 265 allows the auditor to report material weaknesses and significant deficiencies in
a material weakness report that separates from the audit report of financial statements. Likewise, in an integrated
audit, AS 5 allows the auditor to report material weaknesses and significant deficiencies in an ICFR report that
separates from the audit report of financial statements. Figure 8-10 shows an example of a separate report giving an
unqualified opinion on the effectiveness of ICFR. Figure 8-11 shows an example of a combined report expressing an
unqualified opinion on financial statements and an unqualified opinion on the effectiveness of ICFR. Chapter 21
discusses more on the various types of opinion on the effectiveness of ICFR.
If the auditor identified a material weakness or significant deficiency in internal control prior to the yearend as of date specified in managements internal control report, and if management implements changes to the
internal control that eliminated the material weakness or significant deficiency prior to the year-end as of date
specified, the auditor would normally issue an unqualified report with an additional paragraph in the report to
explain that the auditor concluded that management has eliminated an identified material weakness or significant
deficiency prior to the year-end as of date.
In addition, the PCAOBs AS 4, Reporting on Whether a Previously Reported Material Weakness
Continue to Exist, provides guidance for the auditor in reporting on whether a material weakness or significant
deficiency continues to exist at an interim date. According to AS 4, rather than making a client wait twelve months
to receive an unqualified opinion regarding its ICFR in the next year-end ICFR report, the auditor can provide an
interim opinion once management has remediated the material weakness or significant deficiency. Thus, AS 4
allows the auditor to attest on a timely basis as to whether a client has eliminated the cause of a previously issued
adverse opinion regarding its ICFR. However, the auditors engagement to report on whether a previously reported
material weakness continues to exist in conformity with AS 4 is voluntary.
Lastly, the auditor obtains a written management representation from management related to the audit of
ICFR. It includes statements such as management did not rely on work performed by the auditor in forming its
assessment of the effectiveness of ICFR, management has disclosed to the auditor all deficiencies in the design or
operation of ICFR, control deficiencies identified and communicated to the audit committee during previous
engagements have (or have not ) been resolved, and so on. While the required management representations are
typically drafted (worded as if written) by the auditor, they are addressed to the auditor and are signed by the CEO
and CFO. A failure to obtain written representations from management, including managements refusal to furnish
them, constitutes a limitation on the scope of the audit sufficient to preclude an unqualified opinion of the ICFR.
Table 8-8 Auditors Consideration of Reasonable Possibility and Materiality, Communication of Material
Weakness, Significant Deficiency and Insignificant Deficiency, and Forming an Opinion on the Effectiveness
of ICFR
Materiality
Remote
Material
and
Significant
deficiency
Issue
unqualified opinion
Reasonable Possibility
Reasonably Possible or Probable
Communicate Material weakness
Report material weakness to
Issue adverse opinion
Not Material
but
Significant
deficiency
Issue
unqualified opinion
Communicate Significant Deficiency

Report significant deficiency to
Issue unqualified opinion (in minor scope limitation)
Issue qualified opinion (in more than minor scope limitation)
Issue disclaim opinion/withdraw (in serious scope limitation)
Not Material
and
Insignificant
deficiency
Issue
unqualified opinion
Communicate Insignificant Deficiency

Send clients advisory comment letter to
Issue unqualified Opinion
Figure 8-10 An Example of a Separate Report Giving an Unqualified Opinion on the Effectiveness of ICFR
[TITLE]
Report of Independent Registered Public Accounting Firm
ABC CPA, LLP
San Francisco, California
[ADDRESSEE]
The Board of Directors and Stockholders
XYZ Corporation
[INTRODUCTORY PARAGRAPH]
We have audited XYZ Corporations internal control over financial reporting as of December 31, 20xx, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). XYZ
Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the effectives of the companys internal
control over financial reporting based on our audits.
[SCOPE PARAGRAPH]
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit of internal control over financial reporting includes obtaining an understanding of internal control
over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control,
and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for
our opinion.
209
210
[DEFINITION PARAGRAPH]
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A
companys internal over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and
directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the companys assets that could have a material effect on the financial statements.
[INHERENT LIMITATIONS PARAGRAPH]
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate.
[OPINION PARAGRAPH]
In our opinion, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO).
[EXPLANATORY PARAGRAPH]
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated
financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed an unqualified opinion.
[SIGNATURE OF THE AUDITOR]
_____________________________
ABC CPA, LLP
[DATE OF THE AUDIT REPORT]
March 31, 20xx
Figure 8-11 An Example of a Combined Report Expressing an Unqualified Opinion on Financial Statements
and an Unqualified Opinion on the Effectiveness of ICFR.
[TITLE]
ABC CPA, LLP
[ADDRESSEE]
XYZ Corporation
We have audited the accompanying balance sheets of XYZ Corporation as of December 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the year then ended. We also have audited XYZ Corporations internal control over financial reporting as of
December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). XYZ Corporations management is responsible for these financial statements, for
maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial
reporting, included in the accompanying Management Report on the financial statements and Internal Control. Our responsibility is to express an
opinion on these financial statements and an opinion on the effectives of the companys internal control over financial reporting based on our
audits.
[SCOPE PARAGRAPH]
require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement
and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used
and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over
financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing
and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the
circumstances. We believe that our audits provide a reasonable basis for our opinion.
[OPINION PARAGRAPH]
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Corporation as of
December 31, 20xx, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting
principles in the United States of America. Also, in our opinion, XYZ Corporation maintained, in all material respects, effective internal control
over financial reporting as of December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO).

_____________________________
ABC CPA, LLP
March 31, 20xx
A Summary that Compares Internal Control of an Integrated Audit with Internal Control of a Financial
Audit
Table 8-9 provides a summary that compares internal control of an integrated audit with internal control of a
financial audit.
Internal Control of an Integrated Audit
Objective:
In an integrated audit, the objective is to obtain evidence about
the effectiveness of controls to support the auditors opinion
on the effectiveness of a clients ICFR.
Framework:
The auditor uses a Top-Down Approach to understand a
clients ICFR based on the COSOs Internal ControlIntegrated Framework.
Evidence:
The auditor obtains evidence about the effectiveness of
controls for all relevant assertions of all significant account
and disclosures in the financial statements.
Type (Nature):
An integrated audit and a financial audit use the same type of
audit procedures to test controls.
Timing:
The auditor performs tests of operating effectiveness of
controls over a period of time that is adequate to determine
whether the controls are operating effectively as of the date
indicated in managements internal control report.
Extent (Sample Size):
Internal control of a Financial Audit

In a financial audit, the objective is to obtain evidence when control
risk is assessed at less than the maximum of 100% to support the
auditors opinion on the fairness of the financial statements
presentation.
The auditor understands five components of a clients internal
control based on the COSOs Internal Control-Integrated
Framework.
The auditor obtains evidence only for all relevant assertions of all
significant accounts and disclosures that have their control risk
assessed at less than the maximum of 100%.
An integrated audit and a financial audit use the same type of audit
procedures to test controls.
The audit performs tests of operating effectiveness of controls over
the entire financial year to determine whether the controls are
operating effectively according to a clients internal control policies
and procedures.
211
212
Internal Control of an Integrated Audit

The auditor uses professional judgment to determine the
sample size to test controls.
Extensive tests of controls performed in the integrated audit of

ICFR may reduce the extent of tests of balances (substantive
tests) for the financial audit of financial statements.
Report:
The auditor communicates in writing to management all

control deficiencies, regardless of severity this includes
material weaknesses, significant deficiencies, and insignificant
deficiencies.
The auditor communicates in writing to the audit committee
all material weaknesses and significant deficiencies, and an
indication that all deficiencies have been communicated to
management.
The auditor communicates material weaknesses or significant
deficiencies to the audit committee even if the management
has addressed the material weaknesses or significant
deficiencies and has implemented new controls that improve
the effectiveness of internal control.
The written communication on weaknesses to both

management and the audit committee should be made prior to
issuance of the audit opinion on the effectiveness of ICFR.
The PCAOBs AS 4, Reporting on Whether a Previously

Reported Material Weakness Continue to Exist , provides
guidance for the auditor in reporting on whether a material
weakness or significant deficiency continues to exist at an
interim date. According to AS 4, rather than making a client
wait twelve months to receive an unqualified opinion
regarding its ICFR in the next year-end ICFR report, the
auditor can provide an interim opinion once management has
remediated the material weakness or significant deficiency.
Thus, AS 4 allows the auditor to attest on a timely basis as to
whether a client has eliminated the cause of a previously
issued adverse opinion regarding its ICFR. However, the
auditors engagement to report on whether a previously
reported material weakness continues to exist in conformity
with AS 4 is voluntary.
Management Representation:
The auditor obtains a written management representation from

management related to the audit of ICFR. It includes
statements such as management did not rely on work
performed by the auditor in forming its assessment of the
effectiveness of ICFR, management has disclosed to the
auditor all deficiencies in the design or operation of ICFR,
control deficiencies identified and communicated to the audit
committee during previous engagements have (or have not )
been resolved, and so on.
While the required management representations are typically
drafted (worded as if written) by the auditor, they are
addressed to the auditor and are signed by the CEO and CFO.
In an integrated audit, a failure to obtain written
representations from management, including managements
refusal to furnish them, constitutes a limitation on the scope of
the audit sufficient to preclude an unqualified opinion of the
ICFR.
Internal control of a Financial Audit

The auditor uses a CPA firms detailed guidance to determining the
sample size to test controls.
Extensive tests of balance in the financial audit of financial
statements may reveal deficiency in internal controls that are not
detected by the integrated audit of ICFR.
The auditor communicates insignificant deficiencies to management
in writing in a clients advisory comments letter (management
letter).
The auditor communicates in writing to the audit committee all
material weaknesses and significant deficiencies.
The auditor communicates material weaknesses or significant

deficiencies to the audit committee even if the management has
addressed the material weaknesses or significant deficiencies and
has implemented new controls that improve the effectiveness of
internal control. However, the auditor is not required to
communicate material weaknesses and significant deficiencies if (a)
the management has already made them known to the audit
committee, and (b) the audit committee has accepted the
management's conscious effort to trade off the cost against the risk
associated with the deficiencies.
The auditor may choose to communicate all material weaknesses
and significant deficiencies either during the course of the audit or
after the audit of financial statements is concluded.
Ordinarily, a previously communicated material weakness or
significant deficiency that has not been corrected would not need to
be communicated again by the auditor. However, the auditor should
periodically consider whether the passage of time or changes in the
management, the board of directors, or the audit committee would
require the material weakness or significant deficiency to be
communicated again.
The auditor obtains a written management representation (also

known as a management representation letter) from management
related to the audit of financial statements (discussed in Chapter
20).
While the required management representations are typically

drafted (worded as if written) by the auditor, they are addressed to
the auditor and are signed by the CEO and CFO.
In a financial audit, it does not address a failure to obtain written
representations from management. However, it does address a
failure to obtain written representations from a clients lawyer,
which constitutes a limitation on the scope of the audit sufficient to
preclude an unqualified opinion of the financial statements
(discussed in Chapter 20).
8-1
Which of the following factors is not related to a client's control environment?

a. Personnel policies and practices.
b. Audit committee.
c. Segregation of duties.
d. Management philosophy.
8-2
Which of the following procedures is not used by the auditor for documenting a client's internal controls?
a. Fill out an internal control questionnaires.
b. Perform a walkthrough test.
c. Prepare a flow chart about internal controls.
d. Write a report of the characteristics of internal controls.
8-3
If a control activity affects several management assertions, then it is generally considered to be

a. a more relevant control activity and it contributes to more control risk.
b. a less relevant control activity and it contributes to less control risk.
c. a more relevant control activity and it contributes to less effective overall internal control.
d. a more relevant control activity and it contributes to less control risk.
8-4
In relation to material weaknesses, which of the following procedures is not a deficiency in the design of internal controls?
a. Inadequate procedures for applying accounting principle.
b. Absence of reviews and approvals of accounting transactions.
c. Intentional misapplication of accounting principle.
d. Inadequate procedures for safeguarding assets.
8-5
The auditor does not need to communicate material weaknesses if

a. a client's management has already communicated the substance of the material weaknesses to the audit committee and
the committee has accepted the management's explanation of the matter.
b. a client's management has discussed the substance of the material weaknesses with the auditors.
c. the auditor is aware of the material weaknesses near the very end of the audit.
d. the auditor has obtained satisfactory explanations about the material weaknesses from the client's management.
8-6
The auditor should not issue a no-material-weakness report if

a. s/he has issued a management letter.
b. s/he has accepted the management's explanations about the material weaknesses.
c. s/he has previously issued a no-material-weakness report.
d. s/he was not aware of material weaknesses.
8-7
The auditor may communicate material weaknesses to those charged with governance
a. orally.
b. orally and document the communication in the auditor's working papers.
c. in writing and document the communication in the auditors working papers.
d. on internet and make it available to any interested party.
8-8
Proper segregation of duties in an effective internal control calls for segregation of the functions of
a. recording cash sales and also recording credit sales.
b. preparing bank reconciliation and also approving purchase orders.
c. receiving cash and also recording cash transactions.
d. recording daily cash summary and also recording incoming mail.
8-9
When considering internal controls, an auditor should be aware of the concept of reasonable assurance, which recognizes
that the
a. cost of internal control should not exceed the benefits expected to be derived from internal control.
b. separation of duties is necessary to ascertain that internal control is effective.
c. employment of competent personnel provides assurance that the objectives of internal control will be achieved.
d. establishment and maintenance of internal control is an important responsibility of the management.
213
214
8-10
When planning an audit, the auditors assessed level of control risk is

a. determined by using an actuarial table.
b. calculated by using an audit risk model.
c. an economic issue, trading off the costs of testing controls against the costs of testing balances.
d. calculated by using the formulas provided in the AUs.
8-11
After considering a clients internal controls, an auditor has concluded that it is well designed and is functioning as
intended. Under these circumstances the auditor would most likely
a. perform tests of controls to the extent outlined in the audit program.
b. not increase the extent of predetermined tests of balances.
c. determine the control procedures that should prevent or detect errors and frauds.
d. determine whether transactions are recorded to permit preparation of financial statements.
8-12
Which of the following best describes the inherent limitations that should be recognized by an auditor when considering
the potential effectiveness of a clients internal controls?
a. Procedures whose effectiveness depends on separation of duties can be circumvented by collusion.
b. The competence and integrity of client personnel provides an environment conducive to effective internal controls.
c. Procedures designed to assure proper authorizations are effective against fraud perpetrated by the management.
d. The benefits expected to be derived from an effective internal control usually do not exceed the costs of such control.
8-13
Which of the following statements is not correct?

a. It would be unusual to use both a narrative description and a flowchart to describe the same internal controls.
b. The use of both internal control questionnaires and flowchart on the same audit engagement is desirable for
understanding the clients internal controls.
c. The advantage of the narrative description is the ease of describing the details of complex internal controls.
d. When reliable flowcharts on internal controls are available from client, it is desirable to use them rather than have the
auditor prepare his/her own flowcharts.
8-14
The most important aspect of any internal control is

a. proper authorization procedures.
b. separation of duties.
c. independent review by top management.
d. competent and trustworthy personnel.
8-15
Which of the following most likely would not be considered an inherent limitation of the potential effectiveness of a
clients internal controls?
a. Management override.
b. Mistake in judgment.
c. Collusion among employees.
d. Incompatible duties.
8-16
When considering internal controls, the auditor should be aware of the concept of reasonable assurance, which recognizes
that
a. a clients internal control risk cannot be assessed completely.
b. the costs of a clients internal controls should not exceed the benefits expected to be derived.
c. adequate safeguards over access to assets and records should permit a client to maintain proper accountability.
d. establishing and maintaining internal controls is the responsibility of management.
8-17
Which of the following most likely has a significant negative influence on a clients control environment?
a. The client has a formal written code of ethical conduct.
b. Management is dominated by one individual who is also a major shareholder.
c. Internal auditors have direct access to the board of directors.
d. The audit committee is active in overseeing the clients financial reporting practice.
8-18
The primary objective of procedures performed to obtain an understanding of internal control is to provide an audit with
a. knowledge necessary for audit planning.
b. an evaluation of the consistency of application of managements policies.
c. a basis to modify the timing, nature, and extent of tests of controls.
d. evidential matter to use in assessing detection risk.
8-19
In obtaining an understanding of a clients internal controls in a financial statement audit, an auditor is not obligated to
a. determine whether the management monitors the performance of internal controls over time.
b. perform procedures to understand the system of information and communication.
c. search for significant deficiencies in the design of control activities.
d. document the understanding of the internal controls.
8-20
Which of the following statements is correct concerning material weaknesses in an audit?

a. An auditor is required to search for material weaknesses during an audit.
b. An auditor may report all material weaknesses in internal controls.
c. An auditor may communicate material weaknesses during an audit or after the audit is completed.
d. An auditor may report that no material weaknesses were noted during the audit.
8-21
Which of the following statements is correct concerning an auditors required communication of material weaknesses?
a. A material weakness previously communicated during the prior years audit that remains uncorrected causes a scope
limitation.
b. An auditor should perform tests of controls on material weaknesses before communicating them to the client.
c. An auditors report on material weaknesses should include a restriction on the use of the report.
d. An auditor should communicate material weaknesses after tests of controls, but before commencing tests of balances.
8-22
Material weaknesses are matters that come to an auditors attention that should be communicated to a clients audit
committee because they represent
a. disclosures of information that significantly contradict the auditors going concern assumption.
b. material fraud or illegal acts perpetrated by high-level management.
c. manipulation or falsification of accounting records or documents from which financial statements are prepared.
d. significant control deficiencies in the design or operation of internal controls.
8-23
An auditors communication of internal control related matters noted in an audit usually should be addressed to
a. those charged with governance.
b. director of internal auditing.
c. chief financial officer.
d. chief accounting officer.
8-24
A previously communicated material weakness that has not been corrected ordinarily should be communicated again if
a. the deficiency has a material effect on the auditors assessment of control risk.
b. the entity accepts that degree of risk because of cost-benefit considerations.
c. the weakness could adversely affect the clients ability to report financial data.
d. there has been major turnover in upper-level management and the board of directors.
8-25
An auditors material weaknesses report relating to a clients internal controls observed during a financial statements audit
should
a. include a brief description of the tests of controls performed in searching for material weaknesses and material
weaknesses.
b. indicate that the material weaknesses should be disclosed in the annual report to the clients shareholders.
c. include a paragraph describing managements assertion concerning the effectiveness of internal controls.
d. indicate that the audits purpose was to report on the financial statements and not to provide assurance on internal
control.
8-26
Which of the following statements concerning material weaknesses and control deficiencies is correct?
a. An auditor should identify and communicate material weaknesses separately from control deficiencies.
b. All material weaknesses are control deficiencies.
c. An auditor should immediately report material weaknesses and control deficiencies discovered during an audit.
d. All control deficiencies are material weaknesses.
215
216
8-27
Which of the following statements is true concerning insignificant control deficiencies noted in an audit?
a. Insignificant control deficiencies are material weaknesses in the design or operation of specific internal control
components.
b. The auditor is obligated to search for insignificant control deficiencies that could adversely affect the clients ability to
record and report financial data.
c. Insignificant deficiencies should be re-communicated each year, even if management has acknowledged its
understanding of such deficiencies.
d. The auditor may separately communicate those insignificant control deficiencies in a client advisory comment letter.
8-28
Which of the following statements is true concerning the auditors required communication of a material weakness in
internal controls?
a. A material weakness that management refuses to correct should be included in a separate paragraph of the auditors
report.
b. A material weakness previously communicated during the prior years audit that has not been corrected should be
communicated again in writing.
c. Suggested corrective actions for managements consideration concerning a material weakness need not be
communicated to the client.
d. The auditor should test the controls that constitute a material weakness before communicating it to the client.
8-29
Which of the following representations should not be included in a report on internal control related matters noted in an
audit?
a. Control deficiencies related to internal control design exist, but none is deemed to be a material weakness.
b. There are no significant deficiencies in the design or operation of internal controls.
c. Corrective follow-up action is recommended due to the relative significance of material weaknesses discovered during
the audit.
d. The auditors consideration of internal controls could not necessarily disclose all material weaknesses that existed.
8-30
Which of the following statements is true concerning an auditors communication of internal control related matters noted
in an audit?
a. The auditor may issue a written report to those charged with governance representing that no material weaknesses were
note during the audit.
b. Material weaknesses should be re-communicated each year even if those charged with governance has acknowledged its
understanding of such deficiencies.
c. Insignificant control deficiencies may not be communicated in a memo that contains suggestions regarding activities that
concern other topics such as business strategies or administrative efficiencies.
d. The auditor may choose to communicate significant internal control related matters either during the course of the audit
or after the audit is concluded.
8-31
Samples to test internal controls are intended to provide a basis for an auditor to conclude whether
a. the control activities are operating effectively.
b. the financial statements are materially misstated.
c. the risk of incorrect acceptance is too high.
d. preliminary judgment about materiality (PJAM) for planning purposes is at a sufficiently low level.
8-32
Which of the following tests of controls most likely would help assure an auditor that goods shipped are properly billed?
(Hint: Think of the audit procedure that tests the completeness assertion)
a. Scan the sales journal for sequential and unusual entries.
b. traces shipping documents for matching sales invoices.
c. compare the accounts receivable ledger to daily sales summaries.
d. inspect unused sales invoices for consecutive pre-numbering.
8-33
An auditor is least likely to test controls that provide for

a. approval of the purchase and sale of trading securities.
b. classification of revenue and expense transactions by product line.
c. segregation of the functions of recording disbursements and reconciling the bank account.
d. comparison of receiving reports and vendors invoices with purchase orders for proper authorization.
8-34
After obtaining an understanding of a clients internal controls and assessing control risk, an auditor may next
a. perform tests of controls to verify managements assertions that are embodied in the financial statements.
b. consider whether evidential matter is available to support a further reduction in the assessed level of control risk.
c. apply analytical procedures as tests of balances to validate the assessed level of control risk.
d. evaluate whether the internal controls detected material misstatements in the financial statements.
8-35
An auditor uses the knowledge provided by the understanding of internal controls and the final assessed level of control risk primarily
to determine the nature, timing, and extent of the
a. attribute sampling tests.
b. compliance tests of transactions.
c. tests of controls.
d. tests of balances.
8-36
An auditor uses the knowledge provided by the understanding of internal controls and the assessed level of control risk
primarily to
a. determine whether procedures and records concerning the safeguarding of assets are reliable.
b. ascertain whether the opportunities to allow any person to both perpetrate and conceal fraud are minimized.
c. modify the initial assessments of inherent risk and preliminary judgments about materiality.
d. determine the nature, timing, and extent of tests for financial statement assertions.
8-37
Which of the following are considered control environment factors?

a.
b.
c.
d.
8-38
Detection Risk
Yes
Yes
No
No
Commitment to Competence
Yes
No
Yes
No
Which of the following is not a component of internal controls?

a. Control risk.
b. Monitoring.
c. Information and communication.
d. Control environment.
8-39
Which of the following factors are included in a clients control environment?

a.
b.
c.
d.
8-40
Audit Committee Participation

Yes
Yes
No
Yes
Integrity and Ethical Values

Yes
No
Yes
Yes
No
Yes
Yes
Yes
Which of the following components of internal controls includes assignment of authority and responsibility to employees?
a. Monitoring.
b. Control environment.
c. Risk assessment.
d. Control activities.
8-41
The control activity of adequate separation of duties calls for separation of the functions of
a. authorization, execution, and payment.
b. authorization, recording, and custody.
c. Custody, execution, and reporting.
d. authorization, payment, and recording.
8-42
Internal controls cannot be designed to provide reasonable assurance that

a. transactions are executed in accordance with managements authorization.
b. fraud will be eliminated.
c. access to assets is permitted only in accordance with managements authorization.
d. the recorded accountability for assets is compared with the existing assets at reasonable intervals.
217
218
8-43
When obtaining an understanding of a clients internal controls, an auditor should concentrate on their substance rather
than their form because
a. the controls may be operating effectively but may not be documented.
b. management may establish appropriate controls but not enforce compliance with them.
c. the controls may be so inappropriate that the auditor assesses control risk at the maximum.
d. management may implement controls whose costs exceed their benefits.
8-44
An auditor should obtain sufficient knowledge of a clients information system relevant to financial reporting to understand
the
a. safeguards used to limit access to computer facilities.
b. process used to prepare significant accounting estimates.
c. procedures used to assure proper authorization of transactions.
d. policies used to detect the concealment of fraud.
8-45
An auditors flowchart of a clients accounting system is a diagrammatic representation that depicts the auditors
a. assessment of control risk.
b. identification of weaknesses in the system.
c. assessment of the control environments effectiveness.
d. understanding of the system.
8-46
An advantage of using flowcharts instead of internal control questionnaires to document a clients accounting information
and communication is that the flowcharts
a. identify internal control weaknesses more prominently.
b. provide a visual depiction of clients activities.
c. indicate whether controls are operating effectively.
d. reduce the need to observe clients employees performing routine tasks.
8-47
The Sarbanes-Oxley Act of 2002 requires the auditor to issue an opinion in the audit report on the
managements report of its internal control assessment. When issuing this opinion, the auditor
a. uses the understanding and testing of internal controls performed in the audit of the financial statements.
b. must only test controls when control risk is assessed below the maximum (i.e., material weaknesses).
c. performs a combination of tests of controls and tests of balances.
d. performs tests of additional internal controls specified by the management.
8-48
Which of the following is an incorrect statement regarding the requirement of Sarbanes-Oxley Act of 2002 on
managements internal control assessment?
a. The auditor is to issue an opinion in the audit report on the managements internal control
assessment.
b. The management is to issue a report on its internal control assessment in the companys annual report.
c. The auditor is to attest the managements internal control assessment as part of the financial statement audit.
d. The management is required to disclose fraud in its internal control assessment.
8-49
Which of the following is not addressed by the reports of the auditor and the management on internal control assessment
under the Sarbanes-Oxley Act of 2002?
a. State managements responsibilities for establishing and maintaining an adequate internal controls and
procedures for financial reporting.
b. Assure maintenance of records that reasonably reflect the transactions and dispositions of the assets of the company.
c. Provide reasonable assurance that transactions are recorded in accordance with GAAP, and that receipts and
expenditures are authorized by management and directors of the company.
d. Contain an assessment of the efficiency of the internal controls and procedures for financial reporting.
8-50
In AS 5, the PCAOB defines a material weakness as

a. a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting such that
there is a reasonable possibility that a material misstatement of the companys annual or interim financial statements will
not be prevented or detected on a timely basis.
b. a significant deficiency in the design or operation of the internal controls.
c. a more significant deficiency in the design or operation of the internal controls.
d. an insignificant deficiency that would reduce the control risk to an acceptable low level.
8-51
In AS 5, the PCAOB defines a significant deficiency in internal control to mean

a. the absence of significant misstatements in the financial statements provides evidence that there are no significant
deficiencies in internal control.
b. the control failure leads to significant or material misstatements in the financial statements.
c. the presence of a material weakness that results in material misstatements in the financial statements.
d. a control deficiency, or a combination of control deficiencies, in internal control over financial reporting that is less
severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the
companys financial reporting. .
8-52
Which of the following opinions is not required by the PCAOB in the integrated audit report on internal control and
a. An opinion on the fairness of the financial statements.
b. An opinion on the reasonableness of prospective financial statements.
c. An opinion on the managements assessment of internal control over financial reporting.
d. An opinion on the effectiveness of the companys internal control over financial reporting.
8-53
With regard to an auditor communicating insignificant control deficiencies to a client, which of the following
communication procedures is not appropriate?
a. The auditor issues a management letter that addressed to the clients management according to the auditing standard
AU 265 Communication of Internal Control Related Matters Identified in an Audit .
b. The auditor issues a management letter that addressed to the clients audit committee according to Section 301 of the
Sarbanes-Oxley Act of 2002.
c. The auditor combines a management letter and a material weakness report into a special internal control engagement
report that addressed to the audit committee.
d. The auditor combines a management letter and a material weakness report into one report and report it to the audit
committee.
8-54
The Sarbanes-Oley Act of 2002 requires management to include a report on internal control in the companys annual
report. It also requires auditors to report on the effectiveness of ICFR. Which of the following statements concerning these
requirements is false?
a. The auditor should evaluate whether internal controls are effective.
b. Managements report should state its responsibility for establishing and maintaining adequate internal controls.
c. Management should identify material weaknesses in its report.
d. The auditor should provide recommendations for improving internal control in the audit report on financial statements.
8-55
PCAOBs Auditing Standard 5 (AS 5) requires an auditor to perform a walkthrough as part of the internal control audit. A
walkthrough requires an auditor to
a. Tour the organizations facilities and locations before beginning any audit work.
b. Trace a transaction from every class of transaction from origination through the clients information system.
c. Trace a transaction from each major class of transaction from origination through the clients information system.
d. Trace a transaction from each major class of transaction from origination through the clients information system until it
is reflected in the clients financial reports.
8-56
If management makes an adverse assessment of internal control because of a material weakness (i.e., ICFR is not effective)
and the auditor agrees with the assessment, the auditor would issue
a. An adverse opinion.
b. An unqualified opinion.
c. A disclaimer.
d. A qualified opinion.
8-57
Material weaknesses must be communicated to a clients audit committee because they represent
a. Fraud or illegal acts perpetrated by high-level management.
b. Disclosures of information that contradict the auditors going concern assumption.
c. Material weaknesses in the design or operation of internal control.
d. Manipulation or falsification of accounting records.
219
220
8-58
In an integrated audit, which of the following must the auditor communicate to the audit committee?
a.
b.
c.
d.
8-59
Known Material Weaknesses

Yes
Yes
No
No
Known Significant Deficiency

Yes
No
Yes
No
In Auditing Standard 5 (AS 5), which of the following is defined as a weakness in internal control that allows a reasonable
possibility of a misstatement that is material?
a. Control deficiency.
b. Material weakness.
c. Insignificant deficiency.
d. Significant deficiency.
8-60
The auditor identified a material weakness in internal control in August. The management and audit committee were
informed about the material weakness. The management implemented internal control that eliminated the material
weakness prior to the year-end December as of date specified in managements report on internal control. The
appropriate audit report on internal control is
a. an adverse report.
b. a qualified report with an additional paragraph in the report to explain that the auditor concluded that management has
eliminated an identified material weakness prior to the year-end as of date specified in managements report on
internal control.
c. an unqualified report.
d. an unqualified report with an additional paragraph in the report to explain that the auditor concluded that management
has eliminated an identified material weakness prior to the year-end as of date specified in managements report on
internal control.
8-61
In an audit of ICFR, the auditor encountered a minor scope limitation in identifying a reasonably possible and significant
deficiency that has no material magnitude, the auditor would normally issue
a. an adverse opinion.
b. a disclaimer.
c. an unqualified opinion.
d. a qualified opinion.
8-62
Which of the following is not a correct statement with regard to tests of controls preformed in the audit of ICFR or in the
audit of financial statements?
a. In the audit of ICFR, the auditor performs tests of operating effectiveness of controls over a period of time that is
adequate to determine whether the controls are operating as of the date indicated in managements internal control
report.
b. In the audit of financial statements, the auditor obtains evidence about the effectiveness of controls for all relevant
assertions of all significant account and disclosures in the financial statements.
c. Extensive tests of controls performed in the audit of ICFR may reduce the scope of tests of balances (substantive tests)
for the audit of financial statements.
d. Any written communication to both management and the audit committee on weaknesses found in the audit of ICFR
should be made prior to issuance of the audit opinion on ICFR.

8-1 c. 8-2 b. 8-3 d. 8-4 c. 8-5 a. 8-6 d. 8-7 c. 8-8 c. 8-9 a. 8-10 c. 8-11 b.
8-12 a. 8-13 c. 8-14 d. 8-15 d. 8-16 b. 8-17 b. 8-18 a. 8-19 c. 8-20 c. 8-21 c.
8-22 d. 8-23 a. 8-24 d. 8-25 d. 8-26 b. 8-27 d. 8-28 c. 8-29 b. 8-30 d. 8-31 a.
8-32 b. 8-33 b. 8-34 b. 8-35 d. 8-36 c. 8-37 c. 8-38 a. 8-39 d. 8-40 b. 8-41 b.
8-42 b. 8-43 b. 8-44 b. 8-45 d. 8-46 b. 8-47 a. 8-48 d. 8-49 d. 8-50 a. 8-51 d.
8-52 b. 8-53 c. 8-54 d. 8-55 d. 8-56 a. 8-57 c. 8-58 a. 8-59 b. 8-60 d. 8-61 c.
8-62 b.

Simulation Question 8-1 is an adaptation with permission from a case by Agoglia, C.P., K.F. Brown, and D.M. Hanno in the Issues in Accounting
Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts;
however, the names and places have been changed.
For the past two years, Paul Russell has been working as a staff auditor for a Big Four CPA firm. One day, Jean Schmidt, the audit
manager, called Russell into her office to give him the good news of his promotion to senior auditor. Schmidt also informed him that the current
auditor-in-charge of Dickinson Technologies, Inc. engagement was being reassigned and that Russell would be taking over as her in-charge on
the audit. Russells responsibilities on the engagement would include supervising the audit staff in their completion of planning and fieldwork.
Russell was excited about the challenge of his first engagement as an auditor-in-charge. However, he also knew that Schmidt was an
extremely demanding audit manager. The thought of reporting directly to Schmidt made him nervous. True to her reputation as a demanding
manager, Schmidt expected Russell to hit the ground running. She directed him to evaluate Dickinsons control environment right away and
provided him with the following background information:
1. Their CPA firm has audited Dickinson Technologies, Inc. for the past three years and has again been engaged to audit their financial statements
for the fiscal year ending December 31, 20X4. The audit was currently in the early stages of the planning process. Their CPA firm maintained a
good working relationship with Dickinson and has found both management and the employees to be generally cooperative.
2. So far, an audit staff has collected information Dickinsons control environment, and he has documented his observations and comments in the
right-hand column of the Control Environment Questionnaire.
You should access Data File 8-1 in iLearn, which contains the Control Environment Questionnaire.
3.a. The audit client, Dickinson Technologies, Inc., is an international manufacturer of instruments used to measure electricity and electrical
signals, and has manufacturing operations both in and outside of the United States. Its stock is publicly traded on the New York Stock Exchange.
b. Dickinsons net income has increased each year, from $3.8 million seven years ago, to a projected $15.6 million in the current fiscal year.
For fiscal year 20X4, Dickinson Technologies, Inc. expects sales of $247 million. Sales have steadily increased an average of 26 percent per year
over the last seven years. The companys market niche is in a rapidly growing area; new markets and new products should continue to provide
significant sales growth. However, Dickinsons markets are becoming increasingly competitive.
c. Dickinsons management believes its technical staff is highly skilled, but several of its competitors have substantially greater financial
resources and larger technical staffs at their disposal. However, management believes that it is able to maintain its competitive advantage by
relying on a combination of market leadership, highly skilled technical staff, reputation, patents, proprietary knowledge and experience, and the
quality, safety, and cost effectiveness of its products.
d. Dickinson operates research and development centers in the United States, Europe, and Asia. Total research and development costs for 20X4
are projected to be $23.8 million, up from $17.9 million in 20X3 and $11.7 million in 20X2. Management believes customer collaboration is an
important part of their technical strength and competitive advantage, and has built close working relationships with a significant number of
professionals who use the companys instruments.
e. Dickinson has several related and wholly owned subsidiaries and has over 1,100 U.S. employees on its payroll. Approximate breakdown of
employee assignment by function are: 48 percent manufacturing, 17 percent sales and marketing, 15 percent general and administrative, 11
percent quality control and field service, and 9 percent research and development. Dickinson considers its employee relations to be satisfactory.
4. In order to obtain an understanding of the Dickinsons business before consideration of its control environment, financial results for the first six
months of the current year have been obtained from its management as follows:
Dickinson Technologies, Inc.
Unaudited Balance Sheet as of June 30, 20X4
ASSETS
Current assets
Cash
Short-term investments
Accounts receivable, net
Inventories
Prepaid expenses and other current assets
Total current assets
Property, plant, and equipment
Land
Building and building improvements
Machinery and equipment
Furniture and fixtures
Total property, plant, and equipment
Less: Accumulated depreciation
Net property, plant, and equipment
Other assets
Investments in affiliates
Patents
Other assets, net
Total other assets
June 30, 20X4

$ 000
Dec 31, 20X3

$000
Dec 31, 20X2

$000
1,161
1,683
26,189
11,363
1,679
42,075
1,072
1,557
21,906
10,125
1,743
36,403
797
1,654
18,742
7,442
1,083
29,718
1,644
11,171
27,772
2,613
43,200
11,599
31,601
1,515
10,214
25,296
2,584
39,609
10,284
29,325
1,090
7,757
15,733
2,098
26,678
8,784
17,894
7,719
4,419
948
13,086
7,021
3,819
851
11,691
2,397
2,479
759
5,635
221
222
TOTAL ASSETS
LIABILITIES AND STOCKHOLDERS EQUITY
Current liabilities
Notes payable and current maturities of long-term debt
Accounts payable
Accrued payroll and related costs
Deferred revenue
Accrued income taxes
Other accrued expenses
Total current liabilities
Deferred income taxes
Long-term debt, net of current maturities
Common stock
Additional paid-in capital
Retained earnings
Cumulative translation adjustments
Stockholders equity before treasury stock
Less: Treasury stock at cost
Total stockholders equity
TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
86,762
77,419
53,247
1,837
3,618
1,308
855
1,635
832
10,085
2,247
8,521
87
29,309
37,890
(98)
67,188
1,279
65,909
86,762
1,568
3,332
1,179
644
1,039
691
8,453
1,713
8,839
87
29,309
30,375
(78)
59,693
1,279
58,414
77,419
2,160
3,296
906
566
749
523
8,200
1,353
12,629
44
10,774
20,079
168
31,065
-31,065
53,247
Dickinson Technologies, Inc.

Unaudited Income Statement for the Six-Month Period Ended June 30, 20X4
Net revenues
Cost of goods sold
Gross profit
Operating Expenses:
Research and development
Selling, general, and administrative
Total operating expenses
Operating Income
Interest expense
Interest income
Other expense, net
Income before provision for income tax
Provision for income taxes
NET INCOME
For Six Months

Ended June 30,
20X4 ($000)
124,924
61,983
62,941
For Year Ended

Dec 31, 20X3
($000)
200,398
99,876
100,522
For Year Ended

Dec 31, 20X2
($000)
158,975
80,519
78,456
For Year Ended

Dec 31, 20X1
($000)
129,248
65,870
63,378
11,821
38,441
50,262
12,679
(376)
139
(237)
12,442
4,355
8,087
17,931
62,376
80,307
20,215
(787)
240
(547)
19,668
6,884
12,784
11,674
51,395
63,069
15,387
(880)
304
(576)
14,811
5,184
9,627
8,503
42,112
50,615
12,763
(950)
314
(636)
12,127
4,366
7,761
Required
1. Schmidt asked Russell to review the Control Environment Questionnaire (Access Data File 8-1 in iLearn, which contains the Control
Environment Questionnaire) and submit to her a detailed memo on his assessment of Dickinsons control environment regarding:
a.
b.
c.
How likely is it that its control environment will prevent misstatements arising from fraudulent financial reporting?
How likely is it that its control environment will prevent misstatements arising from the misappropriation of assets?
Which one, a. or b. above, should be of greatest concern in the audit of Dickinson Technologies, Inc.?
Assuming the role of Russell, you are to do what Schmidt has asked. You should find the discussion on Overall Audit Objective in Chapter 6 to
be helpful in drafting your memo. Your memo should conclude with an assessment of the overall likelihood that the control environment will
prevent fraud in Dickinson Technologies, Inc. Explain your overall conclusion.

Simulation Question 8-1 is based on publicly available information on the Internet and is based upon a true set of facts. The simulation question
is developed by F. Choo in Financial and Integrated Audits, a publication of AcademicPub of California State Universities.
Enrons Internal Control
Enrons 2000 annual report stated that it has metamorphosed from an asset-based pipeline and power generating company to a
marketing and logistics company whose biggest assets are its well-established business approach and its innovative people. Enrons
metamorphosis seemed to pay off: In 2000 it was the seventh largest company on the Fortune 500, with assets of $65 billion and sales revenues
of $100 billion. From 1996 to 2000 Enrons revenues had increased by more than 750 percent and 65 percent per year, which was unprecedented
in any industry. Yet just a year later, Enron filed for bankruptcy, and billions of shareholder and retirement savings dollars were lost.
At Enron, executives had incentives to achieve high-revenue growth because their salary increases and cash bonus amounts were
linked to reported revenues. In the proxy statement filed in 1997, Enron wrote the based salaries are targeted at the median of a competitor group
that includes peer group companies and general industry companies similar in size to Enron. In the proxy statement filed in 2001, Enron
wrote, The [compensation] committee determined the amount of the annual incentive award taking into consideration the competitive pay level
for a CEO of a company with comparable revenue size and competitive bonus levels for CEOs in specific high performing companies.
Employees also had incentives to achieve high revenues and earnings targets because of the shares of stock they held. Enron made
significant use of stock options as a further means of providing incentives for its executives to achieve growth. For example, Enron noted in its
2001 proxy statement that the following stock option awards would become exercisable as of February 15, 2001: 5,285,542 shares for Chairman
Ken Lay; 824,038 shares for President Jeffrey Skilling, and 12,611, 385 shares for all officers and directors combined. In fact, as of December 31,
2000, Enron had dedicated 96 million of its outstanding shares (almost 13 percent of its common shares outstanding) to stock option plans.
Enrons performance review committee (hereafter, PRC) determined the salaries and bonuses of employees on a semiannual basis.
The PRC was initially instituted in the gas services business during the early 1990s after the merger between Houston Natural Gas and
InterNorth. One Enron employee said, At the time, it was a great tool When we started the ranking process, we were trying to weed out the
lower 5 or 6 percent of the company. We had some old dinosaurs, and we had some younger people who needed incentives. The PRC was
gradually instituted companywide when Jeffrey Skilling, a former McKinsey & Co. consultant who joined Enron in 1990 as the chief executive
of the Enron finance division, was promoted to president and COO.
The PRC made its determinations based on feedback reports that assessed the performance of employees on a scale from 1 to 5. Those
who received ratings of 1 received large bonuses, and a rating of 2 or 3 could cost a vice president a six-figure sum. Those who ranked in the
bottom 10 percent of the review had until the next semiannual review to improve or they would be fired. Those in categories 2 and 3 were also
given notice that they could be fired within the next year.
During the 1990s Enron made significant changes to several of its accounting procedures designed to improve reported earnings and
financial position. For example, Enron began using mark-to-market (MTM) accounting for its trading business, which allowed the present value
of a stream of future inflows and outflows under a contract to be recognized as revenues and expenses, respectively, once the contract was signed.
Enron was the first company outside the financial services industry to use MTM accounting. Enron also began establishing several specialpurpose entities (SPE), which were formed to accomplish specific tasks such as building gas pipelines. If an SPE satisfied certain conditions,
satisfied certain conditions, it did not have to be consolidated with the financial statements of the sponsoring company. This SPE could be utilized
by a company hoping to achieve certain accounting purposes, such as hiding debt.
Required
You should access the PCAOBs Auditing Standard No.5 (AS 5) in http://www.pcaobus.org/Standards/index.aspx to answer the following
questions:
1. Read Paragraphs 21 to 25 of AS 5, then
a. Define what is meant by control environment in AS 5.
b. Comment on your understanding of Enrons control environment.
c. Explain how Enrons control environment would affect your implementation of the Top-Down approach for Obtaining an Understanding of
ICFR and Identifying Controls to Test.
2. Read Paragraphs 62 to 70, then
a. Explain whether Enrons executive incentive scheme might be a material weakness, significant deficiency, or insignificant deficiency in
internal control. State all your assumptions and support your arguments.
b. Explain whether Enrons performance review scheme might be a material weakness, significant deficiency, or insignificant deficiency in
internal control. State all your assumptions and support your arguments.
c. Explain whether Enrons accounting procedures relating to MTM and SPE might be material weaknesses, significant deficiencies, or
insignificant deficiencies in internal control. State all your assumptions and support your arguments.

Simulation Question 8-3 is an adaptation with permission from a case by H. N. Higgins in the Issues in Accounting Education, a publication of
the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
Bank of China and Chinas Banking Sector
Established in February 1912, Bank of China (BOC) functioned as the country's central bank, its international settlement bank, and its
international trade bank until 1949. After the founding of the People's Republic of China, BOC became a state-owned specialist bank engaged in
foreign exchange and foreign trade. In 1994, BOC was restructured into a wholly state-owned commercial bank. In August 2004, BOC was
incorporated into Bank of China Limited, and it went public on the Hong Kong Stock Exchange in June 2006 and on the Shanghai Stock
Exchange in July 2006, becoming the first Chinese commercial bank listed in the Chinese Mainland and in Hong Kong.
The major stockholder (owning 67 percent of BOC) is Central Huijin Investment Limited, owned by the People's Republic of China.
Shareholder rights are exercised by the State Council. Central Huijin provides a structure by which the government can operate under China's
Company Law as a shareholder of the large Chinese banks.
Besides its large share of the domestic market, BOC has substantial overseas operations, including operations in highly regulated banking
environments such as Hong Kong, New York, and London. For this reason, BOC has had perhaps greater exposure to international business and
regulatory standards than any other Chinese state enterprise. You should access Data File 8-3 in iLearn for Figure 1, which shows the
ownership and operational structures of BOC.
223
224
The governance structure of BOC is that of a joint-stock company, composed of the General Meeting of Shareholders, the Board of
Directors, and the Board of Supervisors. The Board of Directors is BOC's decision-making body composed of 15 members, namely its
chairperson, three executive directors, seven non-executive directors, and four independent directors. Its committees include the Strategic
Development Committee, Audit Committee, Risk Policy Committee, Personnel and Remuneration Committee, and Connected Transaction
Control Committee.
The Senior Management, BOC's executive body, reports to the Board of Directors. It consists of a president, vice-president, and other senior
management members. It includes numerous committees responsible for corporate banking, personal banking, global markets business,
operational service, risk management and internal control, securities investment management, purchase review, asset disposal, and anti-money
laundering.
The Board of Supervisors is BOC's supervisory body, consisting of five supervisors, three of whom are shareholders and two of whom are
employees. The Board of Supervisors is responsible to the General Meeting of Shareholders, and it oversees the bank's financial affairs and the
legal compliance of the Board of Directors and the Senior Management. The governance structure of BOC, depicted in Figure 2, is consistent
with a dual board structure often found in countries with a civil law tradition such as Germany and France. You should access Data File 8-3 in
iLearn for Figure 2, which shows the governance structure of BOC.
BOC is one of the Big Four state-owned commercial banks (Industrial and Commercial Bank of China, Bank of China, Agricultural Bank
of China, and China Construction Bank), which together account for the majority of the country's market. The remainder of the country's sector is
made up of policy banks, joint-stock banks partially owned by the government and partially by other interests, foreign banks, and rural credit
cooperatives. The Big Four face little competitive threat and are better known for their poor risk controls than their contribution to the economy.
The Big Four are less profitable, are less efficient, and have worse asset quality than most other banks in China. Lending by the Big Four is less
prudent, although improvements over time are expected as reform initiatives are implemented. Economic growth leads financial development in
China (not the other way around), and until 2005, bank loans had little effect on local growth.
China's banking system is notably different than private, market-based banking systems in the West, in that it is state owned and it plays a
significant role in commercial enterprise financing. The most salient aspect of the system is the dominant role of the state. The Chinese
government holds, on average, 53 percent of a listed company's total shares, while the second-largest shareholder holds roughly 10 percent. State
ownership is exercised by the Chinese Communist Party and government ministries. The state participates actively in managing the banks.
Government officials are routinely appointed as bank managers and directors, and the state sets management compensation at most banks. The
party appoints the boards with the approval of the State Council. Chinese financial regulators tend to pursue macroeconomic policy goals through
regulated institutions, particularly through banks and securities firms. Because China is an extremely populous country and because Chinese
communism emphasizes social and economic equality over the profit motive, social and economic stability are deemed essential and generally
constitute the overarching goals of government policies. Government officials in manager or director positions tend to pursue government
policies without emphasizing profit-seeking goals.
The second most salient aspect of the system is the banks' significant role in commercial financing. Despite significant recent growth in
China's capital markets, close to 90 percent of Chinese enterprise financing comes from the banks. In stark contrast, in the U.S., capital markets
account for about half of total business financing. Even in Japan, a bank-centered economy, bank financing accounts for only about two-thirds of
total business financing. Thus, banks are even more important for commercial financing in China than in Japan.
Bank Governance Problems and Reforms
China opened its economy and launched economic reform in the late 1970s. In the 30 years prior to this, the Chinese economy had
functioned as a socialist economy, based upon state ownership and centralized decision making. Chinese banks executed government directives to
support regional and industrial policies. Owned by the state and not beholden to interested shareholders, they were not profit oriented. Rather,
they allocated resources in accordance with central planning.
Since the launch of economic reform in the late 1970s, Chinese banks have been moving away from being mere extensions of the
government; however, many Chinese banks still have a governance regime that is not well adapted to a more independent, active role in resource
allocation. The four largest commercial banks, including BOC, are owned primarily by the state. The second-largest category of banks consists of
11 joint-stock banks that emerged after the reforms. These banks are co-owned by the government and by other interests. Less constrained by
government directives, these banks have developed a stronger commitment to profitability.
In tremendous growth, China's banking sector is deemed more vulnerable to fraud than the banking sectors of developed countries. Due to
the very recent development of the country's corporate culture, the distinction between government and commercial functions is still blurred in
Chinese enterprises. Because state officials still often act as bank owners, managers, and directors, they often interfere with banking operations
for policy purposes and do not base decisions on commercial principles. Many state-owned commercial banks continue lending to favored
borrowers, many of whom are unprofitable state-owned enterprises. Furthermore, the government has an implicit policy of not letting major
banks fail. Lack of adherence to commercial principles and a bailout mentality open doors to adverse credit selection and to conflicts of interest.
Decades of reform have achieved only limited success in instilling discipline in the state-owned banks. While cumulating huge assets due to
a high savings rate from the thrifty Chinese public (40 percent of national income is in the form of bank deposits from the public), Chinese banks
manage these assets poorly. Particularly, state-owned banks often extend credit to weak but privileged borrowers and then continue approving
further loans to these borrowers in order to avoid reporting non-performing loans. Many such borrowers are loss-making, state-owned enterprises.
Many others are individuals and businesses perpetrating fraud.
Unprincipled lending has led to an increase in non-performing loans. By the end of 1997, non-performing loans generated by China's stateowned commercial banks were equivalent to $400 billion. Estimates of China's non-performing loan ratio varied between 20 percent as officially
reported, to 4050 percent as estimated by some in the West. At the same time, the average capital adequacy rate of Chinese banks was 3.5
percent, much lower than the 8 percent required by the Basel Accords.
Important restructuring began in 1998, when capital of RMB 270 million (3 percent of China's GDP, equivalent to $33 billion) was injected
into the four state-owned banks. In 1999, the Chinese government established Asset Management Companies to purchase RMB 1.4 trillion
(equivalent to $170 billion) of non-performing loans. In these transactions, the Chinese government transferred a substantial number of nonperforming loans to state-owned asset management companies at book value, essentially injecting capital into banks to rid them of their toxic
assets. Further capital injections followed in 2003 and 2004. The estimated cost to the government for non-performing loans was at least 20
percent and as much as 50 percent of one year's GDP, equivalent to 1 to 2.5 percent of GDP annually over 20 years.
Capital injection has indeed played a role in reducing non-performing loans at BOC and at other Chinese banks. In 1997 at BOC, a
whopping 60 percent of total loans were estimated as non-performing. By 2002, this rate was reduced to roughly 26 percent. By 2004, BOC's
non-performing loan rate was only around 5 percent. By 2009, the rate was under 2 percent, helping BOC rank 11th among the world's top 1,000
banks by Tier 1 capital. This bailout demonstrated the Chinese government's resolution to resurrect Chinese banks. Nonetheless, the provision of
funds was insufficient to address banks' balance-sheet problems and provided little incentive to prevent the banks from reverting to earlier
patterns of lending. You should access Data File 8-3 in iLearn for Figure 3, which shows the non-performing loans of BOC over the years.
Another phase of governance reform was undertaken in 2003 as a condition for China's accession to the World Trade Organization (WTO).
WTO membership required China to open the country's finance sectors to more foreign competition. Key reform elements that grew out of WTO
requirements were ownership diversification, public listing, and expanded foreign presence, all designed to subject banks to higher standards of
transparency and to enable external scrutiny. Governance reform and international exposure are intertwined because they are both linked to banks'
attempts to strengthen their balance sheets via additional financial support. At the same time, a specialized independent agency for bank
supervision, the China Banking Regulatory Commission (CBRC), was formed to accelerate new measures of bank supervision. The reform
initiatives aimed to incorporate internationally accepted best practices and to foster banks' transition from their traditional role as government
agencies toward a commercial orientation.
After China's accession to the WTO in 2001, initiatives to strengthen corporate governance and risk management helped uncover a myriad
of fraud instances at Chinese banks. In 2005, China's Ministry of Commerce revealed that over 4,000 corrupt officials had fled the country, taking
with them nearly $50 billion. Corrupt officials had reason to flee: corruption is a crime that can draw capital punishment in China, although the
death penalty often may be reduced to life imprisonment in non-political cases. The following incident relates one such example of fraud.
Fraud Incident
The Gang
The Operation
Co-Conspirators
The Stolen Funds
The Cover
Discovery
BOC has experienced no shortage of fraud orchestrated by management at all levels. One of the most spectacular schemes came to light in
2001, coinciding with China's entrance in the WTO. In the process of improving their systems to comply with WTO requirements, BOC auditors
discovered that amounts equivalent to half a billion U.S. dollars were missing from the bank's accounts. Investigations led to a branch in Kaiping,
a manufacturing town in the Guangdong province.
According to Hong Kong authorities, Xu Chaofan, mastermind of the scheme and a former general manager at the Kaiping branch, began
illegal transfer and use of BOC funds in the early 1990s. While at the branch, he stole an estimated $400+ million. Promoted to manager of the
regional headquarters at Guangzhou in 1999, Xu Chaofan netted an additional $80 million in stolen funds by conspiring with two succeeding
Kaiping general managers, Yu Zhendong and Xu Guojun.
In the 1990s, many mainland Chinese set up so-called window companies to speculate in stocks and real estate in Hong Kong, China's
window to the world. The gang helped create two window companies in 1992; they then used the companies as vehicles to invest BOC funds and
to pull in profits for themselves, as well as to divert stolen funds. Relatives of Xu Chaofan set up both companies, Ever Joint Properties and Yau
Hip Trading Limited. On the surface, the window companies acted as investing arms of BOC Kaiping. However, no permission to remit these
funds abroad was granted by a BOC senior branch manager. Some funds from Ever Joint were funneled to a third organization the gang had
created, Land Galaxy Limited, which paid salaries and expenses incurred by the gang, whose members had created false Hong Kong identities for
this purpose. Ever Joint funds also were moved to other accounts controlled by the gang at casinos and elite financial institutions in Hong Kong
and in other countries. The gang's typical fraudulent transaction was a bank loan. BOC funds were remitted to Ever Joint in Hong Kong mostly
by means of false information purporting to show loans made to intermediary companies in Hong Kong, although there was no genuine business
between Ever Joint and these intermediaries.
The gang's most important co-conspirators were Hui Yat-sing, Xu Chaofan's first cousin, and Wong Suet-mui, Hui Yat-sing's wife. Both
were directors and managers of Ever Joint Properties and signatories of the company's bank account. Wong also ran Yau Hip Trading and was the
signatory of its bank account. The gang also had accomplices managing mainland companies that received loans from BOC Kaiping and remitted
the funds to Ever Joint. Additional accomplices in Hong Kong received funds from Ever Joint and then disbursed them to the gang under
members' false Hong Kong identities.
Ever Joint funded the purchase of three expensive Hong Kong apartments for the gang. Monies from the window company were invested in
real properties, stocks, index futures, and foreign exchange. Some investments apparently met with disastrous results in the wake of the real estate
and stock market crashes of 1997. Ever Joint's biggest stock position was in Leading Spirit High-Tech Holdings Company Limited, a Chinese
stock that plunged 99 percent from its 1997 high. The gang also bought and suffered great loss from a stake in tycoon Richard T. K. Li's Pacific
Century CyberWorks Limited. They also deposited large sums into accounts controlled by themselves, their wives, and their relatives at casinos
in Macau, Australia, and the United States. You should access Data File 8-3 in iLearn for Figure 4, which shows the flow of stolen funds.
Since the bank managers had insider authority to make loans and transfer funds without controls, the stolen funds went unnoticed by BOC's
information system and auditing processes for some time. Lax supervision and the proliferation of non-performing loans also provided a mask,
hiding the theft. The managers could further resort to accounting gimmicks to cover their tracks. A major auditing weakness at the time was the
system's inability to clear and verify a large number of accounts simultaneously, leaving a window of a couple of days for bank managers to
transfer funds from account to account to camouflage shortages.
In October 2001, coinciding with China's entrance to the WTO, a change at BOC in the structure providing for the transfer of funds and
centralization of information helped auditors discover discrepancies in the accounting books of BOC Kaiping. On October 13, 2001, BOC's
auditors examined the accounting records for that branch and found that a huge sum of money was missing.
On the same day, the three managers failed to attend work, fleeing to Hong Kong and using their Hong Kong identity cards to gain entry.
On October 15, 2001, they left Hong Kong for Canada. Their final destination was the U.S., where they and their wives obtained citizenship by
unlawfully using loopholes in the system and by using forged documentation. Via the arrangement of his true wife, Yu Zhendong entered a sham
marriage with a naturalized U.S. woman named Shanna Yu Ma in order to procure his own U.S. citizenship.
Police in China, Hong Kong, Canada, and the U.S. cooperated in the investigation. Yu Zhendong was arrested in Los Angeles in December
2002. He pleaded guilty to racketeering in February 2004, was sentenced to 144 months in prison by a federal court in Las Vegas, and voluntarily
returned to China on China's promise to exempt him from the death penalty. In China, a court in Jiangmen City sentenced him to 12 years in
225
226
prison, comparable to the U.S. sentence. Yu was the first corrupt Chinese official to be repatriated as a result of China's ratifying the United
Nations Convention against Corruption in October 2005. Prior to this convention and before Yu's case, suspects of severe economic crimes in
China had rarely been sent back, because many countries objected to the death penalty for this type of crime. Xu Guojun was arrested in Kansas
in September 2004, and Xu Chaofan was arrested in Oklahoma in October 2004. In 2008, the two were convicted of racketeering, money
laundering, and passport fraud by a Las Vegas court. In 2009, a U.S. district judge sentenced Xu Chaofan to 25 years in prison and Xu Guojun to
22 years in prison.
The Need for More Bank Audits and Reforms in China
In light of the fraud triangle theory, the Kaiping scheme suggested high fraud risk at BOC and other Chinese banks. The concept of a fraud
triangle denotes three factors, namely opportunity, pressure/incentive, and rationalization/attitude that signal high likelihood of fraud. The
Kaiping managers' ability to abuse their positions of trust was consistent with a lack of supervision in many Chinese enterprises, which created
ample opportunities for managers to commit fraud. These opportunities suggested high fraud risk at the bank, and to the extent that other Chinese
banks shared the same governance and control structure, they also had high fraud risk.
Indeed, not just BOC but other Chinese banks and enterprises have similar challenges in applying control activities. The following notes
highlight some common challenges beyond the facts of the described fraud incident. These notes should be important to managers and auditors of
Chinese banks and enterprises.
First, managers often have undivided authority in China. According to Shen Xiaoming, deputy director of the China Banking Regulatory
Commission (CBRC), regulations as of 2005 allowed bank managers to give loans with undivided authority. Banks often accepted forged
commercial papers and illegal deposit pledges in exchange for loan disbursements. Banks typically did not have procedures to limit managers'
authority, such as loan approval committees to assess lenders' merit based on credit and business purposes.
Second, it is common in China for the authorized signatory of bank accounts to use seals in place of handwritten signatures. Usually, the
minimum two seals required are the Legal Representative Seal and the Finance Seal, although some companies may use more seals for better
segregation of duties. However, the intended control is overridden if both seals are accessible to one single individual.
Third, many Chinese banks lack a process for controlling bank confirmations at the branch level; as a result, fraudulent employees at local
branches may give fake bank confirmations without being detected. An essential audit procedure by auditors is to seek bank confirmations of a
firm's cash balance. However, firms with friends at the local bank may deceive their auditors if their friends issue a fake confirmation. To
mitigate this problem, auditors may seek confirmations at both the bank branch and headquarters.
The fraud incident prompted BOC, other Chinese banks, and Chinese bank regulators to strengthen supervisory standards. Today, Chinese
regulators have published standards that are comparable to those of other major financial systems in the world. China's Basic Standard for
Enterprise Internal Control (Basic Standard ) was issued in June 2008, followed by Implementation Guidelines (Guidelines), issued in April
2010. The Guidelines were based on the 1992 Document on Internal Control, published by the Committee of Sponsoring Organizations (COSO
1992).
The COSO framework has been adopted by many organizations and government entities in the U.S. and throughout the world to design and
assess internal control systems. COSO identifies three objectives: effectiveness and efficiency of operations, reliability of financial reporting, and
compliance with applicable laws and regulations. To achieve these objectives, COSO identifies five interrelated components of internal control:
control environment, risk assessment, control activities, information and communication, and monitoring. Thus, the COSO framework may be
visualized as a matrix of three objectives and five components that can assist high-level managers in designing internal control systems and
auditors in conducting COSO-based audits. You should access Data File 8-3 in iLearn for Figure 5, which shows the COSO Internal
Control Integrated Framework.
Although all five components of an internal control system are important, control activities form the first line of defense against fraud.
These activities include establishment of responsibility; segregation of duties; documentation of procedures; establishment of physical,
mechanical, and electronic controls; development of a system for independent internal verification; and creation of human resource controls.
The Guidelines have been dubbed C-SOX since they are similar to the U.S. Sarbanes-Oxley Act Section 404. They outline the regulatory
requirements for Chinese enterprises to establish, evaluate, and assess the effectiveness of their internal controls. C-SOX also requires accounting
firms to audit the effectiveness of the enterprise's internal controls. Enterprises are required to issue assessment reports of internal controls every
year. The CEO and Board of Directors are ultimately responsible for risk management and compliance. In addition, auditors are required to
disclose in their audit reports any noted material deficiencies in internal controls that are both related and unrelated to financial reporting. Note
that China's Guidelines are referred to as C-SOX, it should not be confused with Canada's CSOX.
While these standards should help, some remain fundamentally concerned about the inherent conflicts of interest that emerge in statecontrolled banks, arguing that independence in individuals' judgment is a necessary foundation for implementing governance and reform
standards. State control calls into question the independence of the supervisory process, objectivity of the board, independence of management,
and integrity of the audit and risk management processes.
Other concerns are about the aspects of Chinese culture that may impede systems of internal controls. For example, the most prominent
Chinese cultural characteristics that have strong implications for interpersonal and inter-organizational dynamics are guanxi and mianzi. Guanxi,
which means personal connections, is embedded in a tradition of mutual trust, warmth, loyalty, and respect. Guanxi is consistent with other
characteristics of Chinese culture, such as family orientation, favor, and harmony. Mianzi, which means face, is the recognition by others of an
individual's social standing. Mianzi is consistent with typical Confucian values, such as respect for age and hierarchy, and avoidance of conflict
and overt disagreement. Mianzi is a key component in the dynamics of guanxi, whereby parties of a business relationship must save mianzi for
each other. In the Chinese business context, building guanxi and saving mianzi creates trust and a bond between partners. While guanxi and
mianzi contribute to the success of many Chinese societies, these cultural aspects can become fertile soil for corruption and fraud, especially
when combined with state paternalism and collectivism. Although guanxi is not necessarily a source of corrupt behavior, it is a critical facilitator
of corruption, which some say is ubiquitous in China. Saved faces and special relations with powerful people may turn into power exchange and
gain sharing without obligating formal laws and informal norms. In addition, Chinese fraud often involves more than individual wrongdoing but
also institutionalized corruption that involves guanxi networks between high-ranking government officials and private businessmen. It should be
noted that the intertwinement of connections and corruption may exist in any country, not just in China.
Ultimately, reform success depends largely on the commitment of the government and people. In a country with centuries-old traditions and
a corporate culture that is still quite young, it will be interesting to see whether new standards affect the banks' control environment significantly.
Required
1. Based on your understanding of control activities described in this Chapter, identify the internal control weaknesses that contributed to the
BOC fraud incident.
2. As you reflect on the Fraud Triangle (discussed in Chapter 6), what economic, organizational, institutional, or cultural factors of the fraud
triangle helped foster the described fraud incident?
3. Review Figure 5 in iLearn and do additional research on COSO's Internal ControlIntegrated Framework. Focusing on Effectiveness and
Efficiency of Operations, discuss which control features a bank auditor should look for in assessing the effectiveness of the BOC in mitigating
the risk of lending to risky borrowers.
227
228
Chapter 9
Audit Plan Materiality and Risk
LO9-1 Set qualitative Preliminary Judgment about Materiality (PJAM) and quantitative
Material Threshold (MT) at the overall financial statements level.
LO9-2 Allocate PJAM to Tolerable Misstatements (TM) at an individual account
-balance or a class of transactions level.
LO9-3 Assess Audit Risk (AR) at the overall financial statement level.
LO9-4 Assess Audit Risk (AR) at an individual account-balance or a class of
transactions level.
LO9-5 Distinguish among Inherent Risk (IR), Control Risk (CR), and Detection Risk
(DR).
LO9-6 Apply the audit risk model AR = IR X CR X DR.
LO9-7 Explain the relationship among audit risk (AR), materiality, and audit evidence.
229
230
Chapter 9 Audit Plan Materiality and Risk

Figure 9-1 provides an overview of the materiality concept as it applies to the audit plan.
Figure 9-1 Materiality Concept in the Audit Plan
The Audit Process
Audit Plan
Preplan and
Documentation CH 5
Tests of Controls
Tests of Balances
Financial Audit
Integrated Audit
Objectives CH 6
Evidence CH 7
Program and
Technology CH 10
Audit Report
1. Set preliminary judgment about materiality

(PJAM). Quantify PJAM as materiality
threshold (MT) by considering the appropriate
base, the materiality guideline, and the
qualitative factors at the overall financial
statements level.
2. Allocate PJAM to tolerable misstatements

(TM) by considering the relative propensity for
misstatements, the over- and under-statements,
and the cost of audit at an individual accountbalance or a class of transactions level.
3. Document all misstatements found for an

account-balance at tests of controls and tests of
balances. Compare the total misstatements with
the PJAM. Revise PJAM (RJAM) if necessary.
Perform additional audit work or request the
management to make adjustment for the
misstatements.
4. Combine all misstatements found for all

account-balances at completing the audit.
Compare the combined misstatements with the
PJAM and determine whether the financial
statements taken as a whole is materially
misstated.
Materiality Concept
The Financial Accounting Standards Board defines materiality as "the magnitude of an omission or misstatement of
accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have been changed or influenced by the omission or
misstatement" in its Statement of Financial Accounting Standards No.2 Qualitative Characteristics of Accounting
Information (FASB 1980). This conceptual definition does not provide practical guidance on how to make
materiality decisions in a real-world audit situation. On the other hand, AU 320 Materiality in Planning and
Performing the Audit does not define materiality but offers practical guidance on how an auditor should make
materiality decisions. According to AU 320, the auditor should consider materiality both in:
Planning the audit and designing the audit procedures.
In the planning phase of an audit engagement, the auditor should consider a preliminary judgment about
materiality (PJAM) for the financial statements taken as whole to plan for the nature, timing, and extent of audit
procedures. This PJAM may be based on a clients annualized interim financial statements or financial statements of
one or more prior periods, as long as recognition is given to the effect of major changes in the clients circumstances
(e.g., a significant merger) and relevant changes in the economy as a whole or the industry in which the client
operates.
Evaluating whether the financial statements taken as a whole is presented fairly in conformity with generally
accepted accounting principles.
At the completing the audit, after all audit evidence has been gathered and evaluated, an auditor evaluates
whether the combined amount of misstatements for all accounts will materially misstate the financial statements
taken as a whole.
In theory, an auditor's judgment about materiality at the audit plan is based on the same information
available to him/her at the completion the audit. Therefore, the materiality level for the planning and at the
completing the audit should be the same. However, it is ordinarily not feasible for the auditor, when planning an
audit, to anticipate all of the circumstances that may influence his/her judgment about materiality during an
engagement. Thus, during the engagement, the auditor may adjust the level of his/her preliminary judgment about
materiality (PJAM) in light of the misstatements discovered. The adjusted level of preliminary judgment is referred
to as the revised judgment about materiality (RJAM).
At the completing the audit, the auditor again considers materiality by comparing the combined amount of
misstatement for all accounts with the level of preliminary (or revised) judgment about materiality for the financial
statements taken as a whole. If the combined amount of misstatement exceeds the preliminary (or revised) judgment
about materiality, then the financial statements will be materially misstated, and the auditor will either perform
additional audit procedures or request the management to adjust the misstated accounts. If additional procedures are
not performed and the management refuses to adjust the misstated accounts, then the auditor may issue a qualified or
an adverse opinion.
Example 9-1 illustrates how the materiality concept is applied to the audit plan, testing, and completing the
audit.
Example 9-1 Application of the Materiality Concept at the Audit Plan, Testing, and Completing the Audit
_____________________________________________________________________________________________
At the audit plan, auditor A determines the level of preliminary judgment about materiality (PJAM) for XYZ Company's financial statements
taken as a whole to be $50,000. During the engagement, auditor A considers a significantly higher materiality level is appropriate. His revised
level of judgment about materiality (RJAM) is $25,000. At the completing the audit, auditor A finds the combined amount of misstatement for all
accounts to be $30,000.
How would you explain auditor As application of the materiality concept?
At the audit plan, the level of auditor A's PJAM represents the maximum amount, in this case $50,000, by which XYZ Company's entire set of
financial statements could be misstated and still would not cause him to believe that the decision of reasonable users of the financial statements
would be affected. The purpose of this PJAM is to help the auditor determines the timing, extent and nature of audit procedures to perform
during the engagement.
During the engagement, auditor A revises the materiality level, RJAM, to a higher level, as a result, the maximum amount of misstatement that
could affect the decision of users is smaller than before, that is, $25,000 instead of $50,000. This is done in light of the circumstances
surrounding the audit evidence gathered and any additional information about the client. The purpose of the auditor A's RJAM is to help him to
re-evaluate the sufficiency of the audit procedures he has performed. In this case, the extent and nature of the audit procedures would increase,
since the auditor would need to examine more audit evidence in order to meet the higher level of materiality.
231
232
At the completing the audit, auditor A compares the actual amount of combined misstatement for all accounts of $30,000 with his RJAM of
$25,000. Since the combined amount of misstatement exceeds the materiality level for the financial statements taken as a whole, XYZ Company's
financial statements would be materially misstated. As a result of this comparison, the auditor would consider whether to apply additional audit
procedures, request the management to adjust the misstated accounts, or to issue a qualified or adverse opinion.
___________________________________________________________________________________________________________
Setting PJAM at Audit Plan

In setting PJAM at audit plan, an auditor considers materiality at two levels:
The overall financial statements level, which involves materiality threshold (MT).
The individual account-balance or class of transactions level, which involves tolerable misstatement (TM).
Table 9-1 comments on setting PJAM at the overall financial statements level (MT) and at the individual accountbalance or class of transactions level (TM).
Table 9-1 Setting PJAM at the Overall Financial Statements Level (MT) and Individual AccountBalance or Class of Transactions Level (TM)
Setting Preliminary Judgment About Materiality (PJAM) at Audit Plan
Overall Financial Statements Level Individual Account-Balance or Class of Transactions
Materiality Threshold (MT)
Level - Tolerable Misstatement (TM)
The auditor ordinarily considers materiality for planning

purpose before the financial statements to be audited are prepared by
the client. Thus, the auditor's PJAM is often based on the client's
interim financial statements or prior year's financial statements
adjusted for current changes, such as the general condition of the
economy and industry trends.
The auditor's PJAM may or may not be quantified. If
PJAM is quantified, AU 320 Materiality in Planning and Performing
the Audit states that "the auditor ordinarily considered materiality for
planning purpose in terms of the smallest aggregate level of
misstatements that could be considered material to any one of the
financial statements." This smallest aggregate level of misstatement
is referred to as the materiality threshold (MT). Thus, it is important
to note that the PJAM at the overall financial statements level is
derived quantitatively by considering the MT among the individual
financial statements. This decision rule, the smallest aggregate level
of misstatement (MT) to any one of the financial statements, is an
appropriate one because (1) the financial statements are interrelated
and (2) many auditing procedures pertain to more than one statement.
For example, the auditing procedure to determine whether year-end
credit sales are recorded in the proper accounting period provides
evidence for both accounts receivable (balance sheet) and sales
(income statement). Example 9-2 illustrates the application of MT.
In practice, MT is quantified by considering the following
three factors:
(1) Relativity.
MT is considered in relative term. For example, $50,000 is a suitable
MT for a small company but is not a suitable MT for a very large
company.
(2) Appropriate base for quantification.
The most common bases for quantifying MT are:
(a) Income before taxes,
(b) Total revenues,
(c) Total assets, or
(d) Total stockholders' equity.
The auditor should select a stable and predictable base for
quantifying MT. For example, if income before tax fluctuates greatly
from year to year, total revenues, or total assets is a more stable base
to use. Example 9-3 illustrates the selection of an appropriate base.
(3) Guideline for judging material effect on financial statements.
There is no official percentage guideline for judging material effect
on financial statements. Practicing auditors have developed a variety
of guidelines. For example, a rule of thumb is:
(a) No material effect if MT is between 0% to 5% of a base,
(b) A matter of judgment, if MT is between 5% to 10% of a base, and
Although an auditor's judgment about materiality level

relates to the entire set of financial statements taken as a whole, audit
evidence is accumulated from individual account-balance or class of
transactions. Accordingly, after an auditor's PJAM is quantified by
determining MT, the auditor allocates this overall financial statements
materiality to individual account-balance in the balance sheet or class of
transactions in the income statement.
Although allocation may be made to both the balance sheet
and income statement accounts, most practicing auditors allocate
materiality to balance sheet rather than income statement accounts.
This is because there are usually fewer balance sheet accounts than
income statement accounts, and most income statement misstatements
also affect the balance sheet.
When an auditor allocates the PJAM to individual accountbalance, the materiality allocated to any given account-balance is
referred to as tolerable misstatement (TM). It is also referred to as
tolerable error in AU 530 Audit Sampling. For example, when an
auditor decides to allocate $50,000 from a PJAM of $100,000 to
accounts receivable, the TM for accounts receivable is $50,000. This
means that the auditor is willing to consider accounts receivable fairly
stated if it is misstated by $50,000 or less.
In making the allocation from PJAM to TM for an accountbalance, the auditor should ordinarily consider:
(1) Both overstatement and understatement in the account.
(2) The likelihood of misstatement in the account relative to other
accounts, and
(3) The cost of collecting audit evidence for the account relative to other
accounts.
Although the above considerations implies a certain degree of precision
in allocating the overall PJAM to individual TMs, in the final analysis,
the allocation process is heavily dependent on the auditors subjective
judgment. Example 9-5 illustrates the setting of PJAM (by MT) and the
allocation of PJAM (to TM).
Setting Preliminary Judgment About Materiality (PJAM) at Audit Plan

Overall Financial Statements Level Individual Account-Balance or Class of Transactions
Materiality Threshold (MT)
Level - Tolerable Misstatement (TM)
(c) Material effect if MT is above 10% of a base.
The auditor also considers qualitative factors affecting
MT, such as:
(1) Misstatement attributable to illegal act.
For example, a quantitatively immaterial illegal payment that violates
the Foreign Corrupt Practice Act 1976 may be qualitatively material
because users of financial statements may be significantly influenced
by the management's involvement in the illegal act.
(2) Misstatement attributable to fraud.
For example, a quantitatively immaterial adjustment to working
capital (current ratio) that would result in the violation of a debt
covenant. Assuming a client held a long-term bank loan that carried a
debt covenant requiring the client to maintain a current ratio of 2 to 1.
A quantitatively immaterial adjustment to its working capital may be
qualitatively material because it violates the covenant.
(3) Atypical trend.
For example, a small 2% decline in a growing sales trend may not be
material quantitatively but such atypical interruption of 2% may be
qualitatively material. Example 9-4 illustrates this qualitative factor
consideration.
(4) Ethical implication of a management policy.
For example, a client sells assets to a member of its top management
and then buys the assets back at a higher price; this related party
transaction warrants disclosure even though the dollar amounts are
not large in relation to the financial statements taken as a whole.
Example 9-2 Application of MT at the Audit Plan

_____________________________________________________________________________________________________________________
At the audit plan, auditor A considers the following for XYZ Company:
a. Income statement - misstatements totaling $500,000 would have a material effect on XYZ Company's income.
b. Balance sheet - misstatements totaling $1,000,000 would have a material effect on XYZ Company's financial position.
c. Statement of retained earnings - misstatements totaling $800,000 would have a material effect on XYZ Company's retained earnings.
b. Statement of cash flows - misstatements totaling $1,200,000 would have a material effect on XYZ Company's cash flows.
What should auditor As materiality threshold (MT) be at the overall financial statements level for planning purpose?
The auditor should use the smallest aggregate amount of misstatements considered to be material to any one of the financial statements. In this
case, auditor As materiality threshold for planning purpose would be $500,000. In other words, the auditor should plan and design audit
procedures that would be expected to detect misstatements to a total of $500,000 at the overall financial statements level.
_____________________________________________________________________________________________________________________
Example 9-3 Selection of an Appropriate Base for Quantifying MT

_____________________________________________________________________________________________________________________
At the audit plan of XYZ Company, auditor A expects a significant number of audit adjustments based on past audit experience with this client.
A fact supported by auditor As inspection of prior years' audit working papers.
What would be the most appropriate base for quantifying MT?
Since past experience indicates a reasonable expectation of significant adjustments, a preliminary amount that is based on net income before taxes
would not be stable. A more stable base such as total revenues or total assets is preferred. Note, however, if significant misclassifications are
expected instead of significant adjustments, then net income before taxes is a more stable base than total revenues or total assets.
_____________________________________________________________________________________________________________________
233
234
Example 9-4 Qualitative Factor Consideration in MT

_____________________________________________________________________________________________________________________
In quantifying MT, auditor A noticed that XYZ Company's earnings per share had been $10.00, $11.00, $12.1, and $13.31 for the past four
consecutive years. The client's earning per share for the current financial year is $14.37.
What qualitative factor relating to XYZ Company's earnings trend should the auditor consider?
In the prior four years, XYZ Company's earnings per share had been increasing at a pace of about 10% per year. However, for the current
financial year, this consistent growing trend has been interrupted in that the earning per share figure of $14.37 represents an increase of 8%. In
this case, a quantitative immaterial decrease in earnings trend of 2% from previous year may be considered material qualitatively because of its
potential effect on financial statement users' investment decision. For example, a bank loan officer may consider this reversal marks the beginning
of a long-term downward trend and may request XYZ Company for a higher interest rate to compensate the bank for increased risk.
______________________________________________________________________________________________ _______________________
Example 9-5 Setting of PJAM (by MT) and Allocation of PJAM (to TM)
_____________________________________________________________________________________________________________________
Mr. A, the auditor of XYZ Company, documented in his working papers the setting of PJAM (by MT) and allocation of PJAM (to TM) for the
account-balances of cash, accounts receivable, and inventory as follows:
Reference _________
Date _____________
Prepared by _______
Approved by ______
Setting of PJAM (by MT) and allocation of PJAM (to TM) for XYZ Company
1. The PJAM is set by quantifying MT at the overall financial statements level as follows:
a. Use net income before taxes of $200,000 as the base.
b. Use the rule of thumb that MT of 10% or more of the base would have a material effect.
c. (i) The aggregate level of misstatements for the income statement is expected to be $100,000, therefore, its MT is 50% which would have a
material effect on XYZs income ($100,000/200,000 = 50% > 10% ).
(ii) The aggregate level of misstatements for the balance sheet is expected to be $200,000, therefore, its MT is 100% which would have a
material effect on XYZs financial position ($200,000/200,000 = 100% > 10%).
(iii) The aggregate level of misstatements for the statement of retained earnings is expected to be $10,000, therefore, its MT is 5% which would
have no material effect on XYZs retained earnings ($10,000/200,000 = 5% < 10%).
(iv) The aggregate level of misstatements for the statement of cash flows is expected to be $1,000, therefore, its MT is 0.5% which would have
no material effect on XYZs cash flows ($1,000/200,000 =0.5% < 10%).
d. Consider only the MT that would have material effect, which are the income statement and balance sheet. Applying AU 320, the smallest MT
is selected to set the PJAM. In this case, the income statements MT of 50% is the smallest. Therefore, PJAM is set at the aggregate level of
misstatement expected for the income statement of $100,000.
2. The PJAM of $100,000, of which $50,000 is allocated to TM for cash, accounts receivable, and inventory as follows:
Account-Balance
Cash
Accounts Receivable
Notes Receivable
Inventory
Total current assets
$100,000
200,000
8,000
200,000
$508,000
From the $100,000 PJAM allocate $50,000 to TM

Overstatement
(5%) $5,000
(7.5%) 15,000
(0%) --(15%) 30,000
$50,000
Understatement
(0%) --(0%) --(0%) --(0%) -----
Mr. A's allocation of the PJAM to the account-balances can be explained as follows:
1. Mr. A decided to allocate $50,000 from the PJAM of $100,000 to MT for cash, accounts receivable, and inventory. This means that he was
willing to consider these three account-balances fairly stated if their aggregated level of misstatements were $50,000 or less. Also, he decided
that it was unnecessary to assign any TM to notes receivable.
2. Mr. A decided that the accounts in the current assets were more likely to be overstated than understated. As a result, he concluded that it was
unnecessary to assign tolerable misstatement to understatement.
3. Based on prior experience with the client, Mr. A predicted that the likelihood of misstating cash (5%) was less than accounts receivable (7.5%),
also, both the cash and accounts receivable were less likely to be misstated than inventory (15%).
4. Mr. A also considered the relative cost of gathering evidence for the three accounts. As a rule of thumb, the cost of auditing an account is
directly related to the amount of evidence needed for that account. The amount of evidence needed for the account, on the other hand, is
inversely related to its TM. In this case, since Mr. A anticipated more misstatements in inventory account (15%) than in cash (5%) and accounts
receivable (7.5%), it would be more costly (more evidence is needed) to audit the inventory account than the cash and accounts receivable. But
the amount evidence is inversely related to TM, consequently, the inventory account which has the largest TM ($30,000) would require relatively
less amount of evidence, or relatively lower cost to audit than the cash and accounts receivable.
5. Note that the likelihood of misstatement rather than the size of a recorded account-balance (i.e., cash $100,000, accounts receivable $200,000,
and inventory $200,000) was considered in the allocation of MT.
____________________________________________________________________________________________________________________
Materiality Concept in Testing and Completing the Audit

The next stage of applying the materiality concept is in the testing and completing the audit, which is discussed in
later chapters. Only a brief discussion of its application in those areas is given here. The auditor documents all the
misstatements found in the tests of controls and tests of balances. If audit-sampling techniques are used in the tests,
then the total misstatements for an account-balance is estimated from the sample results. All misstatements found in
an account-balance is combined and compared to the allocated TM. For example, assuming the total misstatements
for accounts receivable in example 9-5 is estimated to be $30,000 of overstatement from testing a sample of sales
invoices. Since the estimated total misstatements $30,000 > the TM $15,000, the auditor would either revise the
PJAM (the RJAM) in light of the evidence found; make new allocation to TM, perform additional audit work to
confirm/reject the estimated total misstatements, or request the management to make accounting adjustment for the
estimated total misstatements. At the completing the audit, the auditor compares the total misstatements of all
account-balances to the PJAM to determine when the financial statements taken as a whole is materially misstated.
If the total misstatements exceed the PJAM, the auditor would consider whether to perform additional audit work,
request the management to adjust the misstated accounts, or to issue a qualified or adverse opinion. See Figure 20-7
in Chapter 20 for an example of the total misstatements documented in a working paper.
PCAOB Guidance on Immaterial Misstatements
Recently, PCAOB has drawn attention to immaterial misstatements. In particular, auditors are to pay attention to the
following three situations:
1. Netting (offsetting) material misstatements. For example, a material overstatement in one account is offset with
a material understatement in another account, thereby making the net misstatement immaterial. The auditor should
consider whether each individual account has been affected by a material amount.
2. Material swings in accounting estimates. For example, an accounting estimate could be misstated by just under
a material amount in one direction one year and just under a material amount in the opposite direction the next year,
thereby making the total swing in accounting estimates immaterial over a two year period. The auditor should
consider the total swing in estimates over the two-year period rather than by using the best estimate each year.
3. Passing on immaterial misstatement. For example, management consistently objects to making adjustment for
misstatements that are not material individually, but are material in aggregate. The auditor should consider the
aggregate effect of the individually immaterial misstatements.
235
236
Figure 9-2 provides an overview of the audit risk concept as it applies to the audit plan.
Figure 9-2 Audit Risk Concept in the Audit Plan
The Audit Process
Audit Plan
Preplan and
Documentation CH 5
Tests of Controls
Tests of Balances
Financial Audit
Integrated Audit
Objectives CH 6
1. Pre-specify Audit Risk (AR) at
overall financial statements level
Evidence CH 7
Audit Report
2. Assume the same AR at

individual account-balance and
class of transactions level

3. Assess Inherent Risk (IR)
Program and
Technology CH 10
4. Assess Control Risk (CR)
5. Derive Detection Risk (DR)

using an audit risk model:
AR = IR X CR X DR
6. Consider the nature, extent,

and timing of Tests of Balances
(TOB) procedures for achieving
the derived DR.
Audit Risk Concept

AU 320 Materiality in Planning and Performing the Audit defines audit risk as "the risk that the auditor may
unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated". This
definition suggests that audit risk is for the entire set of financial statements taken as a whole, and is the risk
associated with issuing an audit opinion at the completion of an audit.
Like the concept of materiality, AU 320 states that an auditor should consider audit risk both in:
Planning the audit and designing the audit procedures.
Evaluating whether the financial statements taken as a whole is presented fairly in conformity with generally
accepted accounting principles.
According to this requirement, an auditor considers audit risk at the planning and designing of an audit to obtain
sufficient appropriate evidence on which to properly evaluate the financial statements taken as a whole at the
completion of the audit. In addition, like the materiality concept, AU 320 states that an auditor should consider audit
risk at two levels:
1. The overall financial statements level.
2. The individual account-balance or class of transactions level.
Assessing Audit Risk (AR) at the Overall Financial Statements Level
Table 9-2 provides comments on assessing audit risk (AR) at the overall financial statements level.
Table 9-2 Assessing Audit Risk (AR) at the Overall Financial Statements Level
AU 320 defines audit risk (AR) at the overall financial statements level as "the risk that the auditor may unknowingly fail to appropriately
modify his opinion on financial statements that are materially misstated." In practice, this is the risk acceptable to the auditor that the client's
financial statements may still contain undetected material misstatements after the audit is completed and an unqualified opinion has been issued.
Also, in practice, this audit risk is pre-specified by the auditor (typically the auditor-in-charge of the audit) at the planning phase of the audit.
Therefore, AR is also referred to as the pre-specified (or acceptable) audit risk (PAR or AAR). The auditor may pre-specify the AR in
quantitative (e.g., 1% or 0.5%) or qualitative term (e.g., low or high). For example, if the auditor's pre-specified AR is 1%, this means that the
auditor is willing to accept a 1% risk that s/he will incorrectly give an unqualified opinion on financial statements that may still contain
undetected material misstatements. Some auditor expresses the pre-specified AR in terms of its complement - audit assurance. For example, if
the pre-specified AR of 1% is expressed in terms of audit assurance, the auditor is 99% confident that s/he will correctly give an unqualified
opinion on financial statements that may still contain undetected material misstatements.
There is no authoritative guideline on percentages for pre-specified AR, except that it should be "acceptably low." One commonly used
percentage is 1% or less. Zero percent for pre-specified AR means complete assurance, which is not possible in practice. Also, 100% for prespecified AR means complete uncertainty, which in effect amounts to issuing an audit opinion without conducting an audit. Such a practice is
prohibited under the generally accepted auditing standards.
According to AU 320, it should be noted that the definition of pre-specified AR excludes the following types of risk:
(1) The risk that the auditor incorrectly concluded that the client's financial statements are materially misstated and incorrectly issued a qualified
opinion (the definition of AR refers to the risk of incorrectly issuing an unqualified opinion).
(2) The risk of issuing an inappropriate form of audit report. For example, a 'disclaimer' form of audit report versus an 'except for' form of audit
report.
(3) The risk of loss or injury to the auditor's professional practice from litigation, adverse publicity, or other events arising in connection with
financial statements that the auditor has audited, even though the audit report issued for the client was correct. This type of risk is often referred
to as business risk (BR). For example, if a client declares bankruptcy after an audit is completed, the business risk of a lawsuit against the CPA
firm is high even if the audit report is a correct one.
In general, an auditor should consider the following factors in pre-specifying the AR:
(1) The degree to which a client's financial statements are relied upon by external users. Indicators of the degree of such reliance include the size
of the client, SEC versus non-SEC clients, and clients with a large number of creditors.
(2) The characteristics of the client's management. These characteristics include: (a) Whether the client's management decisions are dominated by
one individual. (b) Whether the management's attitude toward financial reporting is unduly aggressive. (c) Whether the management turnover is
unusually high. (d) Whether the management overemphasizes meeting earning projections. (e) Whether management's reputation in the business
community is poor.
(3) The characteristics of a client's operation. These characteristics include: (a) Whether the client's profitability relative to the industry is
adequate. (b) Whether the client's operation is sensitivity to economic factors. (c) Whether the rate of change of the client's industry is rapid. (d)
Whether the client is in an industry that is dominated by many business failures.
(4) The characteristics of the audit engagement. Such characteristics include: (a) Whether there will be many contentious or difficult accounting
issues. (b) Whether there will be significant number of difficult to audit transactions or balances. (c) Whether there will be many unusual related
party transactions. (d) Whether there is a significant number of misstatements detected in the prior period audit.
(5) The likelihood of the client having financial difficulties. Indicators of the client's financial position include: (a) Whether the client is in a
237
238

strong or weak liquidity position. (b) Whether the client engages in high versus low financial gearing strategies. (c) Whether the client operates in
a high or low risk industry. (d) Whether the client is managed by a competence or incompetence team of management. (e) Whether the client
suffers from a succession of losses in previous years.
Assessing Audit Risk (AR) at the Individual Account-Balance or Class of Transactions Level
The auditor assesses AR at the individual account-balance or class of transactions level in order to determine the
timing, nature and extent of audit procedures that are used to verify the management's assertions relating to the
account-balance or class of transaction. In addition to the factors considered for pre-specifying the audit risk, AR, at
the overall financial statements level, the auditor also considers the following factors for the AR at the individual
account-balance or class of transactions level:
1. The effect of the risk factors identified at the overall financial statements level on a particular account-balance or
class of transactions.
2. The complexity of accounting issues affecting a particular account-balance or class of transactions.
3. The frequency of difficulty-to-audit transactions affecting a particular account-balance or class of transactions.
4. The significance of misstatements of a particular account-balance or class of transactions detected in the prior
audit.
5. The quality of a client's personnel assigned to processing accounting data affecting a particular account-balance or
class of transactions.
6 The extent of judgment involved in processing accounting data affecting a particular account-balance or class of
transactions.
7. The size and volume of items in a particular account-balance or class of transactions.
8. The complexity of calculation affecting a particular account-balance or class of transactions.
In theory, the auditor seeks to restrict AR at the individual-balance or class of transactions level in such a
way that will enable him/her, at the completion of the audit, to express an opinion at an "acceptable low" level of
AR for the financial statements taken as a whole. In practice, the auditor uses various approaches to accomplish this
objective. The AICPA recommends the application of an audit risk model at the individual account-balance and
class of transactions level. This audit risk model is expressed as:
AR = IR X CR X DR
AR = audit risk for an account-balance or class of transactions.
IR = inherent risk.
CR = control risk that the account-balance or class of transactions contain misstatements.
DR= detection risk that the auditor will not detect such misstatements.
In using this model, the auditor sets the AR (e.g. 1%) for an individual account-balance or class of transactions the
same level as the pre-specified AR (i.e., 1%) for the financial statements taken as a whole. The auditor assumes that
the aggregated audit risks (i.e., the ARs of 1% + 1% + 1% and so on) for all the account-balances or classes of
transactions will accomplish the pre-specified AR (i.e., AR of 1%) at the completion of the audit.
Each components of the audit risk model are commented below. Table 9-3 provides comments on inherent
risk (IR) of the audit risk model. Table 9-4 provides comments on control risk (CR) of the audit risk model. Table 95 provides comments on detection risk (DR) of the audit risk model.
Table 9-3 Inherent Risk (IR) of the Audit Risk Model
Inherent Risk (IR) of the Audit Risk Model
AU 320 defines inherent risk (IR) as "the susceptibility of an assertion to a material misstatement, assuming that there are no related internal
controls." In practice, an auditor would regard a client's IR as the risk of material misstatements of individual account-balance or class of
transactions before considering the client's internal controls.
There is no authoritative guideline on percentages for IR. One commonly used percentage is between 50% and 100%, with 50% as the
minimum and 100% as the maximum IR. Accordingly, a high (for example, 80%) inherent risk implies a high risk of misstatements.
A client's IR at an account-balance or classes of transactions level exists independently of the audit of a client's financial statements. This is
referred to as the client's actual level of IR. The auditor cannot change this actual level of IR. However, the auditor can assess the client's actual
level of IR by carefully evaluating and considering the relevant inherent risk factors. The auditor's assessment of a client's actual IR is referred to
as the assessed level of inherent risk. Ordinarily, the auditors assessed level of IR should closely reflect the client's actual level of IR. In other
words, the actual and assessed levels of IR should be the same.
Inherent Risk (IR) of the Audit Risk Model
On occasion, the auditor may modify the assessed level of IR if it is necessary to do so in the audit plan phase. In doing so, the auditor is said
to have changed the assessed level of IR so that it differs from the client's actual level of IR. For example, if the auditor concludes that the effort
required to evaluate and consider the actual level of IR for an account-balance or class of transactions would exceed the benefit of a reduction in
the extent of tests of balances (TOB) procedures, he/she might simply set the assessed level of IR as being at the maximum when designing TOB
procedures at the audit plan phase of the audit process. Example 9-6 illustrates the trade-off between cost and benefit in assessing IR.
Since some account-balances or classes of transactions are inherently more risky than others, an auditor should consider the following factors
in assessing IR:
(1) Sensitivity of a client's business to technology or economic factors. For example, the impact of technology developments on a client in the
electronic industry might render some inventory obsolete; thereby increasing the inherent risk that inventory might be overstated.
(2) Susceptibility of a client's business to fraud. For example, liquid assets such as cash or marketable securities of a client in the banking
industry are more susceptible to theft, and therefore inherently more risky than non-liquid assets such as coal in the oil and gas industry.
(3) Integrity of a client's management. For example, managerial decision is dominated by one individual; high management turnover, or
management lacks leadership quality. All these might increase a client's inherent risk of intentional misstatements by the management.
(4) Motivation of a going concern problem client to misstate. For example, a client lacks sufficient working capital to continue operations or in a
declining industry characterized by a large number of business failure is prone to window-dressing its current ratio, thereby is inherently more
risky than a non-going concern client.
(5) Results from previous audits. For example, previous audits that have consistently documented a high error rates in recording of accountbalances or classes of transactions would indicate a high inherent risk of misstatements for the subsequent audits.
(6) Initial versus repeat audits. For example, an auditor's increased efficiency and familiarity with a client's operation in a repeat engagement may
deter the client from misstatements, thereby decreasing the inherent risk of misstatements.
(7) Specific nature of the client's accounts. This include:
(a) Contentious accounting transactions. For example, a large number of intra-companies loans increase the inherent risk due to deliberate design
to obscure such related-parties transactions or to inadequately disclose them in conformity with AU 550 Related Parties.
(b) Non-routine versus routine transactions. For example, in classifying a non-routine transaction such as a fire loss, a client may erroneously
determine that the loss is extraordinary when the loss does not meet the two criteria of being both unusual and infrequent in APB Opinion No.30
Reporting the Results of Operations.
(c) Extent of judgment involved in recording transactions. For example, a client may incorrectly estimate the amount of allowance for
uncollectible accounts. Such judgmental error increases the inherent risk of material misstatements.
(d) Complexity of accounting transactions. For example, lease assets, franchising, and oil and gas transactions are more susceptible to
misstatement due to the complex nature of accounting calculations.
(e) Susceptibility of accounts to defalcation. For example, cash and inventory are more susceptible to embezzlement, theft, or other loss than land
or prepaid expenses.
Example 9-6 Trade-off between Cost and Benefit in Assessing IR

_____________________________________________________________________________________________________________________
In planning her audit of XYZ Company's inventory account, Mrs. A judges that the actual level of IR for the inventory account is about 90%.
She decides to carefully evaluate and consider all IR factors relevant to her client's inventory account so that her assessed level of IR for the
inventory account closely reflects her initial judgment about its actual level of IR. Two of these factors are particularly important. First, XYZ
Company lacks sufficient working capital to continue operations, and second, XYZ Company is in a declining industry characterized by a large
number of business failure. Mrs. A knows that clients in this situation are prone to window-dressing their current ratio, therefore they are
inherently more risky. She also knows that it will take considerable amount of audit effort and resources to evaluate the above IR factors in order
to closely match her assessed level of IR with the actual level of IR for the inventory account.
Do you think Mrs. A should try to match the actual and assessed level of IR in planning her audit?
It depends. In the audit plan phase, Mrs. A should balance the higher effort (cost) required to precisely match her assessed and actual levels of IR
with the benefit of lowering the extent and nature of the ensuing TOB. If the effort requires to evaluate and consider the IR factors exceeds the
benefit of lowering the extent and nature of TOB, she should simply set her assessed level of IR at the maximum of 100%.
_____________________________________________________________________________________________________________________
Table 9-4 Control Risk (CR) of the Audit Risk Model
Control Risk (CR) of the Audit Risk Model
AU 320 defines control risk (CR) as "the risk that a material misstatement that could occur in an assertion will not be prevented or detected
on a timely basis by the entity's internal controls." In practice, an auditor regards a client's CR as the risk of material misstatements to an
individual account-balance or class of transactions that is not prevented or detected by a client's internal controls. In general, an auditor considers
the effectiveness of the design and operation of a client's internal controls in assessing its CR.
Like IR, there is no authoritative guideline on percentages for CR. One commonly used percentage is between 0% and 100%, with 0% as the
minimum and 100% as the maximum CR. Accordingly, a high (for example, 80%) CR implies a high risk of misstatements. Furthermore, some
CR will always exist, that is, CR can never be zero (0%) because of the inherent limitations of any internal control. For example, a control may
be ineffective because of human failures due to carelessness or fatigue.
Like IR, CR exists independently of a client's financial statements. Thus, the auditor cannot change the actual level of CR. However, the
auditor can change the assessed level of control risk if it is necessary to do so. For example, for assertions relating to some account-balances or
239
240
Control Risk (CR) of the Audit Risk Model

classes of transactions, the auditor's initial understanding and documentation of the internal controls may cause him/her to conclude that the
internal controls are unlikely to be effective, or effort required to evaluate their effectiveness would be inefficient. For these assertions, the
auditor typically assesses CR at the maximum of 100% at the audit plan in the past. However, note that under AU 320, it is no longer acceptable
to assess CR at the maximum of 100% based on the auditors initial understanding and documentation of the internal controls. The auditor must
develop a greater understanding of the internal controls, which includes testing and evaluating the design and operation of the internal controls, in
order to assess CR at the maximum of 100%. When assessed CR is at the maximum (1) the auditor needs only to document the assessment but
not the basis for the assessment, (2) the auditor would not plan to rely on the internal controls, and (3) the auditor would not plan to perform TOC
but to only perform TOB.
Although the auditor cannot change the actual level of CR, he/she is capable of indirectly changing it. For example, after testing a client's
internal controls, the auditor makes a recommendation to the client's management on how to improve certain internal control weaknesses. If the
client takes up the auditor's recommendation and acts on it, then the original actual level of CR will be changed to a lower level. Of course, if the
client's management does not accept the auditor's recommendation, or accepts the recommendation but does not act on it, then the original actual
level of CR will not change.
If the auditor indirectly changes the actual level of CR, the auditor may or may not need to modify his/her original assessed level of CR
depending on whether the management's action based on the auditor's recommendation is completed before or after the current audit engagement.
If the management's action results in lowering the actual level of CR before the completion of the audit, the auditor may need to modify his/her
original assessed level of control risk in performing the tests of controls (TOC). If the action takes place after the completion of the audit, the
auditor may take this into consideration in assessing the CR for the following year's audit.
An auditor should consider the following two factors in assessing CR:

(1) The auditors understanding of a clients internal controls.
The auditor's understanding of a client's internal controls (discussed in Chapter 8) provides information the auditor can use to assess the level of
CR in two ways: (a) For some account-balances or classes of transactions, the auditor's understanding of the internal controls may cause him/her
to conclude that these internal controls are unlikely to be effective, or effort required to evaluate their effectiveness would be inefficient. For
these account-balances or classes of transactions, the auditor would assess CR at the maximum (100%). When CR is assessed at the maximum,
the auditor needs only to document the assessment (for example, "CR relating to the rights and obligations assertion for accounts receivable is
assessed at the maximum.") but not the basis for the assessment. (b) For other account-balances or class of transactions, the auditor's
understanding of the internal controls may cause the auditor to assess CR at below the maximum. When CR is assessed at below the maximum
level, the auditor should document the assessment (for example, "CR relating to the rights and obligations assertion for accounts receivable is
60% and the basis for this assessment is ).
(2) The auditors testing of internal controls (TOC).
On occasion, an auditor may desire to fine-tune the assessed level of CR by conducting some TOC at the audit plan. In such a case, the auditor
should consider: (a) whether evidential matter is available to support the fine-tuning, and (b) whether the expected effort to perform some TOC
for the purpose of the fine-tuning is likely to result in less audit effort in the tests of balances (TOB). Example 9-7 illustrates the assessment and
fine-tuning of CR.
Example 9-7 Auditors Assessment and Fine-Tuning of CR

_____________________________________________________________________________________________________________________
Under audit-budget time pressure, auditor A sets his assessed level of CR for accounts receivable of XYZ Company to be 100% although he
knows that the actual level of CR is about 40%, based on his understanding of the internal controls. The auditor reasons that, under time pressure,
he will be able to bypass the need to perform TOC for the accounts receivable by setting the control at the maximum.
How should auditor A assess the CR for XYZ Company's accounts receivable?
First, auditor A should assess level of CR to be 100% only if XYZ Company's internal controls for account receivable are unlikely to be effective,
or effort required to evaluate their effectiveness would be inefficient. This is not the case here based on auditor As understanding of XYZ
companys internal controls. Second, auditor A should assess level of CR to closely reflect the actual level of control risk of about 40%. Here, he
should document the assessment as well as the basis for the assessment. Finally, auditor A may consider fine-tuning the assessed level of control
risk of 40% for the accounts receivable. For example, a fine-tuning of the control risk to 35% may be necessary if evidential matter is available
to support the fine-tuning and the expected effort to perform some TOC for the purpose of the fine-tuning is likely to result in less audit effort for
the ensuing TOB on the accounts receivable.
_____________________________________________________________________________________________________________________
Table 9-5 Detection Risk (DR) of the Audit Risk Model
Detection Risk (DR) of the Audit Risk Model
AU 320 defines detection risk (DR) as "the risk that the auditor will not detect a material misstatement that exists in an assertion." In
practice, an auditor considers DR as the risk of material misstatements of an account balance or class of transactions not detected by the auditor
as a result of using ineffective, inappropriate, or misapplying auditing procedures. Accordingly, the auditor considers the effectiveness of an
auditing procedure and its application in assessing DR.
Like IR and CR, there is no authoritative standard for percentage guidelines on detection risk. One common guideline is to use the audit risk
model to derive the detection risk, known as derived level of detection risk, for a given level of AR, IR, and CR.
Since by definition, DR is a function of the effectiveness of audit procedures and their application by the auditor, the auditor can change the
DR by varying the nature, timing, and extent of TOB procedures. For example, the use of a large sample in a TOB will result in a lower DR than
the use of a small sample.

An auditor should consider the following two factors in deriving DR:
(1) The auditors assessment of IR and CR.
(2) The amount audit evidence gathered from TOB that will meet the derived level of DR, or, in terms of the audit risk model, it is the same as
saying the amount of audit evidence that will meet the pre-specified level of AR.
In practice, the amount of audit evidence is typically associated with the extent (or the sample size) of the TOB procedures (discuss in
Chapter 10). It is important to note that although by definition, the auditor can change (i.e., either increase or decrease) the derived level of DR
by varying the extent of the TOB procedures; in practice, the auditor does not change the derived level of DR. Rather, the auditor varies the
extent of the TOB procedure to achieve (i.e., neither increase nor decrease) the derived level of DR. Example 9-8 illustrates how the DR is
derived and its relationship to the amount of evidence. Table 9-6 summarizes the relationships among the components of the audit risk model.
Example 9-8 Derive DR from the Audit Risk Model

_____________________________________________________________________________________________________________________
Mrs. A, the auditor of XYZ Company, pre-specified AR to be 1% at the overall financial statements level. Also, Mrs. A assessed IR and CR to
be 75% and 30%, respectively for the company's accounts payable.
What should Mrs. As DR be for accounts payable?
Assuming Mrs. A sets AR for the accounts payable at the same level as the pre-specified AR for XYZ company's financial statements taken as a
whole. Solving the audit risk model as follows can derive DR for the accounts payable:
Assume AR at overall financial statements level = AR at account balance level = 1%.
Using the audit risk model, AR = IR X CR X DR
and given AR = 1%, IR = 75%, and CR = 30%,
AR
0.01
DR = __________ = _____________ = 0.04 or 4%
IR X CR
0.75 X 0.30
The derived level of DR may be any percentage between a minimum of 0% and a maximum of 100%. In this case, 4% may be regarded as a low
detection risk, that is, low risk of the auditors procedures not detecting material misstatements. In general, a lower detect risk means a lower risk
of not detecting material misstatements, which implies gathering a larger amount of audit evidence in order to achieve the lower detection risk.
On the other hand, a higher detection risk means a higher risk of not detecting material misstatements, which implies gathering a smaller amount
of audit evidence in order to achieve the higher detection risk.
_____________________________________________________________________________________________________________________
Table 9-6 Relationships among the Components of the Audit Risk Model
Components of the Audit Risk Model
1. Between AR and DR
2. Between DR and IR
3. Between DR and CR
4. Between AR and Amount of Evidence
5. Between DR and Amount of Evidence
Relationship
Direct
Inverse
Inverse
Inverse
Inverse
Relationship among Audit Risk, Materiality, and Audit Evidence

Conceptually, AU 320 states there is an inverse relationship between audit risk and materiality. For example, the
risk that a financial statement account (e.g., accounts receivable) could be misstated by a very large amount (e.g., $1
million), might be quite low, but the risk that the account could be misstated by a very small amount (e.g., $100)
might be quite high. In addition, there is an inverse relationship between audit risk or materiality and amount of
evidence. For example, everything else stays constant, either a decrease in the level audit risk or a decrease in the
level of materiality would cause the auditor to vary one or more of the following: select more effective audit
procedures (i.e., vary nature), perform audit procedures closer to the balance sheet date (i.e., vary timing), or
increase the amount of evidence to be gathered (i.e., vary extent). As pointed out earlier (recall Example 9-5 and
Example 9-8), the auditor typically varies the amount of evidence to achieve the decreased level of audit risk or
materiality.
In practice, the auditor first uses a decision aid published by the AICPA to estimate the materiality
threshold (MT) based on the greater of total revenues or total assets as the appropriate base (recall Example 9-3).
Table 9-7 describes the AICPAs decision aid for determining MT. The auditor then revises this estimated MT
according to the derived detection risk (DR) using the audit risk model. Finally, the auditor determines the amount
of evidence according to the derived DR and the revised MT. In going through these steps, the auditor closely
follows the conceptual relationship among audit risk, materiality, and amount of evidence stated in AU 320 above.
241
242
Specifically, there is an inverse relationship between DR and MT, and an inverse relationship between DR or MT
and the amount of evidence, which is typically measured in terms of either the budgeted audit hours or sample size.
For example, if the derived level of DR using the audit risk model were relatively high, then the estimated MT using
the decision aid would be lower, and the sample size would be larger. Example 9-9 illustrates how the relationship
among DR, MT, and budgeted audit hours are determined in practice. Figure 9-3 summarizes the relationships in a
diagram.
Table 9-7 AICPAs Decision Aid for Materiality
If the Greater of Total Revenues or Total Assets Is:
Over $
But Not Over $
0
30,000
100,000
300,000
1,000,000
3,000,000
10,000,000
30,000,000
100,000,000
300,000,000
1,000,000,000
3,000,000,000
10,000,000,000
30,000,000,000
100,000,000,000
300,000,000,000
30,000
100,000
300,000
1,000,000
3,000,000
10,000,000
30,000,000
100,000,000
300,000,000
1,000,000,000
3,000,000,000
10,000,000,000
30,000,000,000
100,000,000,000
300,000,000,000
-
Materiality (MT) Is:

$ + Factor
X the Excess Over $
0 + .059300
1,780 + .031200
3,960 + .021500
8,260 +.014500
18,400 + .009950
38,300 + .006740
85,500 + .004610
178,000 + .003120
396,000 + .002150
826,000 + .001450
1,840,000 +.000995
3,830,000 + .000674
8,550,000 + .000461
17,800,000 + .000312
39,600,000 + .000215
82,600,000 + .000148
0
30,000
100,000
300,000
1,000,000
3,000,000
10,000,000
30,000,000
100,000,000
300,000,000
1,000,000,000
3,000,000,000
10,000,000,000
30,000,000,000
100,000,000,000
300,000,000,000
To illustrate application of the decision aid, assume a client has $12,000,000 of total assets and $20,000,000 of total revenue. MT would be
calculated as follows:
$85,500 + .004610 ($20,000,000 10,000,000) = 131,600
Note: This decision aid applies to audits of public companies but may need to be adjusted for audits of government agencies or of companies in
specialized industries.
Source: AICPA, Audit Sampling, New York: AICPA, 1999, Table C.1.
Example 9-9 Relationship among DR, MT, and Budgeted Audit Hours
_____________________________________________________________________________________________
Auditor A uses the AICPAs decision aid in Table 9-7 to estimate MT which is $131,600. Auditor A then uses the audit risk model to derive DR
which is 1%, and he judged that the derived DR for this particular audit is relatively low. Consequently, the auditor revised the estimated MT to a
higher level of, say, $190,000.
Assume the auditor has budgeted to perform the audit for 20,000 audit hours. What is the impact of the revised MT on the auditors amount of
evidence to be gathered for this audit?
In this case, the amount of evidence is determined by the budgeted audit hours. Since the revised MT is higher, the auditor will need to spend less
audit time in detecting aggregate misstatements equal or below $190,000 in comparison to that of $131,600. Therefore, the auditor can lower the
budgeted audit hours from 20,000 to, say, 10,000 hours. Effectively, this means that the auditor will gather less amount of evidence than that is
originally budgeted for this particular audit.
_____________________________________________________________________________________________
Figure 9-3 Relationship among Audit Risk, Materiality, and Amount of Evidence
Higher
(e.g., 3%)
Audit Risk
DR
(e.g., 2%)
Lower
(e.g., 1%)
Higher
(e.g.,$200,000)
Inverse
Materiality
MT
(e.g., $100,000)
Larger
(e.g., 60,000 hours/400 samples)
Inverse
Lower
(e.g., $50,000)
The relationships:
1. Audit Risk is inversely related to Materiality.
2. Holding Materiality constant, Audit Risk is inversely related to Amount of Evidence.
3. Holding Audit Risk constant, Materiality is inversely related to Amount of Evidence.
Amount of Evidence
Audit Hours/Sample Size
Smaller
243
244
9-1
In the audit process, which of the following objectives is least served by an assessment of the materiality of a client's financial
information?
a. The objective of evaluating whether a client's financial statements taken as a whole are presented fairly.
b. The objective of planning an audit.
c. The objective of designing an audit procedure.
d. The objective of reviewing an audit working paper.
9-2
If an auditor's preliminary judgment about materiality is quantified, which of the following materiality thresholds is most applicable?
a. The aggregate amount of misstatements in the income statement.
b. The aggregate amount of misstatements in the balance sheet.
c. The largest aggregate amount of misstatements in any one of the financial statements.
d. The smallest aggregate amount of misstatements in any one of the financial statements.
9-3
Auditor X sets the preliminary judgment about materiality for ABC Inc. to be 10% of its total assets of $300,000. ABC Inc.'s current
assets consists of cash $5,000, accounts receivables $10,000 and inventory $15,000. Auditor X allocates $500 of the preliminary
judgment about materiality to inventory for overstatement. What is the amount of unallocated preliminary judgment about
materiality?
a. $30,000.
b. $15,000.
c. $10,000.
d. $29,500.
9-4
Auditor B allocates $60,000 of the $100,000 preliminary judgment about materiality to tolerable misstatement for current assets.
$10,000 of the tolerable misstatement is allocated to accounts receivable while $30,000 of the tolerable misstatement is allocated to
inventory. Both the accounts receivable and inventory accounts have the same balance of $700,000. What is the most likely reason for
the auditor's decision to allocate different amount of tolerable misstatements to the two accounts with the same balance of $700,000?
a. The cost of collecting evidence for inventory account is greater than accounts receivable.
b. Inventory account is more likely to be overstated than accounts receivable.
c. The cost of collecting evidence for accounts receivable is greater than inventory.
d. Accounts receivable is more likely to be overstated than inventory.
9-5
Which of the following is not an appropriate definition of audit risk?

a. The risk that the auditor may unknowingly fail to appropriately modify his/her opinion on materially misstated financial
statements.
b. The risk that the auditor is willing to accept when s/he gives an unqualified opinion for materially misstated financial
statements after the completion of the audit.
c. The risk that the auditor derived from an assessment of a client's control risk and inherent risk.
d. The confidence level that the auditor wants to achieve when s/he give an unqualified opinion for fairly stated financial
statements after the completion of the audit.
9-6
Which of the following factors is generally not considered in assessing inherent risk?
a. Integrity of management.
b. The auditor's ability to detect fraud.
c. Related-parties transactions.
d. Nature of inventory.
9-7
Which of the following is not a true statement?

a. Auditor can derive detection risk but cannot directly change it.
b. Auditor can assess inherent risk but cannot change it.
c. Auditor can assess control risk but cannot directly change it.
d. Auditor can derive detection risk and directly change it.
9-8
High detection risk implies

a. a high chance of misstatements that are not detected by the auditor's procedures and a high amount of audit evidence to
be gathered by the auditor.
b. a low chance of misstatements that are not detected by the auditor's procedures and a high amount of audit evidence to
c. a low chance of misstatements that are not detected by the auditor's procedures and a low amount of audit evidence to be
gathered by the auditor.
d. a high chance of misstatements that are not detected by the auditor's procedures and a low amount of audit evidence to
9-9
Which of the following is not a true statement?

a. The auditor cannot change the actual level of control risk.
b. The auditor cannot change the actual level of inherent risk.
c. The auditor can change the assessed level of control risk.
d. The auditor cannot change the level of derived detection risk.
9-10
When the auditor assesses the control risk for an account balance at the maximum of 100%, which of the following is not a true
statement?
a. The auditor has no duty to document the basis for the assessment.
b. The auditor has a duty to document the assessment.
c. The auditor has a duty to document the basis for the assessment.
d. The auditor has a duty to document the assessment but not the basis for the assessment.
9-11
Tolerable misstatement (TM) as set by the auditor

a. decreases acceptable audit risk (AR).
b. increases inherent risk (IR) and control risk (CR).
c. affects planned detection risk (DR).
d. does not affect any of the four risks.
9-12
When allocating materiality (from PJAM to TM), most practitioners choose to allocate to
a. the income statement accounts because they are more important.
b. the balance sheet accounts because they are fewer.
c. both balance sheet and income statement accounts because there could be errors on either one.
d. all of the financial statements because there could be errors on all of them.
9-13
Because control risk and inherent risk vary from cycle to cycle and account to account,
a. detection risk will vary but audit evidence will remain constant.
b. detection risk will remain constant but audit evidence will vary.
c. detection risk and audit evidence will vary.
d. detection risk and audit evidence will remain constant.
9-14
Audit risk (AR) is ordinarily set by the auditor during planning and
a. held constant for each major cycle and account.
b. held constant for each major cycle but varies by account.
c. varies by each major cycle and by each account.
d. varies by each major cycle but is constant by account.
9-15
Regardless of how the allocation of the preliminary judgment about materiality (PJAM) was done, when the audit is complete the
auditor must be confident that the combined errors in all accounts are
a. less than the preliminary judgment.
b. equal to the preliminary judgment.
c. less than or equal to the preliminary judgment.
d. more than the preliminary judgment.
245
246
9-16
Which of the following would an auditor most likely use in determining the auditors preliminary judgment about
materiality (PJAM)?
a. The anticipated sample size of the planned tests of balances.
b. The clients annualized interim financial statements.
c. The results of the internal control questionnaire.
d. The contents of the management representation letter.
9-17
The risk that an auditor will conclude , based on substantive tests of balances, that a material misstatement does not exist in
an account balance when, in fact, such misstatement does exist is referred to as
a. inherent risk.
b. sampling risk.
c. non-sampling risk.
d. detection risk.
9-18
Regardless of the assessed level of control risk, an auditor would perform some
a. analytical procedures to verify the design of internal controls.
b. substantive tests of transactions to restrict detection risk for significant transaction classes.
c. tests of controls to determine the effectiveness of internal controls.
d. dual-purpose tests to evaluate both the risk of monetary misstatement and preliminary control risk.
9-19
Which of the following statements is correct concerning an auditors assessment of control risk?
a. Assessing control risk may be performed concurrently during an audit with obtaining an understanding of the clients
internal control.
b. Evidence about the operation of control procedures in prior audits may not be considered during the current years
assessment of control risk.
c. The basis for an auditors conclusions about the assessed level of control risk need not be documented unless control risk
is assessed at the maximum level.
d. The assessed level of control risk is inversely related to the amount of audit evidence.
9-20
Assessing control risk below the maximum level most likely would involve
a. performing more extensive TOB with larger sample sizes than originally planned.
b. reducing inherent risk for most of the assertions relevant to significant account balances.
c. changing the timing of TOB by omitting interim-audit testing and performing the tests at year end.
d. identifying specific internal control policies and procedures relevant to specific assertions.
9-21
After obtaining an understanding of internal control and assessing control risk, an auditor decided to perform tests of controls because
a. it would be efficient to perform TOC that would result in a reduction in planned TOB.
b. additional evidence to support a further reduction in control risk is not available.
c. an increase in the assessed level of control risk is justified for certain financial statement assertions.
d. there were many internal control weaknesses that could result in many misstatements.
9-22
An auditor may decide to assess control risk at the maximum level for certain assertions because the auditor believes
a. the clients control environment, monitoring, and control activities are interrelated.
b. sufficient evidential matter to support the assertions is likely to be available.
c. control policies and procedures are unlikely to pertain to the assertions.
d. more emphasis on TOC than TOB is warranted.
9-23
After assessing control risk at below the maximum level, an auditor desires to seek a further reduction in the assessed level of control
risk. At this time, the auditor would consider whether
a. it would be efficient to obtain an understanding of the clients internal controls.
b. the clients internal control policies and procedures have been placed in operation.
c. the clients internal control policies and procedures pertain to any financial statement assertions.
d. additional evidential matter sufficient to support a further reduction is likely to be available.
9-24
The acceptable level of detection risk is inversely related to the

a. risk of misapplying auditing procedures.
b. assurance provided by tests of balances.
c. level of preliminary judgment about materiality.
d. risk of failing to detect material misstatements.
9-25
As the acceptable level of detection risk increases (i.e., higher %), an auditor may vary the
a. assessed level of control risk from below the maximum to the maximum level.
b. sample size of TOB from a small to a large sample size.
c. timing of TOB from year-end to an interim-audit date.
d. nature of TOB from a less effective to a more effective procedure.
9-26
An auditor uses the assessed level of control risk to

a. make a conclusion about the effectiveness of the clients internal controls.
b. determine the acceptable level of detection risk for financial statement assertions.
c. determine the acceptable level of inherent risk for the client control environment.
d. determine the materiality thresholds (MT) for planning the audit.
9-27
Which of the following would an auditor most likely use in determining the auditors materiality threshold (MT)?
a. The assessed level of control risk.
b. The planned sample size for tests of balances.
c. The assessed level of detection risk.
d. The planned audit hours for the audit engagement.
9-28
Holding other planning considerations constant, a decrease in the amount of misstatements in a class of transactions that an auditor
could tolerate most likely would cause the auditor to
a. perform planned TOB long before the balance sheet date.
b. increase the budgeted audit hours to be applied to the class of transactions.
c. increase the assessed level of control risk for relevant financial statement assertions.
d. decrease the extent of auditing procedures to be applied to the class of transactions.
9-29
An auditor may compensate for a high assessed level of control risk by increasing the
a. level of detection risk.
b. extent of tests of controls.
c. preliminary judgment about materiality.
d. extent of analytical procedures.
9-30
When an auditor increases the planned assessed level of control risk because certain controls were determined to be
ineffective, the auditor would most likely increase the
a. extent of tests of balances.
b. level of inherent risk.
c. extent of tests of controls.
d. level of detection risk.
9-31
An auditor assesses control risk because it

a. provides evidence to the auditors understanding of the control environment.
b. provides assurance that the auditors materiality levels are appropriate.
c. indicates to the auditor where inherent risk may be the greatest.
d. affects the level of detection risk that the auditor may accept.
9-32
On the basis of audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from
that originally planned. To achieve an overall audit risk level that is substantively the same as the planned audit risk level, the auditor
would
a. increase inherent risk.
b. increase materiality levels.
c. decrease inherent risk.
d. decrease detection risk.
9-33
When assessing control risk below the maximum level, an auditor is required to document the auditors
a.
b.
c.
d.
Assessment of Internal Control

Yes
No
Yes
No
Basis for Concluding that Control Risk is Below the Maximum Level
No
Yes
Yes
No
247
248
9-34
When control risk is assessed at the maximum level for all financial statement assertions, an auditor should document the
auditors
Understanding of the Internal Control
a.
Yes
b.
Yes
c.
No
d.
Yes
9-35
Assessment of Internal Control

No
Yes
Yes
Yes
Basis for Concluding CR at Maximum Level

No
No
Yes
Yes
Which of the following is not a step in an auditors decision to assess control risk at below the maximum?
a. Evaluate the effectiveness of control activity with tests of controls.
b. Obtain an understanding of the clients control environment.
c. Perform tests of balances to detect material misstatements in the financial statements.
d. Consider whether controls can have a pervasive effect on financial statement assertions.
9-36
The ultimate purpose of assessing control risk is to contribute to the auditors evaluation of the risk that (Hint: The key
word is ultimate)
a. tests of controls may fail to identify procedures relevant to assertions.
b. material misstatements may exist in the financial statements.
c. specified controls requiring segregation of duties may be circumvented by collusion.
d. client policies may be overridden by senior management.
9-37
Inherent risk and control risk different from detection risk in that they
a. arise from the misapplication of auditing procedures.
b. may be assessed in either quantitative or non-quantitative terms.
c. exist independently of the financial statement audit.
d. can be changed at the auditors discretion.
9-38
Which of the following audit risk components may be assessed in non-quantitative terms?
a.
b.
c.
d.
9-39
Control Risk
Yes
No
Yes
Yes
Detection Risk
Yes
Yes
Yes
No
Inherent Risk
Yes
Yes
No
Yes
Which of the following statements is not correct about materiality?

a. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in
conformity with GAAP, while other matters are not important.
b. An auditor considers materiality for planning purposes in terms of the largest aggregate level of misstatements that could
be material to any one of the financial statements.
c. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and
qualitative judgments.
d. An auditors consideration of materiality s influenced by the auditors perception of the needs of a reasonable person
who will rely on the financial statements.

9-1 d. 9-2 d. 9-3 d. 9-4 b. 9-5 c. 9-6 b. 9-7 a. 9-8 d. 9-9 d. 9-10 c. 9-11 d.
9-12 b. 9-13 c. 9-14 a. 19-5 c. 9-16 b. 9-17 d. 9-18 b. 9-19 a. 9-20 d. 9-21 a.
9-22 c. 9-23 d. 9-24 b. 9-25 c. 9-26 b. 9-27 c. 9-28 b. 9-29 d. 9-30 a. 9-31 d.
9-32 c. 9-33 c. 9-34 b. 9-35 c. 9-36 b. 9-37 c. 9-38 a. 9-39 b.

Simulation Question 9-1 is an adaptation with permission from a case by Lindberg, D.L. in the Issues in Accounting Education , a publication of
the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and
places have been changed.
Introduction
Background
Karen Rohan, the auditor-in-charge of Lakeview Lumber Inc. (hereafter LL), had a dilemma. Karen was responsible for seeing that
she and her staff complete the fieldwork for LLs FY1998 audit as soon as possible. Audit hours were already over the time that had been
budgeted for the job, and Karen believed that there was still a substantial amount of time needed to finish the audit, because several audit matters
had not yet been resolved.
LL is located in the city of Lakeview, a metropolitan area of approximately 200,000 people. LL sells between 30,000 and 35,000
different kinds of building materials, lawn and garden products, and home improvement supplies to retail customers, as well as to contractors and
other building professional. Retail customers are required to pay in cash or by a major credit card at the time of their purchase. However, the vast
majorities of contractors and building professionals have established credit accounts and are billed on a monthly basis. LLs main competitors in
the area are the Home Depot, Inc. and Eagle Hardware & Garden.
Key accounting personnel at LL include Terry James, the Accounting manager, and John Mosher, the Controller. Terry has a B.B in accounting
and has been with LL for four years. Prior to working for LL, Terry was the night auditor for a small hotel. John Mosher, a CPA, started his
career as an auditor in Karens current CPA firm, Becker & Pippen (hereafter, BP). John was assigned to the audit of LL each of the six years he
worked for BP. In fact, George Mufson, the manager-in-charge of LL audit, and John began their careers with BP the same year and worked on
many of the same clients together. John has been the Controller for LL since 1995. BP have been the auditors for LL since 1982.
LLs Accounting Issues
You should access Data File 9-1 in iLearn for Table 1, which presents LLs Income Statements for the past three years; Table 2, which
presents LLs balance sheet for the past three years; Table 3, which presents LLs Statements of Retained Earnings, and Table 4, which
presents LLs Statements of Cash Flows for the past three years.
The analytical procedures performed at the beginning of fieldwork indicated three main areas of potential concern. The first issue was
that Bad Debts Expense for FY1998 seemed unusually high. The second area of concern was the amount of Warranty Expense recorded for the
current fiscal year. The third issue involved the proper classification of expenses related to a tornado that struck the area at the end of the fiscal
year.
Bad Debts Expense. Bad Debts Expense as a percentage of credit sales was approximately 5 percent for FY1998, whereas in the prior two years it
was 2 percent for FY1997 and 2.1 percent for FY1996, respectively. Approximately 50 percent of LLs sales are on credit. Review and testing of
the aged trial balance of Accounts Receivable indicated that the amount and percentage of accounts receivable in each aging category were
comparable to prior years. However, the percentages used to estimate the uncollectible accounts were almost doubled in practically every aging
category. When Karen questioned Terry James, the Accounting Manager, about the increased percentages, he stated that John Mosher, the
Controller, had instructed him to use the higher percentage.
Karen subsequently discussed the matter with John, who informed her that he was expecting customers to pay more slowly in 1999,
due to the recent downturn in the housing market in the area in which LL does business. When Karen suggested that slower payments did not
necessarily mean that the ultimate collectability of the accounts was in jeopardy, John became agitated, asking how she could possibly be
questioning an increase in the allowance for uncollectible accounts. John stated that auditors should be concerned about an insufficient balance in
the allowance account, not a balance that he was simply trying to assure was adequate. John ended the conversation by noting that Karen didnt
need to be concerned about his conservative approach to valuing accounts receivable.
Product Warranties Expense. The second issue of concern to Karen was that the estimated liability accrual for product warranties, and the related
Warranty Expense account, seemed unusually high. LLs warranty Expense account for FY1998 was approximately $141,000, representing a 25
percent increase from FY1997. Since the audit had not disclosed any significant changes in LLs product mix, Karen was surprised that the
Warranty Expense account has increased so much. She discussed the increase with Terry James, who stated that the charge to Warranty Expense
was just an estimate, and besides, John seems to advocating allocating as many expenses as possible to 1998. When Karen asked Terry why
this would be the case, Terry said he had heard something about company executives at Johns level and above receiving bonuses based on net
income, starting in FY1999. However, when Karen asked John about the increase in Warranty Expenses, John stated that in tough economic
times builders tended to return wood and supplies that might be slightly flawed, whereas in a strong economic climate they were not as particular.
Karen then discussed product warranties with Adam Lester, the manager of the cabinets department, since that department seemed to
experience the largest number of returns. Adam stated he did not keep records of returns per se, since the cabinets that were returned were usually
put back on the selling floor at a discounted price. On the other hand, if the buyer decided to keep the damaged cabinets, in exchange for a price
discount, the adjustment records were prepared by James and then forwarded to the accounting department. Adam said he didnt think that the
returns during FY1998 were much different from those of FY1997.
Tornado Expense. To complicate matters further, about three months before the end of the fiscal year, a tornado struck the city of Lakeview.
Approximately 35 percent of the homes and businesses on the citys western edge were damaged to some degree. Damage to LLs main building,
where retail sales occur, was extensive. However, most of the damage from the tornado was structural, and the inventory inside the building was
relatively unharmed. Fortunately, LL was fully insured for the damage to its buildings and inventory.
Within hours of the storm, business was brisk. Management of LL had rented several large tents and conducted business by selling
relatively small items out of them. Items of inventory too large to move to the tents were covered in double layers of plastic wrap and moved by
forklift to the portion of the main building with the least damage. As new inventory was delivered, it was sold out of the back of semi-trailer
trucks rented for this for this purpose.
Temporary employees were hired to move inventory from the building to the tens and to cover the larger items of inventory in plastic
wrap. In addition, a local security company was called to provide round-the clock security for all inventory items. Even though the local
competitors were not affected by the storm, LL experienced relatively high sales volumes in the days immediately following the tornado. John
had made arrangements with two of the three principal insurance companies in the area to allow residents to buy certain items of inventory
249
250
needed for repairs, with pre-approval from the insurance companies, and bill the charges directly to the insurance companies. This arrangement
was advertised on the local radio stations and was also quickly disseminated by word of mouth.
The sales during the period after the storm and before the end of the fiscal year, totaled approximately$1,600,000. The corresponding
cost of the inventory sold was approximately $1,130,000. The cost of renting the tents, buying plastic wrap, hiring temporary employees and
purchasing additional advertising was approximately $115,000 and is currently included in the Other Selling Expenses total of $575,000 in the
Income Statement. Bob, one of Karens assistants on the audit, said he thought that a tornado was an extraordinary event, and that the expenses
related to the tornado would qualify for treatment as extraordinary on the Income Statement. He argued that the $115,000 in storm-related
expenses should be pulled out of Selling Expenses and listed separately on the Income Statement, net of tax. Since Karen had not yet been on an
audit where an accounting event was classified as extraordinary, and because it had been over four years since she had taken Intermediate
Accounting, she decided to look up authoritative guidelines for classifying an accounting event as extraordinary.
Required
Access Data File 9-1 in iLearn for Table 1, which presents LLs Income Statements for the past three years; Table 2, which presents LLs
balance sheet for the past three years; Table 3, which presents LLs Statements of Retained Earnings, and Table 4, which presents LLs
Statements of Cash Flows for the past three years.
1. a. Perform analytical procedures to corroborate Karens three main areas of concern: bad debt expense, warranty expense, and tornado-related
expense. Specifically, compute and compare both the absolute differences and percentage changes in the FY1998 and FY1997 Income Statement
amounts.
b. Based on your analytical procedures, are there any other areas of concern besides the three areas mentioned in 1 a.?
2. Apply the concept of materiality to determine whether bad debt expense, warranty expense, and tornado-related expense would result in
material misstatements of LLs Income statement.
You should research (a) AU 320, Materiality in Planning and Performing the Audit, to determine the materiality of bad debt expense, warranty
expense, and tornado-related expense, (b) AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related
Disclosures to evaluate the reasonableness of the bad debt and warranty expense estimates, and (c) Accounting Principles Board Opinion No.30,
Reporting the Results of Operations (AICPA1973), to determine whether the tornado-related expense should be classified as extraordinary item
in the income statement.
3. Based on the results of 1 and 2 above, write a Client Advisory Comment letter, in the form of a memo, to advise John Mosher, the Controller,
on how to deal with the three main areas of concern: bad debt expense, warranty expense, and tornado-related expense.

Simulation Question 9-2 is an adaptation with permission from a case by Martin, R.D. and F. Phillips in the Issues in Accounting Education , a
Aerospace Lighting, Inc.
Your Audit Firm
Aerospace Lighting, Inc. (hereafter, ALI) previously a private company based in Chicago- has been a leading supplier of airplane
cabin lighting systems for nearly ten years. Until recently, ALI had been satisfied with its profits and had sold all its products to Bombardier, a
major aerospace company in Canada. This comfortable position began to change in 2003, when a large publicly traded German company
(hereafter, BmG) acquired 100 percent of ALI.
For ALI, the transition from a private, independent company to a subsidiary of a public conglomerate has not been an easy one. Before
the takeover, ALIs management was afforded the luxury of making decisions and taking risks that affected only one owner. Being just one arm
of a much larger international company, however, now requires ALI to satisfy more than its own personnel. Members of BmGs executive team
dominate ALIs board of directors. These individuals have been very critical of ALIs management, particularly in the area of financial
performance. Beginning with the first board meeting in 2003, the German executive team has scrutinized ALIs operating results and has never
hesitated to remind ALI management that BmG views ALI as an investment that is evaluated based on its return to BmG stockholders. BmG does
not tolerate any failures to meet financial targets, and is willing to replace entire management teams if required. BmGs executives take very
seriously the Financial Handbook that they establish each year to communicate the parent companys financial principles, including equity and
capital borrowing guidelines, monthly reporting requirements, and profit expectations.
Since the acquisition, ALI has been pursuing a rapid expansion strategy. The German parent company directed ALI to enter the U.S.
aerospace supply industry in 2004, and quickly increase the number of U.S. contracts on which it bid, with the goal of increasing its revenue by
50 percent in 2005. To reach this goal, ALI adopted a strategy of submitting bid prices to U.S. manufacturers that, after adjusting for exchange
rates, are approximately 20 percent lower than the prices ALI charges to Bombardier. This strategy has been successful so far, as ALI now has
several large contracts with Boeing, Lockheed Martin, and Raytheon the largest aerospace manufacturers in the U.S. ALI has already begun
preparing to work on these contracts, having accumulated a significant quantity of raw materials inventory to use in producing goods for Boeing,
Lockheed Martin, and Raytheon, as well as Bombardier.
ALIs management team has not discussed its new strategy with its board because management believes BmG is interested in financial
results rather than the means by which they are achieved. ALIs management team also wants to keep this strategy quiet because if Bombardiers
executives were to hear about it, they would likely discontinue their relationship with ALI or immediately demand a lower price, as well as insist
on a refund of any excess prices charged in previous years.
Just last week, on June 29, 2005, your firms German affiliate was appointed worldwide audit services provider for BmGs July 31,
2005 year-end. Another firm had provided audit services for BmG and all its subsidiaries in the previous year, but BmGs executive team was
dissatisfied with the previous auditors inability to identify significant business risks that they believed should have been brought to their
attention. Your firms office in Munich asked your San Francisco office to perform the audit of ALI for its year ended July 31, 2005, and to
provide your audit working papers to the Munich office by September 5, 2005. Because BmGs Stock is not traded on a U.S. exchange, the
company and its subsidiaries are not subject to the provisions of the Sarbanes-Oxley Act of 2002.
A recently promoted partner in your San Francisco office has been assigned the responsibility for the 2005 ALI audit. She has
communicated with ALIs predecessor auditor and has provided you with the notes from her review of the predecessors working papers. You
should access Data File 9-2 in iLearn for Exhibit 1, which presents notes from review of predecessor auditors working papers. She also
has obtained information from preliminary discussions with ALIs CFO. You should access Data File 9-2 in iLearn for Exhibit 2, which
presents notes from discussion with ALIs CFO. The partner has asked youas an audit senior-to prepare a memo discussing the important
audit issues and any other matters she should consider regarding the upcoming year-end engagement. She reminds you that she is required to
obtain second partner approval of audit plans developed for high-risk client engagements.
Required
Prepare a memo that addresses the following issues and their impact on ALIs financial statements and/or the audit plan:
1. Clients business risks
2. Auditor business risk
3. Audit risk (AR)
4. Inherent risk (IR)
5. Control risk (CR)
6. Preliminary judgment about materiality (PJAM)
7. Materiality threshold (MT)
8. Tolerable misstatement (TM)
9. Amount of audit evidence
10. Specific accounting and other audit issues
Note:
1. Remember to include in your memo any assumptions that you have made.
2. The partner in San Francisco office expects your memo will help her to:
a. Assess whether ALI should be considered a high-risk management,
b. Justify that assessment to other partners in the firm, and
c. Outline what will be required of you and other members of the audit team to ensure the firm meets the high expectation that BmG has for its
auditors.
3. Bear in mind that the partner on this engagement is also responsible for many other client engagements. Consequently, while you should
endeavor to be direct and succinct in your memo (limiting it to no more than four single-spaced and medium-font pages), you should avoid
assuming that the partner will fully recall all relevant facts or that she will immediately recognize all important implications of those facts. In
sum, be sure to describe the specific facts that you consider relevant and explain the implications for the ALI engagement.
4. Because the contents of your memo will form the basis of discussions that the partner is likely to have with other partners in the firm, make
sure that you clearly identify any specific information that your partner should consider sensitive.
Your memo must address all the above in order to earn the extra credit point.

Simulation Question 9-3 is an adaptation with permission from a case by Daugherty, B. and D. G. Neely in the Issues in Accounting Education , a
Introduction
Milwaukee, Wisconsin-based Koss Corporation's (Koss) founder, John C. Koss, has been recognized for creating the stereo headphone
industry in 1958. Koss is a public company (ticker symbol KOSS), subject to the Securities and Exchange Commission's (SEC) reporting
requirements. John C. Koss has served continuously as the company's Chairman of the Board of Directors since 1958 and as Chief Executive
Officer (CEO) until 1991. In 1987, Michael J. Koss succeeded his father as President, Chief Operating Officer (COO), and Chief Financial
Officer (CFO). He became the company's CEO in 1991 and Vice-Chairman of the Board in 1998. His brother, John Koss, Jr., is Koss' Vice
President of Sales. Ninety-nine percent of Koss' product sales for the fiscal year ended June 30, 2009, were stereo headphones.
For fiscal year 2009, the total compensation paid to John C. Koss, Michael J. Koss, and John Koss, Jr., was $267,242, $450,507, and
$235,122, respectively. Unlike many other companies, Koss remained profitable through the economic downturn of the late 2000s, reporting net
income of $2.0 million and $4.5 million for the fiscal years ended June 30, 2009 and 2008, respectively, with retained earnings of $21.6 million at
June 30, 2009. You should access Data File 9-3 in iLearn for Exhibit 1, which provides Koss' audited income statements and balance
sheets for fiscal years 2009 and 2008.
Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for
fiscal years 2008 and 2009. Ms. Sachdeva, her husbandan attorney, Ph.D., and M.D. at Children's Hospital of Wisconsinand their children
reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the
Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct
251
252
international accounting firm of Arthur Andersen. Ms. Sachdeva was portrayed as an active fundraiser in the nonprofit communityreportedly
raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe.
Internal Control Assertions under Sarbanes-Oxley
Embezzlement and Financial Statement Fraud at Koss
The Koss Corporation case relates to the financial statement audit opinions rendered by Koss' independent audit firm, Grant Thornton
LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) following the passage of the
Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOX requires the CEO and CFO of U.S. registrants, and their external auditor, to separately
report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness
of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's
extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR.
In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who pride themselves on being
good stewards of their company. We've always complied with government regulations, so it's annoying having to deal with this extra layer of
bureaucracy. Small companies like ours are spending hours in auditing committees that would be better spent on strategic planning.
In October 2009, the SEC announced one final extension for nonaccelerated filers for fiscal years ending on or after June 15, 2010
Koss' fiscal year ending June 30, 2010. The SEC estimates more than 6,000 public companies would meet the exemption requirements. However,
one month later, the House Financial Services Committee approved a permanent exemption for nonaccelerated filers' auditor attestation on the
effectiveness of ICFRthe Garrett-Adler amendment to the Investor Protection Act (IPA).
In March 2010, Senator Dodd unveiled the U.S. Senate's 1,336-page version of the IPA, Restoring American Financial Stability Act
of 2010, with the Section 404(b) exemption notably absent. In June 2010, the congressional committee reconciling the House and Senate
versions of the proposed legislation agreed to permanently exempt Section 404(b) compliance requirements for nonaccelerated filers. In July
2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Wall Street Reform Act or WSRA),
permanently exempting nonaccelerated filers from Section 404(b) auditor attestation on ICFR.
Even though nonaccelerated filers are not required to have an audit of ICFR, management is still required to perform its assessment of
ICFR effectiveness and include its report in the SEC filings. The management assessment and report requirement of ICFR came into play prior to
the requirement for an audit, and thus WSRA permanently exempts the auditor's ICFR attestation for these nonaccelerated filer public companies.
It is important to note that ICFR evaluations are designed to detect weaknesses in internal control over financial reporting, including
anti-fraud controls, but are not designed or intended to be a guarantee of fraud detection. The Public Company Accounting Oversight Board's
(PCAOB) Auditing Standard No. 5 (AS 5)An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial
Statements provides guidance to the independent auditor in conducting an audit of the effectiveness of ICFR. AS 5 notes in an ICFR audit that
the auditor may become aware of fraud or possible illegal acts, and indicates auditors must then determine their responsibilities under the
authoritative guidance governing such matters.
However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long
believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small
businesses, comparing those with fewer than 100 employees and those with 100 or more (Koss had 72 employees at June 30, 2009), the 15 most
frequent anti-fraud controls cited for the smallest organizations included external audit of financial statements (#1), management's certification of
financials (# 3), and an external audit of ICFR (# 6). These findings lend credence to the notion that external financial statement and ICFR audits,
coupled with management certifications, are viewed to be deterrents to fraud.
The following are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's
financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009:
Koss Attestation (in part):
Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its
Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control
of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) and designing such internal control to
provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles.
Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the
framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) as of June 2009. Based on this assessment, the Company's management, including its
Chief Executive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over
financial reporting was effective based on the criteria set forth by COSO in Internal Control-Integrated Framework.
However, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute
assurance that all control issues and instances of fraud, if any, within the Company have been detected.
This annual report does not include an attestation report of the Company's registered public accounting firm regarding
internal control over financial reporting. Management's report was not subject to attestation by the Company's registered
public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company
to provide only management's report in this Form 10-K. (emphasis added)
Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part):
The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial
reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness
of the Company's internal control over financial reporting. Accordingly, we express no such opinion (emphasis added).
There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required
to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are
held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael
J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required
signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary
Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but
rather designated as the Principal Accounting Officer.
On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting other events involving Koss Corporation. The
8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information
regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave. You should
access Data File 9-3 in iLearn for Exhibit 2, which contains portions of the 8-K filing.
You should also access Data File 9-3 in iLearn for Exhibit 3, which provides excerpts of the second 8-K filed within the week
by Koss. This filing indicated the previously issued financial statements for the fiscal years ended June 30, 2006, through June 30, 2009, should
no longer be relied upon, and referenced a press release announcing the termination of Ms. Sachdeva.
On December 31, 2009, Koss, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8K
filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on
previously issued financial statements, audit reports, and interim reviews, stating, in part:
The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the
Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the
Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company
has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005
through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the
unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the
Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary
estimates indicate that the amount of unauthorized transactions since fiscal year 2005 through the present has exceeded $31
million, but at this point the Company and its advisors cannot assess the potential impact on its financial statements or
identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent
of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions.
As promptly as possible, the Company plans to restate its financial statements for applicable periods as further
investigation indicates. (Item 4.02(a) of Koss Corporation's 8-K filed January 4, 2010).
On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's
characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: 1
We have read Item 4.01 of Form 8-K of Koss Corporation dated January 4, 2010, and agree with the statements concerning
our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a),
some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing.
Safeguards against Fraud and Embezzlement
Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva.
These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a
Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee),
inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not
engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and Michael J.
Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years.
Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third
party. According to the criminal complaint, neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express
alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card.
The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique.
In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy
Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial
crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill
with Koss funds, but did nothing to stop the fraud until December of 2009.
In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later
concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they
were not detected sooner. Her attorney declined comment on the case. A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34
fur coats, and 65 racks of clothing stored in rented space and at area merchants. The U.S. Marshals Service was reported to inventory some
22,000 items seized by the FBI. The items are scheduled to be auctioned online with net proceeds remitted to Koss.
Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on
bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the
money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney
said sensitive information in Sachdeva's medical records would be directly relevant to her defense, adding, We do not believe it is either
necessary or appropriate that Pre-Trial Services be in possession of these records. It was previously reported that her attorney planned to raise
the issue of mental state in Ms. Sachdeva's defense.
Ms. Sachdeva pled not guilty to accusations that she embezzled $31 million from Koss and remained free on bond as of June 2010.
The case is believed to be one of the largest embezzlements in Wisconsin history and the largest in the U.S. for 2009. Ms. Sachdeva's attorney
said, As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct. Asked
whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks
and added, This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms.
Sachdeva's mental and emotional health are essential to this case. Sachdeva also was ordered by the court to refrain from using alcohol and to
submit to periodic drug and alcohol testing.
If Sachdeva is convicted, she would forfeit her home, car, offices in Milwaukee where she is alleged to have stored thousands of
items of clothing and accessories, a vacation home, profit-sharing payments she received from Koss, and money equal to the proceeds she derived
1
Item 4.01 of Koss' initial auditor dismissal 8-K filing was a factual statement of previous opinions rendered by Grant Thornton indicating they
did not contain adverse, qualified, or disclaimers of opinion; and further documented there were no disagreements between Grant and Koss as to
any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure.
253
254
from her offenses. Sachdeva also would forfeit personal property, clothing, jewelry, art objects, religious statues, and household items that she
purchased and that were being held for her by a number of retailers, and potentially face up to 120 years in prison and $1.5 million in fines.
In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors
indicated they were working toward a plea agreement with Ms. Sachdeva and did not anticipate the case would go to trial. On June 24, 2010,
Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thornton, alleging fraud, negligence, and
breach of fiduciary duty. The suit seeks more than $30 million in damages.
Epilogue
On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the
unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $5.1 million for the fiscal
years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million. For fiscal 2009 (2008), net sales
were originally understated by $3.5 ($2.1) million, and cost of goods sold overstated by $1.7 ($1.0) million. Substantial balance sheet adjustments
at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7
million in product software development costs, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts
payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million.
On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva
agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal
prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010.
Required
Assume you are the auditor of Koss Corporation.
1. With regard to Michael J. Kosss official position in Koss, how would your assessment of inherent risk (IR) at Koss be impacted when one
individual (Michael J. Koss) holds multiple C-level (Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, etc.) and Board of
Director titles in a publicly held client? Defend your answer.
2. With regard to Michael J. Kosss report of ICFR on Koss, how would your assessment of control risk (CR) at Koss be impacted when the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 permanently exempting nonaccelerated filers from Section 404(b)
auditor attestation on ICFR. Defend your answer.
3. For question 3, you should access Data File 9-3 in iLearn for Exhibit 1, which contains Koss Corporation Financial Information and
Ratios.
a. Determine the materiality threshold (MT) of Koss Corporation's income statements for 2009 and 2008, respectively. Briefly describe your
calculations and the factors you took into consideration for determining materiality.
b. Determine the materiality threshold (MT) of Koss Corporation's balance sheets for 2009 and 2008, respectively. Briefly describe your
calculations and the factors you took into consideration for determining materiality.
c. Based on the materiality threshold (MT) in 3a, what dollar amount of Tolerable Misstatement (TM) you would allocate to cost of goods sold
in Koss Corporations income statements for 2009 and 2008, respectively? Briefly describe your calculations and the factors you took into
consideration for determining materiality.
c. Based on the materiality threshold (MT) in 3b, what dollar amount of Tolerable Misstatement (TM) you would allocate to accounts
receivables in Koss Corporations balance sheets for 2009 and 2008, respectively? Briefly describe your calculations and the factors you took
into consideration for determining materiality.
Chapter 10
Audit Plan Program and Technology
LO10-1 Understand an audit program for transaction-, balance-, and presentation-related
information.
LO10-2 Distinguish among the various terms that describe Tests of Controls (TOC) and
Tests Balances (TOB).
LO10-3 Describe the Tests of Controls (TOC) strategy.
LO10-4 Describe the Tests of Balances (TOB) strategy.
LO10-5 Describe the Tests of Completing the Audit (TCA) Strategy.
LO10-6 Explain the effect of information technology on documentation and evidence.
LO10-7 Explain the effect of information technology on internal control and Tests of
Controls (TOC) procedures.
LO10-8 Explain the effect of information technology on Tests of Balances (TOB)
procedures.
LO10-9 Explain the effect of special systems on TOC and TOB procedures.
LO10-10 Explain the effect of information technology on audit report.
255
256
Chapter 10 Audit Plan Program and Technology

Figure 10-1 shows the last step in an audit plan the development of an audit program for transaction-, balance-,
and presentation-related Information.
Figure 10-1 An Audit Program for Transaction-, Balance-, and Presentation-Related Information
The Audit Process
Audit Plan
Preplan and
Documentation CH 5
Tests of Controls
Tests of Balances
Financial Audit
Audit Report
Integrated Audit
Objectives CH 6
An Audit Program
Evidence CH 7
Tests of Controls Strategy
(TOC Strategy)
Tests of Balances Strategy

(TOB Strategy)
Tests of Completing the Audit

Strategy (TCA Strategy)
A Set of TOC Procedures
A Set of TOB Procedures
A Set of TCA Procedures
Test Transaction-related
Information
Test Balance-related
Information
Test Presentation-related
Information
Program and
Technology CH 10
An Audit Program for Transaction-, Balance-, and Presentation-Related Information

Recall Chapter 6 comments that the auditor develops an audit program that consists of a Tests of Controls (TOC)
strategy, a Tests of Balances (TOB) strategy, and a Tests of Completing the Audit (TCA) strategy. Each of the three
strategies prescribes a set of audit procedures the auditor would use to test the three aspects (transaction-, balance-,
and presentation-related) of information reflected in the financial statements. For example, an audit program may
prescribe audit procedures for transaction-related information such as transactions relating to inventory actual
occurred (i.e., occurrence), that they are completed (i.e., completeness or no valid transactions were left out), that
they are classified properly (i.e., classification, e.g., as an asset rather than an expense), and that they are recorded
accurately (i.e., accuracy) and in the correct period (i.e., cutoff). Similarly, the audit program may prescribe audit
procedures for balance-related information such as inventory represented in the inventory account balance exists (i.e.
existence), the client owns (i.e., rights and obligations) the inventory, that the balance is complete (i.e.,
completeness), and that the inventory is properly valued (i.e., valuation and allocation). Finally, the audit program
may prescribe audit procedures for presentation-related information such as the financial statements properly
classify and present (i.e., classification) the inventory (e.g., inventory is appropriately presented as a current asset on
the balance sheet) and that all required disclosures (i.e., understandability) having to do with inventory (e.g.,
footnote indicating that the client uses the LIFO inventory method) are complete (i.e., completeness), accurate (i.e.,
accuracy), and understandable (i.e., understandability).
Terms that Describe Tests of Controls and Tests of Balances
Figure 10-2 shows the various terms that describe Tests of Controls and Tests Balances
Figure 10-2 Terms that Describe Tests of Controls and Tests of Balances
Tests of Controls (TOC)
(Also known as Compliance Tests)
e.g., Test for separation of duty
An Account
Accounts Receivable
Tests of Details
of Balances (TOB)
(Also known as
Substantive Tests)
e.g., Test for accuracy of balances
Beginning Balance X
Cash Receipts X
Sales
Sales Returns X
Balance
Compliance Tests of Transactions

e.g., Test for adequate documentation
Substantive Tests of Transactions
e.g., Tests for accuracy of unit
price
Analytical procedures
e.g., compare with previous
balances for reasonableness
Tests of Control (Also Known as Compliance Tests)

There are two categories of tests of controls: 1. Tests of Controls. 2. Compliance Tests of Transactions. The auditor
performs tests of controls to assess the effectiveness of the design and operation of the client's internal control policy
and procedures. For example, the auditor tests the effectiveness of a proper separation of duties between the person
who is responsible for recording cash transactions and the person who is responsible for depositing cash in the bank
daily. Many tests of controls involve examining documents. When transaction documents are examined to determine
if internal control policies and procedures have been followed, the tests are referred to as compliance tests of
transactions. For example, the auditor examines credit memos for the initials of an accounting clerk responsible for
257
258
their authorization. The presence or absence of the initials indicates whether the control procedure of authorization
has functioned properly. Since the term tests of controls usually stands for both categories of tests; hereafter, only
the term tests of controls (TOC) is used in the discussion.
Tests of Balances (Also Known as Substantive Tests)

There are three categories of tests of balances: 1. Tests of Details of Balances. 2. Substantive Tests of Transactions.
3. Analytical Procedures. The auditor performs tests of details of balances to assess the accuracy of the ending
balances in the financial statements. For example, the auditor confirms individual customer accounts to determine
the correctness of the accounts receivable balance in the financial statements. Many tests of details of balances
involve examining documents to identify any material misstatements in the recording of the transactions. When
transaction documents are examined to determine if dollar errors have occurred during the processing of the
transactions, the tests are referred to as substantive tests of transactions. For example, the auditor performs a sales
cut-off test by tracing sales invoices to the sales journal to determine the occurrence, accuracy, and completeness of
the sales figure in the financial statements. Since the term tests of balances usually stands for both the tests of details
of balances and substantive tests of transactions; hereafter, only the term tests of balances (TOB) is used in the
discussion. Analytical procedures are used by the auditor to assess the reasonableness of financial and non-financial
information. The auditor studies and compares plausible relationships among the information. For example, the
auditor compares the client's current ratio with the industry average to identify potential misstatements of the current
assets and/or current liabilities balances in the financial statements.
Tests of Controls (TOC) Strategy
A typical audit client has five major transaction cycles: 1. Revenue cycle, 2. Expenditure cycle, 3. Inventory cycle,
4. Payroll cycle, 5. Capital cycle, and General cash and Investments. For each of these transaction cycles, the auditor
implements a Tests of Controls (TOC) Strategy. The auditors TOC strategy consists of five audit tasks. Table 10-1
provides some comments on these five audit tasks. Figure 10-3 shows the TOC strategy, the five audit tasks, and the
five transaction cycles. It can be seen from Figure 10-3 that the auditors TOC strategy follows closely the
recommendations of the Committee of Sponsoring Organizations of the Treadway Commission - COSOs Internal
Control-Integrated Framework (recall Chapter 8).
Table 10-1 Five Audit Tasks in the TOC Strategy
TOC Strategy
Audit Tasks
(1) Understanding of Internal
Control
(2) Documenting
the Understanding of Internal
Control
(3) Assess CR (Control Risk)
(4) Perform TOC Procedures

Apply Attribute Sampling Plan
(5) Communicating Internal

Control-related Matters
Comments
For each transaction cycle, the auditor obtains sufficient knowledge on five components of its internal
control (recall Chapter 8): (1) Control environment. (2) Risk assessment. (3) Control activities. (4)
Information and communication. (5) Monitoring. For risk assessment, the auditor should understand how
the management meets the five basic assertions of: (1) Existence or Occurrence. (2) Completeness. (3)
Valuation or Allocation. (4) Rights and Obligations. (5) Presentation and Disclosure. For information and
communication, the auditors TOC and TOB procedures should meet the eight types of specific audit
objectives: (1) Existence or Occurrence. (2) Completeness. (3) Rights and Obligations. (4) Valuation and
Allocation. (5) Classification. (6) Cutoff. (7) Accuracy. (8) Understandability (Recall Chapter 6).
The auditor may use a narrative description, internal control questionnaires, or flow chart to document the
understanding of internal control. After the documentation, the auditor identifies the presence and absence
of the five basic control activities (the 3rd component of internal control) to assess the strength and
weakness of the internal control. The five basic control activities are: (1) Adequate separation of duties. (2)
Proper authorization of transactions and activities. (3) Adequate documents and records. (4) Physical
control over assets and records. (5) Independent checks on performance.
Based on the auditors understanding and documentation of internal control, s/he assesses CR (control risk)
for account-balances or classes of transactions at either the maximum of 100% or less than the maximum
of 100% (recall Chapter 9). If CR were at the maximum, then the auditor would normally make no reliance
on internal controls and would plan to perform only TOB. One the other hand, if CR were at below the
maximum of 100%, the auditor would plan to perform both TOC and TOB procedures.
The auditor performs the TOC procedures that address the nature, extent, and timing of evidence. For the
nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC
procedures but perform only TOB procedures. For the extent, if CR were assessed at below the maximum
of 100%, the auditor would apply an attribute sampling plan (discuss in Chapter 11) to determine the
sample size of evidence.
The auditor communicates the results of the TOC in either a material weakness report or a clients advisory
comments letter (recall Chapter 8).
Figure 10-3 Tests of Controls (TOC) Strategy, Audit Tasks, and Transaction Cycles
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
1. Understanding of Internal Control
2. Expenditure Cycle
CH 14
2. Documenting the Understanding of Internal Control
3. Assess CR (Control Risk)
3. Inventory Cycle
CH 15
4. Perform TOC Procedures

4. Payroll Cycle
CH 16
5. Communicating Internal Control-related Matters
5. Capital Cycle
CH 17
General Cash and Investments

CH 18
259
260
Tests of Balances (TOB) Strategy

A typical audit client has five major transaction cycles: 1. Revenue cycle, 2. Expenditure cycle, 3. Inventory cycle,
4. Payroll cycle, 5. Capital cycle, and General cash and Investments. For each of these transaction cycles, the auditor
implements a Tests of Balances (TOB) Strategy. The auditors TOB strategy consists of five audit tasks. Table 10-2
provides some comments on these five audit tasks. Figure 10-4 shows the TOB strategy, the five audit tasks, and the
five transaction cycles. It can be seen from Figure 10-4 that the auditors TOC strategy follows closely the
requirements of AU 320 Materiality in Planning and Performing the Audit (recall Chapter 9). Figure 10-5 provides
an example of a partial program of TOB procedures for Accounts Receivable
Table 10-2 Five Audit Tasks in the TOB Strategy
TOB Strategy
Audit Tasks
(1) Allocate PJAM to TM
(2) Derive DR (Detection Risk)
(3) Perform Analytical Procedures
(4) Perform TOB Procedures

Apply Variable Sampling Plan
(5) Document Total Misstatements
Comments
The auditor allocates PJAM (Preliminary Judgment about Materiality) to TM (Tolerable Misstatement) at
the individual account-balance or class of transaction level of a transaction cycle. (Recall Chapter 9)
The auditor derives the DR (Detection Risk), based on a pre-specified AR (Audit Risk), assessed IR
(Inherent Risk) and CR (Control Risk), by using the audit risk model of AR = IR x CR x DR at the
individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The
derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the
auditor.
The auditor performs six common types of analytical procedures: (1) Compare client and industry data. (2)
Compare client data with similar prior-period data. (3) Compare client data with client-determined
expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data
with expected results, using non-financial data. (6) Compare financial ratio analysis on client data (recall
Chapter 7).
The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the
procedures but perform only TOB procedures. In addition, the auditor would apply a variable sampling
plan (discuss in Chapter 12) to determine the sample size of evidence.
The auditor documents all misstatements found by performing the TOB procedures and compares the total
misstatements with the PJAM. Based on the misstatement found, the auditor may revise PJAM if
necessary. The auditor should perform additional audit work or request the management to make
adjustment for the misstatements.
Figure 10-5 Example of a Partial Program of TOB Procedures for Accounts Receivable
A Partial Program of TOB Procedures for Accounts Receivable
(1) Audit Objective: To test for completeness
Procedure: Obtain the December 31, 200x, aged accounts receivable trial balance
and
(a) Foot the trial balance and agree total to accounts receivable control account.
(b) Judgmentally select five accounts from the aged trial balance; agree the
information per the aged trial balance to the original sales invoice and determine if
the invoice was included in the appropriate aging category.
(2) Audit Objective: To test for existence
Procedure: Confirm accounts receivable using a monetary-unit sampling technique.
Set the risk for incorrect acceptance = 10%, tolerable misstatement = $50,000, and
expected misstatement = $20,000.
(a) For all responses with exceptions, follow up on the cause of the error.
(b) For all non-responses, examine subsequent cash receipts and/or supporting
documents.
(c) Summarize the statistical test results.
(d) Summarize the confirmation results.
(3) Audit Objective: To test for cutoff
Procedure: Test sales cutoff by identifying the last shipping advice for the year and
examining five large sales for three days before and after the year-end.
(4) Prepare a memo summarizing the tests, results, and conclusion.
W/P Ref:
Completed By:
Date
Figure 10-4 Tests of Balances (TOB) Strategy, Audit Tasks, and Transaction Cycles
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
1. Allocate PJAM to TM
CH 14
2. Derive DR (Detection Risk)
3. Inventory Cycle
CH 15
3. Perform Analytical Procedures
4. Perform TOB Procedures

5. Document Total Misstatements
4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
261
262
Tests of Completing the Audit (TCA) Strategy

After the auditor has completed the TOC (Tests of controls) and TOB (Tests of Balances), s/he completes the
engagement by following a Tests of Completing the Audit (TCA) Strategy to test presentation-related information.
The TCA procedures include: 1. reviewing contingent liabilities, 2. reviewing subsequent events, 3. reviewing
working papers, and 4. considering subsequent discovery of facts (discuss in Chapter 20).
Nature, Extent, and Timing of Audit Procedure
According to AU 330 Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit
Evidence Obtained, in developing an audit program, the auditor considers the nature (i.e., what audit procedures to
use), extent (i.e., how many items to test) and timing (i.e., when to perform the audit procedures) of audit procedures
necessary to accomplish specific audit objectives.
Nature of Audit Procedure

Nature of audit procedure refers to the type (e.g., inspection, observation, confirmation, etc.) of audit procedure that
the auditor uses to gather audit evidence. The auditor has a variety of audit procedures from which to choose. A
criterion for choosing among them is which audit procedure produces persuasive evidence. The persuasiveness of
evidence is determined by the appropriateness (reliability + relevant) and sufficiency (amount or sample size) of
evidence (Recall Chapter 7). In short, the nature of audit procedure is closely related to the persuasiveness of
evidence. For example, an auditor may choose between an inspection and examination of a client's invoices. Here,
the former is a less persuasive audit procedure than the latter. Another criterion for choosing the type of audit
procedure is based on the risk of material misstatement. The higher the auditors assessment of risk, the more
reliable and relevant is the audit evidence sought by the auditor from TOC and TOB procedures (Recall Chapter 9).
For example, an auditor may choose to confirm the completeness of the terms of a contract with a third party, in
addition to inspecting the document and obtaining managements representation letter.
Extent of Audit Procedure

Extent of audit procedure refers to the scope of audit procedures that the auditor uses to gather audit evidence. A
criterion for determining the scope of audit procedures is the amount of evidence gathered or sample size used by
the auditor (recall Chapter 7). For example, when all of the invoices of a client are examined by the auditor, the
scope of the examination is larger than when just a small sample of the invoices is examined. In addition, the
auditor considers the representativeness of individual sample items in determining how many items to tests. In
practice, the auditor also uses the number of budgeted audit hours to determine the scope of audit procedures to use,
which is sometime referred to as the audit effort or costs of audit. Finally, an auditor may uses techniques such
as computer-assisted audit techniques (CAATs) to enable him/her to extensively test electronic transactions and
account files (discuss in later half of this chapter). Such techniques can be used to select sample transactions from
key electronic files, to identify transactions with specific characteristics, or to test an entire population instead of a
sample.
Timing of Audit Procedure

Timing of audit procedure refers to whether some of the audit work can be performed before year-end. Typically, an
audit engagement is characterized by two major time frames, an "interim audit" and a "year-end audit."
1. Interim Audit.
During an interim audit, the auditor first obtains an understanding of the client's internal controls; makes an
assessment of the control risk, and prepares an interim audit program. Second, the auditor performs TOC according
to the interim audit program. Based on the results of the TOC, the auditor determines the detection risk (DR), and
prepares a year-end audit program necessary for the year-end audit. Interim audit work is typically conducted during
the second half of the client's financial year; however, for very large clients, the interim work may be performed in
both the first and second halves of the financial year to even out the workloads and time constraints.
2. Year-End Audit (or Final Audit).
During a year-end audit, also known as a "final audit," the auditor performs TOB. For the tests, the auditor performs
the year-end audit program prepared at the interim audit. Final audit work is typically conducted at year-end shortly
after the balance date, however, for very large clients, the final audit may be performed prior to the balance sheet
date to avoid excessive year-end workloads and time constraints. Figure 10-6 shows an example of a timeline for
performing the audit procedures.
In general, the higher the risk of material misstatement, the more likely it is that the auditor may decide it is
more effective to perform TOB procedures nearer to, or at, the unpredictable time (i.e. a spot check). In addition,
certain audit procedures can be performed only at or after period end, for example, agreeing the financial
statements to the accounting records, or examining adjustments made during the course of preparing the financial
statements. Finally, in considering the timing of audit procedures, the auditor should consider such matters as:
1. The control environment.
2. When relevant information is available. For example, electronic files may subsequently be over-written, or
procedures to be observed may occur only at certain times.
3. The nature of the risk. For example, if there is a risk of inflated revenues to meet earnings expectations by
subsequent creation of false sales agreements, the auditor may examine contracts available on the date of the
period end.
4. The period or date to which the audit evidence relates.
In addition to performing the TOB procedures at the year-end audit, the auditor also performs TCA (Tests
of Completing the Audit) procedures that address a set of presentation-related information. Typically, the TCA
procedures are performed between the clients balance sheet date and the audit report issue date. The year-end TCA
procedures are discussed in Chapter 20.
Figure 10-6 Example of a Timeline for Performing the Audit Procedures
Beginning of
Financial Year
Middle of
Financial Year
Interim Audit
|
1/1
Audit
Plan
End of
Financial Year
Year-End Audit
|
6/30
Perform TOC
Audit
Report
|
12/31
Perform TOC
|
1/31
Perform TCA
Perform TOB
Transactionrelated
information
Transactionrelated
information
Balancerelated
information
Presentationrelated
information
263
264
Effect of Information Technology on the Audit Process

When a client uses information technology to process and store accounting information, the audit process is
impacted in several ways. Figure 10-7 provides an overview of the effect of information technology on the audit
process.
Figure 10-7 Effect of Information Technology on the Audit Process
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Documentation
Internal Control
Evidence
TOC Procedures
TOB Procedures
Special Systems
Special System
Audit Report
Report
on
Web site
Effect of Information Technology on Documentation

The auditor uses information technology to convert traditional paper-based documentation into electronic files and
to store audit documents electronically. Some CPA firms develop their own software, while others use commercially
available documentation software. Examples of such software are described in Table 10-3.
Table 10-3 Examples of Documentation Software
Documentation Software
Automated Client
Engagement (ACE)
Spreadsheet Software, e.g.,

Excel, Lotus 1-2-3, and Quattro
Pro.
Description
CPA firms developed ACE that can be used to prepare a working trial balance, lead schedules, financial
statements, and to perform ratio analysis. Tick marks and other explanations, such as senior reviewer
notes, can be entered directly into computerized files. In addition, data can be imported and exported to
other applications, for example, downloading a clients general ledger into ACE and exporting tax
information to a commercial tax preparation package such as TurboTax.
Commercially available spreadsheet software can be used to prepare a working trial balance, lead
schedules, financial statements, and to perform ratio analysis. Typically, a spreadsheet software is used
in an audit engagement as follows:
(1) Cash preparing cash lead schedules, and preparing bank reconciliations or proofs of cash.
(2) Receivables computing estimated bad debts expense, computing turnover ratios, preparing
confirmation requests, and preparing aging summaries.
(3) Inventory computing LIFO indexes and final balances, computing turnover ratios, tracing
inventory test counts to perpetual inventory records, and analyzing variances.
(4) Fixed assets computing depreciation, computing capitalized interests, and computing saleleaseback gain deferral.
(5) Investments determining portfolio valuation at the lower of costs or market, and obtaining market
prices at year end from public data sources.
Documentation Software
Database Management
(DBM) Systems Software, e.g.,
dBASE, FoxPro/Lan, and
DataEase.
Text Retrieval Software, e.g.,

Folio Views, Lotus Magellan,
ZyIndex, and Adobe Reader.
Description
(6) Liabilities computing warranty provisions, determining debt covenant compliance, and preparing
loan amortization schedules.
(7) Income taxes analyzing permanent and timing differences, reconciling pretax accounting and
taxable income, computing deferred taxes, and computing effective tax rate.
(8) Equity computing earnings per share, computing stock splits and preferred stock dividends, and
analyzing treasury stock.
DBM systems software can be used to store and analyze data in a relational structuring form across
several files. For example, an auditor may store and relate date in an accounts receivable file and a cash
receipts file to monitor collection of past due accounts. The DBM Systems Software can also be used in
analytical procedures, confirmation requests, sampling, monitoring audit hours charged, and global data
links for multinational clients.
Text Retrieval Software can be used to access and retrieve any electronically stored text such as the
FASBs Original Pronouncements and AICPAs Professional Standards, both of which are available on
CD-ROM. Similarly, such software can be used to retrieve on-line financial information from the SECs
EADGAR database. The auditor also uses the internet to retrieve information for understanding a
clients business and industry during the audit plan phase. For example, internet Explorer,
Communicator or Firefox can be used to access the website of a clients competitor for a company
overview, annual report, or product information.
Effect of Information Technology on Evidence

AU 500 Audit Evidence states that, Because of the growth in the use of computers and other information
technology, many entities process (transmit, maintain, or access) significant information electronically. When
evidence can be examined only in electronic form, there are commercially available windows-based software, for
example, ACL (Audit Command Language) and IDEA (Interactive Data Extraction and Analysis) software that can
be used to obtain copies of client databases or master-file and perform a variety of tests of the clients electronic
data. The software usually can be applied to a wide variety of clients with minimal customization. Table 10-4
summarizes the guidance of AU 500 on audit evident in electronic form.
Table 10-4 Auditing Electronic Evidential Matter
Electronic Evidential
Matter
Tests of Balances
Availability of
Information
Data Mining
The Auditor Should:

When a client transmits, processes, maintains, or accesses significant information in an electronic form,
AU 500 states that an auditor may determine that it is not practical or possible to achieve detection risk
(DR) at an acceptably low level by performing only TOB for one or more financial statement assertions. In
those cases, the auditor should perform TOC to gather evidence to support an assessed level of control risk
(CR) below the maximum level for the affected assertions. Evidence gathered from these TOC, in
conjunction with evidence provided by the performance of TOB, should be sufficient to support the
auditors opinion.
When information is available in electronic form, it may not be accessible after a specified period of time if
files are changed, unless backup files are created. The auditor should consider the time when information is
available in determining the nature, timing, and extent of TOC and TOB. Examples of such electronic
information include:
(1) EDI (Electronic Data Interchange) With EDI, a client and its customers/vendors (i.e., trading
partners) transact business electronically where purchasing, shipping, billing, cash receipt, and cash
disbursement functions are achieved through electronic exchanges, ordinarily without paper documents.
However, the electronic exchanges require translation software to convert transactions from the clients
internal format to a worldwide standard EDI format. The client may use either the Internet or WAN (Wide
Area Network) to transmit and exchange electronic data to trading partners instantaneously. See Figure 107 for an example of EDI.
(2) Image Processing With image processing systems, paper documents are scanned into electronic
images for electronic storage and retrieval. A client might only keep paper documents for a limited time
after this conversion.
Data mining is the discovery of previously unknown information from raw data. An example of a data
mining tool is the application of Benfords Law as an analytical procedure (recall Chapter 7). Such a data
mining tool allows the auditor to sift through large amount of data quickly, identify and analyze
questionable relationships, and discover fraud in a timely manner.
Effect of Information Technology on Internal Control

The use of information technology affects the classification of internal control into two categories:
1. General controls
265
266
Those controls that relate to all or many computerized accounting applications and often include control over the
development, modification, and maintenance of computer programs and control over the use of and changes to data
maintained on computer files. General controls also concern with off-site backup of hardware facilities in the case of
a power outage or disaster. A hot site backup is a service bureau that is a fully operational processing facility and is
promptly available to backup hardware facilities. On the other hand, a cold site backup is a shell facility suitable for
quick installation of computer equipment which would take some time to do so in the case of a power outage or
disaster. Finally, if an auditor anticipates assessing control risk at a relatively low level, the auditor will initially
focus on the general controls.
Some general controls that an auditor usually focuses on for potential fraud include:
a. The information technology environment regularly undergoes periods of internal re-organization.
b. The information technology division has an unusual alliance with a single computer supplier.
c. Financial and non-financial from the information technology division takes much longer to produce.
d. Employees promoted to manage senior level of the information technology division have no adequate
training/experience in internal controls.
e. Internal and external auditors are blocked from accessing the back-end system logs of the financial application by
the information technology division.
f. Staff of the information technology division password-protected and file-encrypted their My Documents folder on
their local hard drive or insist on taking key records home on USB sticks.
g. Executives of the information technology division demand 24/7 access to the companys electronic financial
systems, yet the system records indicate they have never used them.
2. Application controls
Those controls that relate to specific computerized accounting applications, i.e., input (e.g., check digit), processing
(e.g., parity check), and output controls (e.g., encryption) for a specific accounting application such an accounts
receivable application. There is usually a lot of interdependency of controls among computerized accounting
applications. Accordingly, an auditor usually focuses more on the general controls than application controls because
the latter is often dependent upon the former.
Effect of Information Technology on TOC Procedures
In fully computerized accounting systems, the nature of an auditors TOC procedures depend on whether audit
evidence generated by the computer is external to the computer (i.e., directly observable), or internal to the computer
(i.e., not directly observable). TOC procedures involving external, directly observable audit evidence usually take
the form of inquiries, observation, and inspection of documents. For example, for testing the general control of
segregation of computer department and users, the TOC procedures would include inquiries of computer
personnel, management, and operating employees; observation of actual operations; and inspection of documentary
evidence such as management reports and organization charts. In contrast, TOC procedures involving internal,
unobservable audit evidence require the auditor to use CAAT (Computer Assisted Audit Techniques) to obtain a
reasonable degree of assurance that controls are operating as planned. Table 10-5 provides brief comments on some
common CAATs.
Table 10-5 Brief Comments on Some Common CAATs
Common CAATs
Test Data
BCSE (Base Case

System Evaluation)
ITF (Integrated Test
Facility)
Parallel Simulation
Brief Comments
The auditor prepares a limited number of fictitious transactions (test data), some of which are valid and some
of which contain errors that should be detected by the controls the auditor wants to test. The auditor uses the
clients programs to process the test data and then examines the output (including error listing) to identify
controls that have been compromised. Test data provides no assurance that the programs tested are actually
used by the client.
BCSE is a special type of test data that the auditor uses to test every possible internal controls that are related
to a clients programs. BCSE would provide the auditor with greater assurance about the clients internal
controls than the test data would. However, it is more time-consuming and expensive to develop.
ITF is another type of test data that allows the auditor to test whether a client actually uses the programs that
the auditor tests. Unlike test data, which is run independent of client data, an ITF integrates the auditors
fictitious data file (e.g., a fictitious company file) with the clients actual data file allowing the auditor to
compare the clients output with the output expected by the auditor. When processed throughout the year, ITF
provides assurance that the programs tested are actually used to compile financial statements.
In Parallel Simulation, the auditor prepares programs to process the clients data on the clients computer. If
controls have been operating effectively, the clients programs should generate the same exceptions as the
auditors programs. Like test data, Parallel Simulation provides no assurance that the clients programs are
Common CAATs
EAM (Embedded Audit
Modules)
Audit Hooks and

Tagging
Brief Comments
actually used throughout the year to process all data.
EAM involves planting program code in the clients application program to collect audit evidence for the
auditor. For example, the auditor plants an accounts receivable confirmation program code (known as a
module) within a clients monthly billing program. When desired, the planted audit module is activated by the
auditor to select customer accounts for confirmation, and to print the confirmation requests. The EAM are
sometimes used to create what is referred to as SCARFs (Systems Control Audit Review Files), which are
computer logs that collect transaction information for review subsequently by the auditor.
Audit Hooks are exit points in a clients program that allow the auditor to modify the program by inserting
specific commands to accumulate data or manipulate data for audit purpose. The auditor sometime uses Audit
Hooks to accomplish Tagging, in which transactions are tagged (i.e., are specially marked) at the auditors
discretion. Then, as they are processed, additional documentation is generated so that the auditor can see how
the transactions are processed at various control points inside the computer system.
Effect of Information Technology on TOB Procedures

Large CPA firms use GAS (Generalized Audit Software) as TOB procedures when a client uses information
technology to process and store accounting data. GAS is a set of programs (i.e., software package) specifically
designed to perform certain data processing functions that are useful to the auditor. The two most widely used GAS
are ACL (Audit Command Language) software and IDEA (Interactive Data Extraction and Analysis) software that
can be used to obtain copies of client databases or master-file and perform a variety of TOB of the clients electronic
data. A primary advantage of using GAS to perform TOB procedures on a client is that the auditor may access
information stored on computer files while having a limited understanding of the clients hardware and software
features. Table 10-6 describes some basic features of the GAS as TOB procedures.
Table 10-6 Some Basic Features of GAS for TOB
Basic Features of GAS
Examining Records
Testing Computations
Comparing Data files
Analyzing Samples
Summarizing data
Comments on Using GAS as TOB Procedures

GAS can be used to examine accounting records for quality, completeness, consistency, and correctness. It
can be instructed to scan the records, store in a file, and print those that are exceptions to auditor-specified
criteria. Examples include:
(1) Examining accounts receivable balances for amounts that are over the credit limit.
(2) Examining inventory quantities for negative or unreasonably large balances.
(3) Examining payroll files for terminated employees.
(4) Examining bank demand deposit files for unusually large deposits or withdrawals.
GAS can be used to test the accuracy of mathematical computations and perform quantitative analyses to
evaluate the reasonableness of client representations. Examples include:
(1) Re-computing the extensions of inventory items, depreciation amounts, the accuracy of sales discounts,
and interests.
(2) Testing the accuracy of the net pay computations for employees.
Gas can be used to determine if identical information on separate files agrees. Example include:
(1) Comparing changes in accounts receivable balances between two dates with details of sales and cash
receipts on transaction files.
(2) Comparing payroll details with personnel records.
(3) Comparing current and prior-period inventory files to assist in locating obsolete or slow-moving
inventory.
GAS can be used to select statistical samples, print the sample items for the auditors working papers or on
special confirmation forms (e.g., accounts receivable confirmation requests), and when the results are know
(e.g., when the accounts receivable confirmations are returned), analyze the data statistically. Examples
include:
(1) Select and print accounts receivable confirmations.
(2) Select inventory items for observation.
(3) Select fixed asset additions for vouching.
GAS can be used to summarize, reformat and aggregate data in a variety of ways. Examples include:
(1) Re-footing account files.
(2) Testing accounts receivable aging.
(3) Preparing general ledger trial balances.
(4) Summarizing inventory turnover statistics for obsolescence analysis.
(5) Re-sequencing inventory items by location to facilitate physical observations.
Effect of Special Systems on TOC and TOB

Special accounting information systems affect the auditors TOC and TOB. Table 10-7 provides brief comments on
some special systems and their effect on TOC and TOB.
267
268
Table 10-7 Effect of Special Systems on TOC and TOB
Special Systems
OLRT (On-line Real-time) System

In an OLRT system, transactions are processed and files updated as
transactions occur. The transactions are processed fast enough to get
the response back in time to influence the process. Examples of OLRT
systems include:
(1) Airline reservations systems in which the customer receives the
reservations confirmation almost instantaneously.
(2) POS (Point-Of-Sales) terminals in retail stores where a customers
credit limit is checked while the customer waits for approval.
Distributed Systems
Distributed systems are a network of remote computer sites consisting
of smaller computers (known as computer nodes) that are connected to
a main computer system in a variety of system configurations.
Examples of Distributed Systems include:
(1) National rental car companies that use Distributed Systems to track
the customers renting, dropping off, and payment of a rental car at
different locations throughout the country.
(2) International hotel chains that use Distributed System to do on-line
reservations, receiving payments, and remitting receipts from all over
the world to the hotels head-office.
Service Bureau (Service Center)

A service bureau provides EDP services to its clients for a fee.
Processing of client data occurs at the service bureau and the clients
computerized master files are usually maintained at the bureau. An
example of a service bureau is a payroll service center that processes
monthly payroll for its client.
LANs (Local Area Networks) and WANs (Wide Area

Networks)
LANs link equipment within a single or small cluster of buildings and
are used only for intra-company computing purposes. WANs link
equipment in larger geographic regions, including global operations. In
LANS and WANs, the application software and data files used to
process transactions reside on servers. Access to the application from
workstations is managed by network server software.
E-commerce System
E-commerce System links a companys internal computer accounting
systems to external computer accounting systems of outside parties,
such as customers and suppliers. Business transactions, such as EDI
transactions, are electronically conducted among the internal and
external computer accounting systems using either the WANs or the
Internet. The cost of transmitting and processing EDI transactions
using the Internet is usually less than that using the WAN.
EDI- A simplest form of E-Commerce System
A simplest form of E-Commerce System is EDI, which can be defined
as an exchange of business documents between economic trading
partners, computer to computer, in a standard format. The documents
are received, validated, and accepted into the job stream of the
receiving computer, and immediately processed if so desired. Because
EDI is computer-to-computer communication, organization must
decide if they should have direct linkages with specific trading
partners, or if they will be linked by an intermediary. The
intermediary, which serves as an electronic mail service, is referred to
as a VAN (value-added network) An example of EDI is shown in
Figure 10-7.
Effect on TOC and TOB

Because of the technical complexity of OLRT systems, the auditor
must have higher technical expertise to perform the TOC and TOB.
The auditor must also exercise care not to disrupt the system which is
perpetually on-line and real-time processing. CAATs such as test data,
ITF, and Tagging may be used to perform the TOC. GAS may be used
to perform TOB on the data files.
Because of the smaller computers (nodes) are in a vast different

geographical locations, the auditor must perform TOC and TOB for
each of these computer nodes separately. A primary concern of the
auditor is adequate control over access at each of the computer nodes.
EAM is commonly used to perform TOC across all or selected
numbers of the computer nodes. IDEA is commonly used to perform
TOB on the nodes and their links to the main computer.
The auditor may visit the clients service bureau to observe the internal
control. The service bureau must have effective internal control to
protect the clients data. Moreover, it must have adequate
reconstruction (back-up) procedures in case the audit clients data are
destroyed or deleted accidentally. It is increasingly common to have
one independent auditor obtain an understanding and perform TOC
and TOB of the service bureau for use by all the bureaus customers
and their independent auditors.
Before performing TOC and TOB on LANs and WANs, the auditor
must have a good knowledge of the network configuration, including
the location of servers, workstations, and computer links to one
another, and knowledge of network software used to manage the
system. The auditor must also have detail knowledge about controls
over access and changes to application programs and data files located
on the servers.
The auditors TOC and TOB on E-commerce System focus on:

(1) Providing assurance about the reliability of the internal and
external accounting systems, such as the WebTrust and SysTrust
assurance services provided by the auditor.
(2) Preventing exposure of sensitive data, programs, and hardware to
potential interception or sabotage by external parties, such as creating
Firewall to control the flow of e-commerce communication or use
Encryption to protect the security of e-commerce communication.
(3) Verifying the authenticity of external computer accounting
systems, such as the use of Digital Signature where a trusted
certification authority issues a digital certificate to individuals and
companies engaging in e-commerce.
The auditors risk assessments of TOC and TOB on E-commerce
System focus on:
(1) Security of system and protection against malicious intrusion or
penetration by outsiders.
(2) Integrity and completeness of processing.
(3) Integrity of data communications.
(4) Trading partner agreements.
(5) Systems interdependences.
(6) Paperless systems resulted in soft controls.
Figure 10-7 An example of EDI A Simplest Form of E-Commerce System
A Company
(Automated, Paperless)
B Company
(Trading Partner)
Automated Accounting
Information System
Automated Accounting
Information System
Purchase Order
Vendor Invoice
Sales Order
Internet/
WAN
Translation
Software
Value
Added
Network
Internet/
WAN
Translation
Software
Sales Invoice
VAN
Receiving Report
Shipping
Document
Electronic Funds
Transfer
Electronic Funds
Transfer
For example, A Company wishes to place an order with B Company, a purchase order is generated and translated into a format that can be read
by every company that uses EDI. In the United States, the agreed-upon format is referred to as ANSI.X12. It is a standard agreed upon by the
American National Standards Institute (ANSI). Once the purchase order is in the standard format, it is communicated to the VAN, which stores
the message in a mailbox. B Company periodically polls the VAN to determine if it has any messages. It reads the purchase order from A
Company, determines if it can meet the order at the requested time, price, and location, and sends an electronic acknowledgement back to A
Companys mailbox. Subsequently, B Company generates a sales order, sales invoice, and shipping document and transmits them to A Company
all without generating paper documents. When A Company receives goods, most likely they will contain a bar code that is read by an electronic
scanner and transmitted directly into A Companys accounts payable system. The accounts payable system matches the purchase order, receiving
report, and vendor invoice for discrepancies. If they are no discrepancies, it generates an order to electronically transfer the appropriate amount of
funds to B Company. If they are discrepancies, an exception report is generated and sent to a supervisor for investigation.
Effect of Information Technology on Audit Report

Many audit clients provide access to financial information through their home Web page on the Internet. Visitors to
a clients Web site can view the companys most recent audited financial statements, including the auditors report.
In addition, it is common for the client to include such information as unaudited quarterly financial statements, other
selected financial information, and press releases that are often labeled as About the Company or Investor
Relations on its Web site. Under current AICPA and PCAOBs auditing standards, the auditor has no obligation to
perform any procedures to test financial information published on the clients Web site. Also, the auditor is not
required to read financial information published on the Internet, including the audited financial statements on the
clients home Web page. Auditing standards note that electron sites; specifically, a Web page containing financial
information is a means of distributing information and are not considered documents, as that term is used in
auditing standards.
269
270
10-1
The auditor looks for an indication on duplicate sales invoices to see whether the invoices have been verified. This is an
example of
a. test of details of balances
b. a test of control.
c. a substantive test of transactions
d. both a test of control and a substantive test of transactions.
10-2
Analytical procedures may be classified as being primarily

a. tests of controls.
b. tests of balances.
c. tests of ratios.
d. compliance tests of transactions.
10-3
To support the auditors initial assessment of control risk below maximum, the auditor performs procedures to determine that internal
controls are operating effectively. Which of the following audit procedures is the auditor performing?
a. Tests of details of balances.
b. Substantive tests of transactions
c. Tests of controls.
d. Tests of trends and ratios.
10-4
The auditor faces a risk that the audit will not detect material misstatements that occur in the accounting process. To minimize this
risk, the auditor relies primarily on
a. tests of balances.
b. tests of controls.
c. internal control.
d. statistical analysis.
10-5
The sequence of steps in gathering evidence as the basis of the auditors opinion is:
a. substantive tests, assessment of control risk, an tests of controls.
b. assessment of control risk, substantive tests, and tests of controls.
c. assessment of control risk, tests of controls, and substantive tests.
d. tests of controls, assessment of control risk, and substantive tests.
10-6
Which of the following ultimately determines the specific audit procedures necessary to provide an independent auditor
with a reasonable basis for the expression of an opinion?
a. The audit program.
b. The auditors judgment.
c. Generally accepted auditing standards.
d. The auditors working papers.
10-7
If the results of the tests of controls are not consistent with the auditors expectations, the tests of balances will be
a. decrease
b. increase
c. unaffected
d. changed.
10-8
Tests to determine whether the accounting transactions have been properly authorized, correctly recorded and summarized
in the journals, and correctly posted to subsidiary ledgers and the general ledger are
a. tests of controls.
b. substantive tests of transactions.
c. substantive tests of balances.
d. analytical procedures.
10-9
Which of the following statements is false?

a. Analytical procedures emphasize the overall reasonableness of transactions and the general ledger balance.
b. Substantive tests of transactions emphasize the verification of transactions recorded in the journals and then posted in the
general ledger.
c. Tests of controls are concerned with evaluating whether controls are sufficiently effective to justify reducing control risk
and thereby reducing analytical procedures.
d. Tests of balances emphasize the ending balances in the general ledger.
10-10
Which of the following audit tests is usually the most costly to perform?
a. Analytical procedures.
b. Tests of controls.
c. Tests of balances.
d. Substantive tests of transactions.
10-11
Which of the following is considered a component of a local area network (LAN) ?

a. Program flowchart.
b. Key verification.
c. Transmission media.
d. Input routine.
10-12
Which of the following best represents an additional cost of transmitting business transactions by means of electronic data
interchange (EDI) rather than in a traditional paper business environment?
a. Translation software is needed to convert transactions from the clients internal format to a standard EDI format.
b. Internal audit work is needed because of the potential for random data entry errors in an EDI system.
c. More supervisory personnel are needed because the amount of data entry is greater in an EDI system.
d. Redundant data checks are needed to verify that individual EDI transactions are not recorded twice.
10-13
Many audit clients use the Internet as a network to transmit EDI transactions. An advantage of using the Internet to
transmit EDI transactions rather than a traditional WAN (Wide Area Network) is the Internet
a. permits EDI transactions to be sent to trading partners as transactions occur.
b. automatically batches EDI transactions to trading partners.
c. possesses superior characteristics regarding disaster recovery.
d. converts EDI transactions to a standard format without translation software.
10-14
Which of the following would an auditor ordinarily consider the greatest risk regarding a clients use of EDI?
a. Authorization of EDI transactions.
b. Duplication of EDI transactions.
c. Improper distribution of EDI transactions.
d. Elimination of paper documents.
10-15
Which of the following is true when a client use EDI to conduct E-commerce?
a. The cost of sending EDI transactions using a WAN (Wide Area Network) is less than the cost of using the Internet.
b. Software maintenance contracts are unnecessary because translation software for EDI transactions need not be updated.
c. EDI transactions are formatted using strict standards that have been agreed to worldwide.
d. EDI commerce is ordinarily conducted without establishing legally binding contracts between trading partners.
10-16
Which of the following control procedures most likely could prevent EDP personnel from modifying programs to bypass
programmed controls?
a. Periodic management review of computer using reports and systems documentation.
b. Segregation of duties within EDP for computer programming and computer operations.
c. Participation of user department personnel in designing and approving new systems.
d. Physical security of EDP facilities in limiting access to EDP equipment.
10-17
An auditor anticipates assessing control risk (CR) at a low level in a computerized accounting information system. On
which of the following procedures should the auditor initially focus?
a. Programmed control procedures.
b. Application control procedures.
c. Output control procedures.
d. General control procedures.
271
272
10-18
An auditor would most concern with which of the following controls in a special Distributed System?
a. Hardware controls.
b. System documentation controls.
c. Access controls.
d. Disaster recovery controls.
10-19
Which of the following input controls is a numeric value computed to provide assurance that the original value had not
been altered in construction or transmission?
a. Hash total.
b. Parity check.
c. Check digit.
d. Encryption.
10-20
When an auditor tests a computerized accounting information system, which of the following is true of the test data
procedure?
a. Test data are processed by the clients computer programs under the auditors control.
b. Test data must consist of all possible valid and invalid conditions.
c. Several transactions of each type must be tested.
d. The program tested is different from the program used throughout the year by the client.
10-21
When an auditor creates a fictitious company within the clients actual data files, the auditor is using which of the
following CAATs?
a. Parallel Simulation.
b. ITF.
c. GAS.
d. EAM.
10-22
A primary advantage of using generalized audit software (GAS) to audit a clients computerized accounting information
system is that the auditor may
a. consider increasing the use of TOB procedures instead of analytical procedures.
b. substantiate the accuracy of data through self-checking digits and hash totals.
c. access information stored on computer files while having a limited understanding of the clients EDP system.
d. reduce the level of required tests of controls to a relatively small amount.
10-23
As the acceptable level of detection risk increases, an auditor may change the
a. assessed level of control risk from below the maximum to the maximum level.
b. assurance provided by TOC by using a larger sample size than planned.
c. timing of TOB from year-end to an interim audit date.
d. nature of substantive tests from a less effective to a more effective procedure.
10-24
Which of the following TOB procedure is least likely to be performed before the balance sheet date?
a. Observation of inventory.
b. Testing bank reconciliation.
c. Search for unrecorded liabilities.
d. Confirmation of receivables.
10-25
Which of the following computer-assisted auditing techniques (CAATs) allows fictitious and real transactions to be
processed together without the knowledge of client operating personnel?
a. Integrated test facility (ITF).
b. Input controls matrix.
c. Parallel simulation.
d. Data entry monitor.
10-26
Processing data through the use of fictitious data files provides an auditor with information about the operating
effectiveness of controls. One of the techniques involved in this approach makes use of
a. controlled reprocessing.
b. an integrated test facility.
c. input validation.
d. program code checking.
10-27
Which of the following statements is not true of the test data approach to testing an accounting system?
a. Test data are processed by the clients computer programs under the auditors control.
b. The test data need consist of only those valid and invalid conditions that interest the auditor.
c. Only one transaction of each valid and invalid condition need be tested.
d. The test data must consist of all possible valid and invalid conditions.
10-28
An auditor most likely would test for the presence of unauthorized computer program changes by running a
a. test data.
b. ITF.
c. parallel simulation.
d. audit hooks and tagging.
10-29
To obtain evidence that user identification and password controls are functioning as designed, an auditor would most likely
a. review the online transaction log to ascertain whether employees using passwords have access to data files and computer
programs.
b. examine a sample of assigned passwords and access authority to determine whether password holders have access
authority incompatible with their other responsibilities.
c. extract a random sample of processed transactions and endure that transactions are appropriately authorized.
d. observe the file librarians activities to discover whether other systems personnel are permitted to operate computer
equipment without restriction.
10-30
An auditor anticipates assessing control risk at a low level in a computerized environment. Under these circumstances, on
which of the following procedures would the auditor initially focus?
a. Programmed controls.
b. Application controls.
c. Output controls.
d. General controls.
10-31
To obtain evidence that online access controls are properly functioning, an auditor most likely would
a. create checkpoints at periodic intervals after live data processing to test for unauthorized use of the system.
b. examine the transaction log to discover whether any transactions were lost or entered twice because of a system
malfunction.
c. enter invalid identification numbers or passwords to ascertain whether the system rejects them.
d. vouch a random sample of processed transactions to assure proper authorization.
10-32
Which of the following controls most likely could prevent computer personnel from modifying programs to by pass
programmed controls?
a. Periodic management review of computer utilization reports and systems documentation.
b. Segregation of duties for computer programming and computer operations.
c. Participation of user department personnel in designing and approving new systems.
d. Physical security of computer facilities in limiting access to computer equipment.
10-33
For control purposes, which of the following should be organizationally separated from the computer operations function?
a. Data conversion.
b. Surveillance of email messages.
c. Computer system development.
d. Minor maintenance according to a schedule.
273
274
10-34
An auditor should design the written audit program so that

a. all material transactions will be selected for substantive testing.
b. substantive tests prior to the balance sheet date will be minimized.
c. the audit procedures selected will achieve specific audit objectives.
d. each account balance will be tested under either tests of controls or tests of transactions.
10-35
An audit program should be designed so that

a. most of the required procedures can be performed as interim work.
b. inherent risk is assessed at a sufficiently low level.
c. the auditor can make constructive suggestions to management.
d. the audit evidence gathered supports the auditors conclusions.
10-36
In designing an audit program, an auditor should establish specific audit objectives that relate primarily to the
a. timing of audit procedures.
b. cost-benefit of gathering evidence.
c. selected audit techniques.
d. financial statement assertions.
10-37
Ordinarily, an audit program cannot be finalized (i.e., the nature, timing, and extent of audit tests cannot be determined)
until the
a. understanding of internal control and assessment of control risk have been completed.
b. engagement letter has been signed by the auditor and the client.
c. material weaknesses have been communicated to those charged with governance.
d. search for unrecorded liabilities has been performed and documented.
10-38
In an E-commerce System, a purchasing company with just-in-time inventory systems specified its shipping requirements to a supplier
company. The shipments are loaded directly into production with no inspection or counting. Which of the following best describes the
auditors risk assessments for TOC and TOB on this feature of the E-commerce System?
a. Integrity of data communication.
b. Paperless systems resulted in soft control.
c. Trading partner agreements.
d. Integrity and completeness of processing.

10-1 b. 10-2 b. 10-3 c. 10-4 a. 10-5 c. 10-6 b. 10-7 d. 10-8 b. 10-9 c. 10-10 c. 10-11c.
10-12 a. 10-13 a. 10-14 c. 10-15 c. 10-16 b. 10-17 d. 10-18 c. 10-19 c. 10-20 a. 10-21 b.
10-22 c. 10-23 c. 10-24 c. 10-25 a. 10-26 b. 10-27 d. 10-28 c. 10-29 b. 10-30 d. 10-31 c.
10-32 b. 10-33 c. 10-34 c. 10-35 d. 10-36 d. 10-37 a. 10-38 b.

Simulation Question 10-1 is an adaptation with permission from a case by Splettstoesser, I. B. in the Issues in Accounting Education, a
Overview
Information Systems and Business Processes
Accounting Systems
Marthra Tool, Inc. (hereafter MTI) is owned by George Mathra, an experienced machinist. George established the business over 20
years ago, and it has grown into a $10-million-a-year business, with an excellent reputation for high-quality machined parts. MTI has clients in
the automobile sector and the health-care sector and has recently begun producing parts for environmentally friendly products, such as recycling
containers, due to the businesss versatility in dealing with a variety of metals as well as plastics.
MTI has a broad range of equipment, ranging from grinders, stampers, cutters and small presses to numerically controlled machiningand-turning centers, some of which individually cost over $250,000. This latter group of equipment is tied into the companys computer-aided
design and manufacturing (CAD/CAM) system used by the four senior tool and die personnel.
Machining-and-turning center suppliers have helped MTI develop efficient operations, by furnishing sample numerical control
programs for standard machine operations and by providing training to employees. One of the suppliers unfortunately sent sample programs that
had been infected with a virus. Georges daughter, Tiffany, had to cleanse the servers and each of the machines, using her copy of an anti-virus
software. When contacted, the supplier did not know that his software was infected and apologized profusely.
The four CAD/CAM terminals and printers are connected to the companys local area network (LAN), which is maintained by Tony
Lee, the owner of a computer shop conveniently located three blocks away. All computer equipment, software and supplies are purchased from
Mr. Lee, who is responsible for attaching and maintaining equipment, upgrading software and maintaining user security profiles on the network.
There is one user identification and password for accounting (shared by Tiffany, George and the accounting clerk). Each of the plan supervisors
has individual password, and a common password is used to initiate the timekeeping system. The two word processing staff members have their
own password and use the common accounting password when they need to do data entry.
A standard routine has been set up to back up the accounting systems. One of the accounting staff inserts one of seven tape cartridges
into the system at the end of the day (they are labeled with the day of the week) so that the company has a full set of backups for the week.
Tiffany keeps these in her office. These are particularly important, since during the last office move, two years ago, the original disks for the
accounting system were misplaced.
Tiffany, Georges youngest daughter, has been working in the business for 15 years. She started as a machine operator and has
finished several college diplomas in numeric control and in accounting over the years. She is being groomed to take over the business in two
years and is proving herself competent both on the shop floor and in administration. She works along with the tool and die machinists and the
shop supervisors in discussing design problems, quality control methods, and costing of quotes for potential orders.
Every Wednesday morning at 7:00 AM, Tiffany and George hold a meeting with the supervisors (one purchasing, three production,
one design, one quality control) to maintain a good working relationship and to review any problems that need to be addressed in the coming
week. This includes any potential scheduling changes required due to rush jobs that have been accepted or are being quoted.
This good working relationship is extremely important for satisfying some of the companys larger customers. MTI has paid for
computer for each of the supervisors, so that they have fully functioning microcomputers at home. If a rush job requires weekend work, then
these senior personnel can work at home to get the necessary quoting or design work completed. Since the at home systems are identical with
the office systems (Mr. Lee simply copied the image from the MTI systems to the home computer hard drives), diskettes can easily be taken
home and then brought back to the office. It is understood that when work slows down, a day off can be taken to compensate for this weekend
work.
Almost ten years ago, Tiffany arranged for the implementation of the network, and the purchase of a standard integrated accounting
package (general ledger, order entry/accounts receivable, purchases/payable, payroll), and for the purchase of the job-costing and timekeeping
system. The job-costing package is used to prepare and print quotes. For automotive customers, the quote is entered into the stand-alone EDI
system for transmission. Customer purchase orders received via EDI are simply printed and filed. Once a quote has been accepted, the job is
given a unique job number. The job control sheets include a list of the machining center, labor and quality control tasks, each with a unique
optical scanning label used by the employees to sign in and sign out of particular tasks by machine type and by operation. Standard control
sheets are also used for overhead tasks, such as cleaning or machine setup. Employees have plastic cards with their employee number and the
operation label for each activity, as it is commenced or completed. To sign out, they simply scan their employee card again.
A variety of reports are printed daily, weekly, or monthly from the costing system; these are used for monitoring employee hours, the
status of jobs, the costs accumulated for particular jobs and the work-in-progress inventory. The weekly report of hours from the costing system is
approved by the production supervisors and is used as a data entry input source into the payroll system for hours worked. The accounting clerk
enters the hours into the accounting system, so that weekly payroll checks and reports can be produced. When volume is high, one of the
administrative staff also do filing or document matching.
Tiffany is really pleased with her accounting clerk, Isabel, who has been with the company for three years. She insists that fate had a
hand in getting Isabel for MTI. Isabel was pounding the pavement, having recently immigrated, and had no local business experience. Her
accounting skills were rudimentary, but she quickly learned the accounting software and has reorganized the filing system. Tiffany considers her
indispensable. When Isabel goes on vacation, many things simply dont get done. Tiffany can do the payroll in a pinch, but Isabel always does
accounts payable and cash disbursements. If she is away, suppliers are simply told to wait, or Tiffany issues a manual check, which is recorded
later. Isabel is very good at responding to queries from suppliers and ensuring that new suppliers are set up properly. The purchasing supervisor
and his staff rely on Isabel, for she checks the account allocation of purchases and makes any necessary corrections. Isabel also ensures that
necessary EDI acknowledgments are sent and reports printed.
Tiffany and George are signing officers, although Tiffany realizes that she checks supporting materials more thoroughly than George,
who usually just queries Isabel verbally about larger purchases. George normally handles the bank deposits, while Tiffany does the monthly bank
reconciliation. Every three months, an accountant from Moss Adams CPA firm (MTIs auditor) reviews the regulatory returns for reasonableness,
as well as journal entries made in the last three months. He updates the recurring journal entries and advises Tiffany of any changes in procedures
275
276
or modifications to monthly journal entries that are required to help ensure accuracy and completeness of transaction processing. Tiffany runs the
standard financial statements every month from the accounting package, but normally some additional adjustments are required when the
accountant comes in. These are adjustments to depreciation expenses, changes to prepaid expenses and some account reallocation (e.g., repairs
and maintenance to capital accounts) based on discussions with Tiffany. The regular accountant assigned to MTI is Louis Jaborwock, who has
just completed the most recent month-end entries.
Louis informed Mark that MTI had a problem with one of their systems on Friday. Apparently, one of the servers might have
crashed. Luckily, this was the server with the accounting systems and was fully backed up on tape. A new server was to be installed the next
day, and Mr. Lee was reconfiguring the network so that the remaining systems could function from the single server.
Work-in-Progress Inventory
Ezen Momota, the engagement partner from Moss Adams believes that MTIs growth may have expanded the company sufficiently to
warrant increased levels of controls reliance during the audit. She is particularly interested in work-in-progress (WIP) inventory, the largest item
on the balance sheet; typically close to three months sales. She has requested an updated controls analysis and that computer-assisted audit
techniques (CAATs) using the firms generalized audit software be considered. To this end, Mark Green, the in-charge audit manager, has
updated the narrative description associated with WIP inventory.
To calculate the WIP inventory for any particular month, one of the purchasing staff transfers data from a report in the job-costing
system into a spreadsheet (Exhibit 1). Since the job-costing system does not have sales information, progress billings are added manually, and the
spreadsheet total is used for the monthly financial statements work-in-progress figure.
You should access Data File 10-1 in iLearn for Spreadsheet 1, which shows a portion of the work-in-process accounting spreadsheet.
The purchasing staff has explained the contents of her spreadsheet and described the origin of the information. Following is an
explanation of the spreadsheet on a column-by-column basis:
Job Number : A unique job number is assigned by one of the production supervisors. There is a manual log in the production area, and the
supervisors write down the customer, purchase order number and the job numbers used. Where a purchase order lists multiple parts, a different
job number must be used for each part produced.
Customer Code: Each customer has a unique customer code. Tiffany assigns these codes, so that the same code can be used in the accounting
system and in the job-costing system.
Customer Purchase Order Number : These match the purchase orders received from customers.
Due Date and Scheduled Completion Date : The customer purchase order will indicate the date that an order is due. The production supervisors
will schedule the job so that it is completed prior to the due date.
Customer Part Number and Part Description : MTI always uses the part numbers of its customers and the customer description when describing
parts being produced. These must match customer purchase orders.
Quantity Ordered : The quantity ordered on the purchase order is entered into the job-costing system.
Quantity on Hand: The quantity on hand is based upon the figures in the job-costing system. This is initiated with the first operation. For
example, if component parts are purchased and then additional work is done on a component part, then the quantity on hand is based upon the
parts purchased. If raw material is purchased and cut on the premises, then the person who completes the first operation notes the quantity cut, for
subsequent entry by the production supervisor. Any damaged parts that cannot be passed on to the next operation are reported to the quality
control staff, who enters the part into the system as damaged, thereby reducing the quantity on hand. All data entry is accomplished using the
common job-costing password. Such entries will show ion a damaged-parts report, which is discussed every Wednesday at the supervisors
meeting.
Percentage Complete: Each operation on the job control sheet is assigned a percentage of the job. The system tracks which operations have been
completed and reports the percentage completed based upon the last operation that has been fully completed for all the parts.
Quoted Costs (Labor Center, Materials, and Total ): These costs are all listed at a rate-per-individual-unit part. Labor center rates are based upon
standard rates that have been developed by George and Tiffany. They include the labor rate of the employee multiplied by a factor, depending
upon the machine used. The factor incorporates both plant overhead charges plus machine charges. The lowest factor is 2.5, the highest 23. Thus,
an employee earning $10 per hour would result in a labor center cost at the lowest factor of $25 per hour and $230 per hour at the highest factor.
Material cost is based upon quotes from suppliers, plus a markup. Some customers have a fixed arrangement with the markup as low as 5 percent,
while others are marked up as much as 150 percent. During the last year, the company has changed its costing and overhead allocation methods to
absorption costing, based upon Moss Adams, the CPA firms advice. MTI reduced its labor center factors by 10 percent and added a flat materials
handling charge ($50) and ordering charge ($25) to each of its quotes.
Actual Cost-to-Date: As work is completed and supplier invoices are received, these costs are entered into the job-costing system. Actual hours
worked on an operation may be higher or lower than quoted. The hours worked are automatically posted using the timekeeping system. The
production supervisors review each daily printout of hours worked, to ensure that employees have properly clocked out. Production supervisors
must approve any job-cost system adjustments, which are entered by one of the purchasing staff. As supplier invoices are received, they are
recorded into the job-costing system by the purchasing staff and then forwarded to Isabel for entry into the accounts payable system.
Sales Price: This is the price that the customer has agreed to pay, according to the purchase order.
Progress Billings: Normally, MTI does not request advance payments or progress billings. However, if a customer is new or a part requires a
substantial material purchase, an advance payment is requested to cover the cost of the material. MTI then considers this material as already
owned by the customer and deducts this progress billing from the cost of its WIP.
Work-in-Progress Inventory Value: Isabel updated the spreadsheet template this year, applying a formula to calculate inventory as follows:
([quantity on hand] x [percentage complete/100] x [actual cost to date]) [progress billings]. She reviews the inventory list prepared by
purchasing for one of two necessary adjustments. First, if a job has not been started it will show as zero percentage complete. Sometimes, parts
have been ordered on a subcontract basis and been placed into production. Then, the WIP value must be increased from zero to the value of these
parts. Second, if a job has an overrun and the actual costs exceed the sales price, then the value of the inventory must be reduced so that it does
not exceed the sales price. Isabel makes these changes by manually scanning the inventory listing and changing the inventory value for these
items.
Required
Ezen Momota, the engagement partner has requested a meeting tomorrow to discuss engagement planning for MTI. To prepare for that meeting,
she has requested you to provide a description of specific computer-assisted audit tests that could be conducted for the WIP inventory using
generalized audit software. These generalized audit software tests should cover the following areas: (Some test descriptions are provided to help
you complete the rest)
1. Tests of Mechanical Accuracy/Data Entry Accuracy
a. On the Control Total:
Recalculate the extended value of inventory as defined by the client: ([quantity on hand] x [percentage complete/100] x [actual cost to date])
[progress billings]. Investigate errors for possible causes.
b. Formula for WIP Calculation:
c. Duplicate Job Numbers:
d. Duplicate Part Numbers:
2. Classification Tests
a. Percentage Complete Equal to 100:
Such goods would likely be finished goods and should be reclassified on the financial statements. Investigate these goods to determine whether
any additional operations, such as subcontracted plating, are requires. If the latter is the case, they are appropriately considered WIP.
b. Percentage Complete Equal to 0:
3. Valuation Tests
a. Net Realizable Value:
Calculate gross margin, both as a dollar amount and as a percentage. Provide a listing of all products with unreasonably low gross margins based
upon the percentage complete. Depending upon the perception of average gross margins in this industry, unreasonably low could be anything
less than 20 percent.
b. Sales Pricing Against Costs:
c. Sales Pricing Against Quotes:
d. Total Costs Against Material Costs:
e. Pricing:
4. Obsolescence Tests
a. Due Dates Against Production Schedule:
To determine whether goods in inventory will be sold, look at due dates and scheduled completion dates. Print a list of all items that have a
scheduled completion date later than the due date. These could represent data entry errors or items where the company has missed a due date and
could be liable for penalties or may be unable to sell its goods.
b. Due Dates and Cut-off:

Simulation Question 10-2 is developed by F. Choo in Financial and Integrated Audits, a publication of the CSU AcademicPub in San Francisco,
California. This simulation question is based upon a true set of facts; however, the names and places have been changed.
Information Technology and Internal Control at EA Inc.
The information systems (IS) department at Electronic Arts Inc. (hereafter, EA) consists of eight employees, including the IS manager,
Golden Warrior. Golden is responsible for the day-to-day oversight of the IS function and reports to EAs chief operating officer (COO). The
COO is a senior vice president responsible for the overall retail operations. The COO reports directly to the president and chief executive officer.
The COO attends board of director meetings to provide an update of key operating performance issues. Because Golden takes an active role in
managing the IS department, the COO rarely discusses IS issues with the board or CEO. Golden and the COO identify hardware and software
needs and are authorized to approve those purchase.
In addition to Golden, the IS department is composed of seven other individuals: three programmers, three operators, and one-data
control clerk. Golden has been employed by EA for 12 years, working her way up through various positions in the department. Fortunately, she
has been able to retain a fairly stable staff and has experienced minimal turnover. All IS personnel have been employed in their current positions
since mid-2006. When hiring personnel, Golden does extensive background checks on prospective employees, including reference, credit, and
criminal checks. Golden has developed a trust with each employee and, as a result, delegates extensively to each individual. This is especially
beneficial because Golden spends most of her time working with user departments in a systems analyst role, identifying changes needed to
existing applications. She conducts weekly IS departmental meetings on Tuesday mornings. Each staff member attends, including night
operators, to discuss issues affecting the performance of the department.
The three programmers are responsible for maintaining and updating systems and application software. The lead programmer is
responsible for assigning duties among the programming staff. All three programmers have extensive experience with the operating, utility,
security, and library software as well as all of EAs application software packages. Programming assignments are made based on who is least
busy among the programming staff at the time. This method of management keeps all programmers familiar with most software packages in use
at EA and keeps programmers excited about the job tasks because of the variety of assignments they receive. Golden encourages each
programmer to take continuing education courses to keep current with the latest technical developments. In addition to programming
responsibilities, the programming staff maintains the library of programs and data tapes, which is located in a locked room nearby. The
programming staff maintains extensive logs of tape use and of changes made to program files.
The three operators consist of a day operator and two night operators. Most of the applications are based on online inputting from various
user departments for batch processing overnight. Thus, the heaviest volume of processing occurs during the night shift, although there is some
daytime processing of payroll and general ledger applications. All operators are responsible for monitoring the operation of the equipment and
correcting system-caused errors. In addition, when a small change is identified for an application program, Golden asks the day shift operator to
implement that change to avoid overburdening the programming staff. Operators follow the production schedule prepared by Golden, who
consults with user departments to develop the schedule. The day shift operator reviews the job processed log generated at the end of the previous
277
278
day shift for deviations from the schedule. If jobs processed reconcile to the job schedule, the job processed log is discarded. When there are
deviations, the operator doing the review leaves a copy for Golden, highlighting the deviation. Before doing batch processing jobs, the operators
generate an input listing report that summarizes the number of online input entries submitted during the day for processing. This number is
recorded and then later compared by the operators with the computer output generated after batch processing and file updating occur. This
provides a check figure of the number of transactions processed. When the numbers agree, the output is submitted to the data control clerk.
When the number disagrees, the operators identify the error and resubmit the application for processing.
The data control clerk collates all computer output, including output reports and exception listings. The data control clerk reviews
exception reports and prepares correction forms for reprocessing. Examples of changes that the data control clerk might make include correcting
inputting errors (that is, amounts accidentally transposed) and preparing change request forms for changes to existing master files (that is,
revising sales price lists and inventory product numbers in the sales master file and adding new employee names, addresses, and social security
numbers to the payroll master file). After all corrections are made, the data control clerk distributes all computer output to the various user
departments. User departments have high regard for the IS staff. Output reports are reconciled to input reports by users on a test basis quarterly.
Required
You are the senior auditor assigned to the audit of EA. The audit partner has asked you to assist in doing the IS internal controls review. The
partner has asked you to review the above narrative information and write him a memo that addresses the following issues:
1. a. What is your assessment of the control strength of the lines of reporting from IS to senior management?
b. What is your assessment of the control deficiencies of the lines of reporting from IS to senior management?
c. For control deficiencies assessed in 1b., provide recommendations that can be included in the management letter (also known as
clients advisory comments letter).
2. a. What is your assessment of the control strength of Golden Warrior fulfilling her IS management responsibilities?
b. What is your assessment of the control deficiencies of Golden Warrior fulfilling her IS management responsibilities?
c. For control deficiencies assessed in 2b., provide recommendations that can be included in the management letter.
3. a. What is your assessment of the control strength of the programming function at EA?
b. What is your assessment of the control deficiencies of the programming function at EA?
c. For control deficiencies assessed in 3 b., provide recommendations that can be included in the management letter.
4. a. What is your assessment of the control strength of the IS operations function at EA?
b. What is your assessment of the control deficiencies of the IS operations function at EA?
5. a. What is your assessment of the control strength of the data control function at EA?
b. What is your assessment of the deficiencies of the data control function at EA?
6. Make some recommendations for improving controls over the involvement of the various users/user departments.

Simulation Question 10-3 is an adaptation with permission from a case by A. F. Borthick, G. P. Schneider, and A. Vance in the Issues in
Accounting Education, a publication of the American Accounting Association in Sarasota, Florida.
Scene 1: Kiran, the accountant, interviewing Pat, the payables manager
The time is early in the year, when 24-Seven accounting staff members are documenting internal control for accounts payable for
vendors supplying store inventory.
Kiran: Thank you for making time to talk to me. I really appreciate it because I know you're busy!
Pat:
Not a problem. What would you like to know?
Kiran: I'm familiar with the payables process up to the point where we receive invoices from vendors. Would you start there?
Pat:
Sure. On the 5th and 20th of the month, the system matches all unprocessed invoices to purchase orders (POs).
Kiran: Just what gets matched?

Pat:
PO number on the invoice to purchase order number on the PO, and PO and invoice amounts. When matched, invoice status is set
to A' for payable.
Kiran: What happens if there's not a match?

Pat:
The system sets invoice status to S' for suspended,' and payables staff resolve the mismatch and set status to payable.
Kiran: How are payments made?

Pat:
The payables system requests the bank to send an electronic funds transfer (EFT) to the vendor's bank.
Kiran: How do you know an EFT was made?

Pat:
On the 10th and 25th of the month, EFT requests are prepared. Before the EFT request goes to the bank, the system sets the EFT
status for an invoice to P' for pending.' After the system sends a batch of EFT requests to the bank, it changes the EFT status for
each one in the batch to R' for requested.' After making payments, the bank returns EFT confirmations to us.
Kiran: How do you know the process works correctly?
Pat:
As part of closing the month, we run a report that verifies that payments were made only for valid requests.
Kiran: Are there adjusting entries for payables each month?

Pat:
Yes. To close the month, we download the payables file from the system into a spreadsheet on the first of the month, which sums
the amounts of invoices with status = R.' The sum becomes the amount for the adjusting entry to the general ledger that enters the
payables amount for the month being closed.
Kiran: And the prior month's entry is reversed?

Pat:
Yes. The spreadsheet keeps up with the monthly amounts.
Kiran: Where is the spreadsheet, and how do you know that it does what it is supposed to do and nothing else?
Pat:
The spreadsheet is on Bern's PC. That's because when we started using a spreadsheet to calculate the entry, Bern [an accounts
payable staff member] had the time to develop it.
Kiran: When Bern isn't here, who runs the spreadsheet to create the adjusting entries, and was it tested by anybody else?
Pat:
[thinking] I looked over test results based on the month before we started using it, and everything looked fine to me. I know it's
easy to use because when Bern's not here, other accounts payable staff members go to Bern's PC to run it.
Kiran: I've got to ask. Is there a reason the enterprise system (ES) doesn't do the adjusting entries every month?
Pat:
I'm with you on that one. We started using a spreadsheet when we acquired the first company that wasn't integrated into our
existing ES. Over time, there were more of these. If you look at other financial statement balances, you'll find spreadsheets used
similarly. And there's a monster spreadsheet that consolidates all the financial data from all the different systems run by all the
subs (subsidiaries). As long as we keep acquiring companies, but not integrating them into our ES, I guess we'll keep using
spreadsheets to prepare the adjusting entries.
Kiran: So are the subs volatile, i.e., is there much change in them?
Pat:
Actually, there will be changes several times a year. Some are acquisitions and some are spin-offs. You just never know what
will happen next. Finding out about the spin-offs is easythere are no data when we go to download it. Usually, we see a press
release when there's a new acquisition. Bern just adds and deletes columns as the companies change.
Kiran: How hard is it to set up the data download for a new acquisition?
Pat:
Must not be too hard because Bern doesn't spend much time setting them up.
Kiran: Has anybody ever cross-checked the entries calculated in the spreadsheet against the trial balances of the subs?
Pat:
I don't think so. Because each of the subs has its own idiosyncrasies, which might be quite a job.
Kiran: Can we go back to the process for a moment? Where was the status set to R'?
Pat:
When we receive an invoice from a vendor, the system sets status = R' for received.'
Kiran: Okay. What can you tell me about how the payables application was developed?
Pat:
Unfortunately, not much because I wasn't here when it was installed a couple of years ago.
Kiran: I understand. Have there been problems with it? Does it get updated often?
Pat:
I guess the best responses are no' and no.' You'll have to talk to one of the application developers.
Kiran: I'll do that. Can you tell me who has access to payables?
Pat:
Now, that I can answer. All the payables staff (eight full-time and four part-time) have ready access to payables transactions and
reports. All the staff can edit payables transactions. Only my two supervisors and I can develop reports that run against the
transactions in the database or enter adjusting entries. Depending on their job functions, payables staff members can run reports.
Kiran: What kind of reports do you have?

Pat:
Some of them are analysis reports, e.g., we just wrote one that identifies groups of similar payables so we can inspect them
visually for potential duplicates. Another one matches employee addresses to vendor addresses.
Kiran: How did you get started writing reports? In Structured Query Language (SQL)?
Pat:
We got started because it took so long to get ad hoc reports developed by the IT development group. When one of the IT analysts
indicated an interest in rotating through payables to understand the business better, I jumped at the chance. Jan, who knew SQL,
wrote the first ones and explained them to us. When we saw how powerful the report writer was, we paid attention because we
realized that we could answer a lot of our questions ourselves by querying the data. The pressure to analyze data is relentless. A lot
of people want information about payables. The report writer we're using supports SQL and Query-By-Example (QBE). Although
I'm not exactly a whiz at it and Jan has long since rotated out, I have friends in IT and in other app areas that will answer
occasional questions. Sometimes, I can search the web for answers to specific querying questions. Now that we've written several
reports, we can use them as models for new ones.
Kiran: How hard was it to learn to write reports yourself?

Pat:
Not very. We'd already been experimenting with the QBE interface in Microsoft Access , which worked the same way in the
report writer. Access is on all our PCs. Once you get familiar with one relational database manager, you're familiar with them
all!
Kiran: What do you do about checking for errors in the queries?

Pat:
[looking puzzled] We just keep modifying reports until they run to our satisfaction.
Kiran: Do you modify them often? Do you run them only for yourselves?
279
280
Mostly, the reports are just for us and, yes, we modify them often. Actually, it's more like we take an existing report and work
with it to create a new one. Sometimes, though, one of our reports strikes the fancy of others, who clamor to get access to it. For
example, buyers like the report that shows purchases by inventory item ID grouped by vendor. They can use that information to
manage their buying better.
Pat:
Kiran: Do the buyers run the reports from your private program library?
The libraries are organized into a hierarchy. When I get a request for running one of our reports from non-payables staff
members, I decide whether it makes business sense. If so, I request the database administrator (DBA) to copy the report to a
library that they can access. If the DBAs are busy, it might take a while.
Pat:
Kiran: Would buyers have access to updated versions of reports?

[thinking] I never thought of that. I haven't asked the DBAs to republish reports for buyers or anybody else. Maybe I should.
Pat:
Kiran: There's one more area to talk about. How will the payables application change with the contemplated system?
The current plan is to use the existing application to the extent feasible. I'm looking forward to doing away with the payables
flowing from the delivery tickets. I've never been quite sure how accurate the tickets were and whether they were accurately
reflected in the invoices.
Pat:
Kiran: Why was that?

I guess I'm just a born skeptic. Everywhere else we have receiving reports, but not with these deliveries. Another change will be
that instead of all invoices coming over leased lines from vendors, some invoices will be created in web forms.
Pat:
Kiran: Which ones?

The ones from small vendors, e.g., the souvenir makers. For these, the vendor will complete a web form and submit it. If the
validation routine detects missing or inconsistent fields, it will prompt for changes until the invoice passes all the edit checks.
Once validated, the invoices will go straight to the database, where they'll be handled like any other invoice. When stores take
delivery, the store manager (or designee) will indicate receipt to the system.
Pat:
Kiran: Cool! Thank you very much for talking to me!

Pat:
You're welcome!
Scene 2: Kiran Interviewing Denny, the IT Applications Development Manager
Kiran: Thank you for finding time to talk to me. Would you explain your development process? Maybe illustrate it with the payables
application.
Denny: Sure. Users and management get together to agree on application functions. When they sign off on them, we start. Sometimes,
we suggest changes based on the difficulty and cost of implementing features. Usually, we're able to come to agreement that
pleases everyone involved. Analysts develop the specs in more detail. If they encounter surprises, they go back to users with them
and work them out.
Kiran: Are there many surprises?
Denny: There used to be a lot, but that was before the new CIO (chief information officer) helped management develop a strategic IT
plan for supporting the business.
Kiran: How did that change the process?
Denny: Part of the plan is the requirement that every user proposal be vetted against the plan. As long as proposals enable the plan and
fit the budget, everything's fine. When they don't enable the plan, the proposal has to go to the IT steering committee. If the
proposal improves on the plan in some way, the committee is likely to incorporate it into the plan. If not, the committee suggests
changes users might make.
Kiran: Okay. What happens after the analyst has developed the specs?
Denny: Programmers develop programs and test them. Once they're satisfied that programs pass program-level tests, they check them
into the development program library. Once a week, all the programs are compiled together into a build, and integration tests are
run against all the programs in that build. Any programs that break the build are returned to programmers for rework. When the
build is deemed complete, we do what we call stress testing, i.e., throw enough transactions at the application to see how fast it
will run before stalling. Part of the stress testing is maxing out on the volume to see where the app breaks.
Kiran: Is this the electronic version of running one's car at high speed to see how long it lasts?
Denny: Sort of, but in the case of programs, there's no damage analogous to blowing out the engine after redlining the tach for too long.
It may be tedious to analyze the results to see what broke first, but the programs themselves are intact.
Kiran: This kind of testing must be expensive. How did you come to this approach?
Denny: Once you get in the pattern, this testing is probably no more expensive than what we used to do. The reason we do it is because
several years ago, when we brought up a new system, everything came to an abrupt halt because the load was too much. In
hindsight, we figured out that the throughput and volume were predictable. We think we learned our lesson. Once an app passes
stress testing, users get a shot at it in user acceptance testing. When users sign off, the app goes to QA (quality assurance), which
occasionally finds things that need fixing. From there, QA authorizes the DBAs to install the app in the production library.
Kiran: Who can run programs from the production library?
Denny: Only operations personnel. When programmers need data for the next program iteration, whatever extracts they need are made
available to them in their development libraries.
Kiran: Do you have much of a backlog?
Denny: Not as much as we used to have. The strategic plan helped, and more users are writing more of their own ad hoc reports now. I'm
skeptical of their quality, but can't do anything about it because we just don't have the staff to write reports for everyone. But even
BI (business intelligence) reports would be better than spreadsheets. Another thing that worries me is desktop control. Users
actually want IT to defend their desktops against viruses and bots. After that, it's a mess. Users want to install new software before
IT can vouch for its good behavior. Even worse, users can plug in external media like USB drives. Although users need
flexibility, it makes us vulnerable. In my opinion, it's just a matter of time before we're written up in the business press about
some unintended data exposure.
Kiran: I see balancing control and ease of use getting even more complex. Thank you for talking to me.
Scene 3: Kiran Interviewing Kwan, the IT Security Manager
Kiran: Thank you for finding time to talk to me. This won't take long. Tell me who authorizes access.
Kwan: It all goes back to user management. When employees are hired, their managers specify the access privileges they get based on
existing profiles. For example, there's a base-level profile for entry-level accounts payable staff. When employees move to
different positions, their managers authorize us to add privileges consistent with their new roles.
Kiran: When do you terminate access?
Kwan: Usually, it's when employees leave the company. We remove the employees from the access tables, and that takes care of that.
You won't hear about our former employees still having access to IT resources! We get lists of terminated employees daily from
HR (human resources), which means we do not have to rely on managers to tell us.
Kiran: How secure is the system?
Kwan: Of course, it's very secure. Employees gain access to their areas with radio frequency identification badges, and passwords have
to be eight characters with some upper and lower case letters and some numbers. The system enforces password changes every 90
days, and passwords can't be reused within a year.
Kiran: What can you tell me about server security?
Kwan: You mean the computers in the operations center?
Kiran: Yes.
Kwan: You need to see Dana in systems support.
Kiran: Thanks!
Scene 4: Kiran Interviewing Dana, Systems Support Manager
Kiran: Kwan said you could tell me about server security.

Dana: I'd like to say secure,' but I know better. After reading about the holes in one company's security perimeter, we did a little
sleuthing. As a result, we identified over a hundred servers that weren't protected. We're in the process of protecting them,
although some users aren't exactly ecstatic about it.
Kiran: Has there ever been a penetration test of perimeter security?
Dana: No, we haven't been able to budget for it. Finding that many unprotected servers is giving us reasons to ask for more securityrelated funding. Now that we've identified all the servers (I think!), we're working through changing all the default settings. The
stuff to fix is endless!
Kiran: At least you know why you're doing it!
Dana: Yes, but users don't always appreciate their work being rearranged.
Kiran: [puzzled] What's rearranged'?
Dana: Changing default settings entails users having to deal with harder passwords and more of them. In some cases, access privileges
were removed. The end result is that it takes users longer to get their work done.
Kiran: Okay, I get it.
Dana: After we get the servers protected, we'll worry about how to deal with the growing tide of personal technology that users want to
have all the time.
Kiran: How's that a problem?
Dana: We can't support every personal technology, e.g., iPhones, but users figure out how to use them anyway. If we could work with
users, we'd be more likely to help them take advantage of personal technology for business use without creating information or
system vulnerabilities. The security risks are enormous.
Kiran: I think I understandthe personal technologies aren't going away. They're multiplying instead.
Dana: Like rabbits!
Required
Part 1
Select the best response for each of the following multiple-choice questions based on 24-Seven's situation, as represented in the conversation
above. The questions are independent of each other.
281
282
1.
In the current system, the process with the most manual effort is:
a. Preparing and posting month-end adjusting entries.
b. Sending purchase orders to vendors.
c. Receiving and entering invoices from vendors.
d. Updating corporate inventory and sales.
2.
The use of a spreadsheet model for calculating month-end adjusting entries represents a control:
a. Strength because the spreadsheet sums the payable amounts.
b. Weakness due to the potential for undetected errors.
c. Strength because all staff members can use it for the entries.
d. Weakness because the spreadsheet program was bundled with other office applications.
3.
The best approach to strengthening control over the calculation of month-end adjusting entries would be by:
a. Sending the payables transactions to an independent person to perform the calculations.
b. Verifying that backups of payables transactions are usable as backups.
c. Calculating them with a query manager that can access the transactions directly.
d. Comparing the entries to those from prior months as a form of consistency checking.
4.
Verifying that each EFT request has a corresponding EFT confirmation would ensure the:
a. Existence or occurrence of payments.
b. Completeness of payments.
c. Valuation of payments.
d. Existence or occurrence, and completeness of payments.
5.
Payables staff could ensure the validity of EFT requests by verifying that each:
a. EFT request has a corresponding payable invoice.
b. Payable invoice has a corresponding EFT request.
c. EFT request has a corresponding EFT confirmation.
d. EFT confirmation has a corresponding EFT request.
6.
The coding scheme for values of the invoice status and EFT status attributes is:
a. Desirable because no values are duplicated.
b. Desirable because some values are duplicated.
c. Undesirable because no values are duplicated.
d. Undesirable because some values are duplicated.
Part 2
The table below has separate sections for (1) control weaknesses only in the current payables system, (2) control weaknesses only in the
contemplated payable system, and (3) control weaknesses in both payables systems. Complete the table of control weaknesses and their potential
effects on the financial statements and operational effectiveness.
Current Payables System Only
Control Weakness
Potential Effect On
Operational Effectiveness
1
2
3
Contemplated Payables System Only
Control Weakness
Potential Effect On
1
2
3
Current and Contemplated Payables Systems
Control Weakness
1
2
3
Potential Effect On
Chapter 11
Audit Sampling for Tests of Controls
LO11-1 Distinguish among audit sampling approach, plan, technique, and method.
LO11-2 Apply the 14 steps of an Attribute Estimation Sampling (AES) technique in
TOC.
LO11-3 Understand the Sequential (Stop-or-Go) Sampling technique in TOC.
LO11-4 Understand the Discovery Sampling technique in TOC.
283
284
Chapter 11 Audit Sampling for Tests of Controls

Figure 11-1 shows where the audit sampling for tests of controls fits in the audit process.
Figure 11-1 Audit Sampling for Tests of Controls
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
AU 530 Audit Sampling defines audit sampling as:

the application of an audit procedure to less than 100 percent of the items within an account balance or class of
transactions for the purpose of evaluating some characteristics of the balance or class.
Accordingly, audit sampling is a process of selecting certain items from an audit population consisting of all items
within an account balance or class of transactions and using the characteristics of the selected sample to draw
inferences about the characteristics of all items in the entire population. The underlying assumption is that the
sample characteristics are representative of the population characteristics.
Audit Sampling Approach
There are two general approaches auditors use to conduct audit sampling:
Statistical audit sampling approach.
This audit sampling approach applies the laws of probability to determine the sample size, the selection of sample
items, and the evaluation of sample results.
Non-statistical audit sampling approach.
This audit sampling approach applies judgmental reasoning rather than the laws of probability to decide the sample
size, the selection of sample items, and the evaluation of sample results.
The choice between a statistical and a non-statistical audit sampling approach depends on the auditor's
consideration of the relative costs and effectiveness. Both statistical and non-statistical audit sampling approaches
require that the auditor use professional judgment. In addition, both can provide sufficient appropriate evidential
matter required under the Third Standard of Field Work. However, there is one important difference between the
two. Statistical audit sampling approach allows an auditor to quantify sampling risk. In contrast, non-statistical audit
sampling approach provides no means of quantifying sampling risk.
Sampling risk is the risk that the sample characteristics are not representatives of the population
characteristics. In other words, the risk that the auditor's conclusion based on a sample may be different from the
conclusion he or she would reach if the test were applied to the entire population. Sample risk varies inversely with
sample size. That is, the larger the sample size, the smaller the sampling risk. However, auditing a larger sample size
is more costly.
All aspects of audit risk not due to sampling are referred to as non-sampling risk. Non-sampling risk
includes:
1. The risk of selecting inappropriate or ineffective procedure for a given audit objective. For example, confirmation
of accounts receivable should not be relied on to reveal unrecorded accounts receivable.
2. The risk of not recognizing misstatements in the documents examined by the auditor, which makes the audit
procedure ineffective.
Non-sampling risk cannot be quantified but can be guarded against. It can be reduced by adequate planning and
supervision of audit work in accordance to AU 300 Planning an Audit in a financial audit and AS 9 Audit Planning
in an integrated audit, and adherence to CPA firms' quality control standards.
Audit Sampling Plan
Depending on the auditors characteristic of interest in the sample items, there are two common audit sampling
plans:
Attribute sampling plan
In TOC, audit sampling is designed to obtain evidence about whether a client is complying with the control
procedures prescribed by management. A characteristic of the control procedure that is of interest to the auditor is
called an attribute. When this characteristic of interest to the auditor is absence, it is called an exception. An
attribute sampling plan is used to test the extent of the exception, that is, the exception rate (or deviation rate) of a
prescribed control procedure.
Variable sampling plan
In TOB, audit sampling is designed to obtain evidence about whether monetary misstatement exists within an
account balance or a class of transactions. A characteristic of the account balance or class of transactions that is of
interest to the auditor is called a variable. When this characteristic of interest to the auditor is absence, it is called an
285
286
exception. A variables sampling plan is used to test the extent of the exception, that is, the exception rate (or
misstatement rate) of a recorded amount.
Table 11-1 summarizes the differences between the two sampling plans.
Table 11-1 Differences between Attribute Sampling and Variable Sampling Plans
Attribute Sampling Plan

For TOC
Estimate the exception rate (deviation rate) from prescribed

controls in a population. For example, the % of sales order without
supporting documents.
Results stated in terms of population exception rate (in %).
Variable Sampling Plan

For TOB
Estimate the exception rate (misstatement rate) of a recorded

amount. For example, the % of sales (or book value) is misstated.
Results stated in terms of population misstatement within a

range of $ values.
Audit Sampling Technique

Within the attribute sampling plan, there are several attribute sampling techniques that the auditor can use to
determine a sample size for a test of controls. These are:
Attribute estimation sampling technique
Attribute estimation sampling technique is the most commonly used technique to determine a sample size for
a test of controls. This technique enables the auditor to estimate the maximum rate of exception (deviation) from a
prescribed control procedure. The auditor is primarily concerned that the sample estimation of the maximum
population exception rate (MPER) does not exceed the pre-specified tolerable exception rate (TER).
Sequential (stop-or-go) sampling technique
In attribute estimation sampling technique, one sample is audited and a conclusion is reached based on that
sample. In sequential (stop-or-go) sampling technique, the audit sampling is a multi-stage process. The auditor starts
with the smallest possible sample. If the results of this initial sample do not provide enough information to make a
decision about the control procedures, the auditor expands the sample size and repeats the process until a decision
about the control procedures can be made.
Discovery sampling technique
Discovery sampling technique is typically used for special audit, for example, fraud investigation. This
technique is most suitable when the expected rate of exception is very low, for example, zero or near zero, and when
the auditor's objective is to find at least one exception to indicate possible manipulation of records supporting the
financial statements. In this technique, a single exception in a sample is sufficient to conclude that the actual
population exception rate exceeds or equals a predetermined critical exception rate.
Audit Sample Selection Method
Once the auditor has applied one of the audit sampling techniques to determine a sample size for a test of controls,
one of several sample selection methods is used to select the sample items for TOC. These sample selection methods
apply a basic principle of the laws of probability, which requires each sample unit to be given an equal chance of
being selected, that is, the sample unit must be selected at random. If each sample unit is not given an equal chance
of being selected, the sample will be biased toward those items in the population that have a greater chance of
selection. Two common sample selection methods in auditing are:
Random number sampling method.
Random number sampling method can be applied by the use of random number tables or computer generated
random numbers to select the sample units. Random number tables contain columns and rows of randomly
generated digits. Table 11-2 shows a partial page of a random number table. There are three steps in using the
random number table:
1. Establish a random start on the random number table. For example, the auditor may blindly point to a spot on the
table with a pencil as the random starting point, or the auditor may find the number of the table that correspond to
the serial number on a dollar bill.
2. Establish a correspondence between the digits on the random number table and the numbering system of the
population. For example, assuming that the auditor is selecting a sample of 150 sales invoices from a population of
sales invoices beginning with sales invoice number 1886 and ending with 9732. Since the sales invoices in the entire
population carry a maximum of 4 digits, a corresponding 4 digits from the 5 digits random number table should be
established. To illustrate, if the auditor decides on using the first 4 digits of the table, and the random starting point
is row 7 and column 4, then the first sales invoice to be select is one that has an invoice number that matches the 4
digits '6499' in the table. If the sampling units in the population do not have a numbering system, the auditor should
arbitrarily assign a number to each of the items in the population in order to establish a correspondence between the
population items and the digits on the random number table.
3. Establish a consistent pattern of selecting the digits from the table. The pattern can be established by reading
down a column of digits, or a row of digits, or even diagonally across digits on the table. Once a pattern is
established, it must be consistently followed. To illustrate, if the auditor decides to read down a column of digits
starting from the random starting point of '6499' above, the next sales invoice to be selected will be invoice number
'3453', followed by '4872'. Note that the next 4 digits on the table are '0800', which is outside the range of the
population numbering system. This is discarded and the next 4 digits '9225' will be used.
In using the random number selection method, it is possible that the same number from the table may be
picked more than once. If the duplicated number is ignored, the auditor is said to be sampling without replacement
(else it is sampling with replacement). In practice, the auditor typically samples without replacement because no
new information will be obtained from examining the same corresponding item (e.g., a sales invoice) in the
population twice.
Instead of using the random number table, computer programs can also be used to select the random
numbers. This computer programs, called random number generators, may be programmed to provide a list of
random numbers that falls within the numbering system of the population. This is done by pre-specifying certain
characteristics or parameters such as the range of value to be input to the program.
Table 11-2 A Partial Page of a Random Number Table
____________________________________________________________
Column
Row 1
2
3
4
5
6
7
8
1 37039 97547 64673 31546 99314 66854 97855 99965
2 25145 84834 23009 51584 66754 77785 52357 25532
3 98433 54725 18864 65866 76918 78825 58210 76835
4 97965 68548 81545 82933 93545 85959 63282 61454
5 78049 67830 14624 17563 25697 07734 48243 94318
6 50203 25658 91478 08509 23308 48130 65047 77873
7 40059 67825 18937 64998 49807 71126 77818 56893
8 84350 67241 54031 34535 04093 35062 58163 14205
9 30954 51637 91500 48722 60988 60029 60873 37423
10 86723 36464 98305 08009 00666 29255 18514 49158
11 50188 22554 86160 92250 14021 65859 16237 72296
12 50014 00463 13906 35936 71761 95755 87002 71667
13 66023 21428 14742 94874 23308 58533 26507 11208
14 04458 61862 63119 09541 01715 87901 91260 03079
15 57510 36314 30452 09712 37714 95482 30507 68475
16 43373 58939 95848 28288 60341 52174 11879 18115
17 61500 12763 64433 02268 57905 72347 49498 21871
18 78938 71312 99705 71546 42274 23915 38405 18799
19 64257 93218 35973 43671 64055 88729 11168 60260
20 56864 21554 70445 24841 04779 56774 96129 73594
____________________________________________________________
Source: Interstate Commerce Commission, Table of 105,000 Random Decimal Digits.
Systematic sample selection method.

This method involves selecting every nth item in the population after establishing a random start number. To
illustrate, assuming that the auditor determines that the sample size is 200 sales invoices from a population of 6000
sales invoices; the auditor first calculates a sample interval (SI) by dividing the population size (6000) by the sample
size (200). The sample interval is therefore 6000/200 = 30. Next, within this sample interval of 30, the auditor
selects a random start number between 0 and 30. If the random start number is 8, then the first invoice to be selected
is invoice number 8. This is followed by the 38th invoice, which is calculated by adding the random start number 8
to the sample interval 30. The remaining invoices to be selected are the 68th (38+30), 98th (68+30), 128th (98+30),
and so on till 200 samples are selected from the entire population.
A problem with using the systematic sample selection method is that it could result in biased sample if the
control characteristic of interest, such as certain types of supporting documents to the sales invoice, is not randomly
287
288
distributed throughout the population. An advantage in using the systematic sample selection method is that it
enables the auditors to select a sample from a population that does not have a numbering system. This is because
under the systematic sample selection method, it is not necessary to number the items, as required under the random
number selection method. The auditor simply counts off the sampling interval to select the sample item.
Attribute Estimation Sampling (AES) Technique in TOC
An attribute estimation sampling (AES) technique for tests of controls involves 14 main steps as presented in Table
11-3.
Table 11-3 Fourteen Steps in an AES Technique for Tests of Controls
Steps in Attribute Estimation Sampling (AES) Technique
1. State the objective of the test.
The objective of TOC is to assess the effectiveness of the control procedures in preventing and detecting material misstatements. The auditor uses
an AES technique to efficiently assess the effectiveness of these control procedures.
Example:
An auditor is interested in testing a control procedure under the occurrence objective (recall Chapter 6, the occurrence objective translated from
the existence or occurrence assertion), and the control procedure of interest is the client's matching of sales invoices to customer orders, sales
orders, and shipping documents. Here, the occurrence objective will be documented in the auditor's working paper for audit sampling as:
Audit Objective: To perform a test of controls with regard to the occurrence of the sales invoices. The TOC procedure is to inspect individual
sales invoices for supporting documents.
2. Decide whether audit sampling applies.

The auditor examines the audit program (recall Chapter 10) and identifies the audit procedures for which audit sampling technique applies.
Example:
The TOC procedure, inspect individual sales invoices for supporting document, requires the application of an AES technique to the population of
sales invoices.
3. Define the exception condition.

As stated earlier, an attribute is a characteristic of a control procedure whereas an exception is the absence of the attribute. There can be more
than one attribute to a control procedure. Also, when a sample item does not have one or more of the attributes it is classified as an exception. As
an example, the control procedure that sales invoices are supported by shipping documents will have several attributes including: 1. The
quantities on the invoices match with the quantities on the shipping documents. 2. The descriptions on the invoices match with the customer
orders. 3. Each matching set of sales invoices, shipping documents, and customer orders contains the appropriate initials. The absence of these
attributes is exceptions. In this case, exceptions are: 1. The quantities on the invoices do not match with the quantities on the shipping documents.
2. The descriptions on the invoices do not match with the customer orders. 3. Each matching set of sales invoices, shipping documents, and
customer orders does not contain the appropriate initials. An exception has occurred each time an auditor found one or more of these exceptions.
It is important that the exception conditions must be clearly defined before the TOC is performed; otherwise, the auditor performing the TOC
may not identify an exception when s/he sees one.
Example:
The prescribed control procedure of interest is whether each sales invoice is supported by the relevant shipping document, sales order, and
customer order. This control procedure addresses the management assertion on existence and occurrence of the sales invoices. The audit TOC
procedure is to inspect the relevant documents.
4. Define the population.

There are three factors to be considered in defining the population: 1. The defined population must be appropriate for the specific audit objective.
For example, if the auditor's objective is to test controls designed to ensure that all shipments have been recorded as sales, the appropriate
population should be all shipping documents issued during the period. It should not be all sales invoices issued during the period because there
might be goods shipped but not invoiced. 2. The period covered by the population must be noted. Typically, the auditor performs the TOC during
the interim audit. As such, the population will only cover the period up to the interim audit. The auditor must also consider testing a population
that covers the period after the interim audit and before the year-end. 3. The defined population must contain the appropriate sampling unit. A
sampling unit is the individual items making up the population. It could be a document, a line item on a document, a journal entry, or a physical
item depending on the audit objective and the control procedure being tested. For example, a sample unit for proper authorization of
disbursements might be identified in terms of a voucher, which is a summary form attached to a vendor's invoice. On the other hand, if one
voucher pays several invoices from the same vendor, the sampling unit might be identified in terms of a line item on a voucher, with each line
item representing an individual vendor invoice.
Example:
The population is the total number of sales invoices for the financial year, i.e., 6240.
5. Define the sampling unit.

As stated above, a sampling unit is the individual items making up the population and it could be a document, a line item on a document, a
journal entry, or a physical item. The major consideration in defining a sampling unit is to make it consistent with the objectives of the TOC. For
example, if the auditor wants to determine how often the client fails to fill a customers order, the sampling unit should be defined as the
customers order. If, however, the objective is to determine whether the proper quantity of the goods described on the customers order is
correctly shipped, the sample unit should be defined as the shipping document.
Example:
The sampling unit is individual sales invoices.
6. Specify the tolerable exception rate (TER).

The TER is the maximum population exception rate (MPER) from a prescribed control procedure that an auditor is willing to tolerate without
modifying the assessed level of control risk (CR). The auditor relates the TER directly to the assessed CR as follows:
CR
TER
low
2-6%
moderate
7-10%
high
11-20%
For example, a lower level of CR (or a stronger control) means a smaller % of TER (or a less tolerance for exceptions). In other words, the
stronger the control, the more the auditor would place reliance on that control, and for which the auditor would tolerate less for any exceptions. In
addition, TER is inversely related to the sample size. For example, a smaller % of TER (or a less tolerance for exceptions) means a larger sample
size (or a better chance to detect those exceptions that are less tolerated).
Example:
The assessed level of CR is low and the TER is specified at 4%.
7. Specify the acceptable risk of over-reliance (ARO) or acceptable risk of assessing CR (ARACR) too low.
When an auditor applies statistical sampling approach to TOC, the auditor must apply professional judgment in assessing sampling risk. Two
aspects of the sampling risk are critical in the TOC:
Acceptable risk of under-reliance (ARU) or ARACR too high.

This is the risk that the assessed level of CR based on the sample is greater than the true operating effectiveness of the internal controls.
This risk is also known as the acceptable risk of under-reliance (ARU) on a client's internal controls procedures. When the sample results caused
the auditor to assess CR at a higher level than it actually is, the auditor will perform more TOB (because of lower detection risk) than is
necessary in the circumstance. This unnecessary increased TOB (also known as over auditing) reduces the efficiency of the audit, but it does not
lessen the effectiveness of the audit as a means of detecting material misstatements. For this reason, the auditor usually does not attempt to
directly control (meaning does not specify) the ARU. Another reason for not controlling ARU is that it decreases the risk of potential litigation.
In statistics, ARU is equivalent to Type I error or alpha risk.
Acceptable risk of over-reliance (ARO) or ARACR too low.

This is the risk that the assessed level of CR based on the sample is less than the true operating effectiveness of the internal controls. This
risk is also called the acceptable risk of over-reliance (ARO) on a client's internal controls. When the sample results caused the auditor to assess
CR at a lower level than it actually is, the auditor will perform less TOB (because of higher detection risk) than is justified in the circumstance.
This unjustified reduction in TOB (also known as under auditing) lessens the effectiveness of the audit as a means of detecting material
misstatements. For this reason, the auditor usually directly controls (meaning does specify) the ARO. Another reason for controlling ARO is that
it increases the risk of potential litigation. In statistics, ARO is equivalent to Type II error or beta risk.
The auditor directly controls ARO by exercising professional judgment in specifying the appropriate level of this risk. Some auditors specify a
low 5% of this risk for all TOC. Other auditors relate ARO directly to the assessed level of CR as follows:
CR
ARO
low
5%
moderate
10%
high
20%
For example, a lower CR (a stronger control) means a lower % ARO (a smaller risk of over-reliance on a control which is strong in its true state).
Instead of specifying the ARO, some auditors specify the compliment of the risk, that is, the reliability or confidence level (one minus the risk).
Thus specifying a 95% reliability or confident level is the same as specify a 5% ARO. In addition, the ARO is inversely related to the sample
size. For example, at a 1% ARO, the sample size will be larger (or a better chance of detecting weak internal controls) than at a 10% ARO.
Example:
The assessed level of CR is low and the ARO is specified at 5%.
8. Estimate the expected population exception rate (EPER).
EPER is the auditors expectation with regard to the exception rate from prescribed control procedures for the entire population before
performing the tests of controls. The auditor needs to exercise professional judgment in estimating the EPER. In practice, the auditor makes the
estimation using one of three ways:
Estimate based on prior year's sample exception rate (SER).

The prior year's sample exception rate is applicable only if the effectiveness of the control procedures has not changed since last year's
tests of controls using audit sampling. If there were changes, the last year's sample exception rate might need to be adjusted judgmentally for
current year's changes in the effectiveness of the internal controls.
Estimate based on the auditors professional judgment about the internal controls.
This assessment is commonly obtained via the initial walk-through tests of the internal controls.
The rate found in a preliminary sample of 50 items randomly selected from the current year's population.
If a preliminary sample is used, it can be used as part of the actual sample. For example, the preliminary sample is 50 items. Later, if the
actual audit sample is 200 items, then only an additional sample of 150 items will need to be selected and tested.
The EPER has a directly relationship to sample size. For example, a larger EPER (more exceptions are expected in the population) means a larger
the sample size (a better chance to detect the larger number of exceptions that are expected in the population).
Example:
Based on the exception rate found in a preliminary sample of 50, the auditor estimates the EPER to be 1%.
9. Determine the sample size.

Once the auditor has specified the TER, ARO, and EPER, the sample size can be determined from standard tables as show in Table 11-4. Apart
from these three factors, the population size also affects the determination of sample size. However, the effect of population size is very little,
particularly for population over 5,000 items. The standard tables are compiled on the assumption of a large population. To use the tables, the
auditors perform the following four steps: 1. Select the table that corresponds to the specified ARO. 2. Locate the EPER at the far left column of
the table. 3. Locate the TER at the top row of the table. 4. Read the sample size from the intersection of the specified EPER column and TER
289
290

row.
Example:
ARO = 5%, EPER = 1%, and TER = 4%, the sample size is 156 being the intersection of 1% EPER and 4% TER in Table 11-4.
10. Select the sample item.

After the sample size is determined, the auditor selects the sample items by using either the random or systematic sample selection method (see
earlier discussion). In addition to these two sample selection methods, the auditor may also use a stratified sample selection method. Under this
method, the auditor first subdivides the population items into homogeneous subgroups, called strata, and then selects separate samples for each of
these subgroups by using either the random or systematic sampling method. To illustrate, the auditor may divide inventory items into groups
according to their types.
11. Perform the TOC procedure on sample items.

For testing the selected sample items, the auditor examines each sample item for the attributes of interest according to the predetermined audit
program detailed in the audit working papers. Each item will be examined according to the TOC procedures in the audit program for any
exception from the prescribed control procedure. Items with an exception from the prescribed control procedure are tabulated in the audit
working papers.
Example:
After inspecting the sample sales invoices, the auditor found 2 sales invoices without adequate supporting documents.
12. Evaluate the sample results.

After performing the TOC procedures on the sample items, and items containing exceptions tabulated, the auditor evaluates the sample results.
The auditor's evaluation will include the following two steps:
Determine the sample exception rate (SER).

This step involves calculating the SER by dividing the number of exceptions found in the sample by the sample size. In the example, two
exceptions are found in a sample of 156, the SER is therefore 2/156 X 100 = 1.3%. Note, this calculation is primarily performed and documented
to provide an option for estimating the EPER for the following years audit. Also note that the SER is typically about the same as the population
exception rate, but the chance that the two rates are exactly or positively the same is very small.
Determine the maximum population exception rate (MPER).

The MPER is also called the computed upper exception rate (CUER) or achieved upper precision limit. The auditor may use the
computer to calculate this rate, hence the term "computed" upper exception rate (CUER). The auditor may also use standard sample results
evaluation tables, as shown in Tables 11-5, to identify this rate. This exception rate represents the MPER rate that the auditor can expect based on
the number of the exceptions found in the sample. To use the tables, the auditor performs the following four steps: 1. Select the table that
corresponds to the specified risk of ARO for determining the sample size. 2. Locate the sample size used at the far left column of the table. 3.
Locate the number of exceptions found by the TOC procedure on the sample items at the top row of the table. 4. Read the MPER rate from the
intersection of the sample size and the number of exceptions.
Note: MPER can also be determined by adding SER and the auditors subjective allowance for sampling risk (ASR).
Example:
ARO = 5%, a sample size of 156, and 2 exceptions found in the sample, the MPER is 4.1 being the intersection of the 156 sample size and the 2
exceptions. Statistically, this result is expressed as: based on the TOC procedure applied to the sample, there is a 95% probability (i.e., 5% ARO)
that the true but unknown population exception rate is less than or equal to 4.1 %.
13. Analyze qualitative characteristics of exceptions.

For each exception found in the sample, the auditor must also analyze its qualitative characteristics. For example, exceptions that are result from
intentional misrepresentations (fraud), rather than those that are due to misunderstanding of instructions or carelessness, will have more impact
on the auditor's evaluation of the internal controls and the subsequent TOB.
14. Draw a conclusion about the population.

The auditor compares the MPER with the TER. When the MPER is greater than the TER, the control is not effective in preventing or detecting
material misstatements. The auditor may decide to take one of the following four courses of action:
Revise the TER or ARO.

Assuming everything else stays constant, the TER may be relaxed so that it will not be smaller than the MPER. Likewise, assuming
everything else stays constant, if the ARO is increased from 5% to 10%, the corresponding MPER will decrease; thereby reducing its probability
of being greater than the TER. Examine Tables 11-4 for the impact of these changes on the MPEP. Since the auditor will need to justify any
revision of either the TER or the ARO, this course of action is most suitable when the MPER is marginally greater than the tolerable exception
rate.
Expand the sample size.

Assuming everything else stays constant, an increase in the sample size will decrease the MPER, thereby reducing its probability of being
greater than the TER. Depending on the nature of the sample items, sometimes it may neither be cost effective nor practical to increase the
sample size. Also, the sample exception rate for the additional sample must not increase.
Revise assessed control risk (CR).

If the result of the sample tests indicates that that MPER is greater than TER, the prescribed control procedure is judged to be ineffective
in preventing or detecting material misstatements. In fact, this is the same as saying that the result of the sample tests does not support the
auditor's assessed CR. In this case, the auditor should revise the assessed CR upward, for example from 40% to 60%. The effect of this revision
will increase the TOB because the detection risk DR component of the audit risk model will be smaller. The costs of additional TOB must be
considered when this course of action is to be deployed.
Inform the management.

The auditor should always inform the management when the population is not acceptable and when one of the above three courses of
action is taken. If the auditor has decided not to take one of the above three actions, s/he may inform the management in writing (in a clients
advisory comments letter or management letter) about the ineffectiveness of the prescribed control procedure.

Example:
MPER is 4.1% and TER is 4%. Since MPER > TER, the prescribed control is not operating at an acceptable level. Moreover, the MPER is
marginally greater than TER (4.1 > 4%), the auditor should revise the TER or ARO.
Table 11-4 Statistical Sample Sizes Table for TOC

__________________________________________________________________
5% ARO (ARACR)
__________________________________________________________________
Expected
Tolerable Exception Rate (TER)
Population _______________________________________________________
Exception
Rate (EPER) 2% 3% 4% 5% 6% 7% 8% 9% 10% 15% 20%
__________________________________________________________________
0.00
149 99 74 59 49 42 36 32 29
19
14
0.25
236 157 117 93 78 66 58 51 46
30
22
0.50
* 157 117 93 78 66 58 51 46
30
22
0.75
* 208 117 93 78 66 58 51 46
30
22
1.00
* * 156 93 78 66 58 51 46
30
22
1.25
*
* 156 124 78 66 58 51 46
30
22
1.50
* * 192 124 103 66 58 51 46
30
22
1.75
* * 227 153 103 88 77 51 46
30
22
2.00
* *
* 181 127 88 77 68 46
30
22
2.25
* *
* 208 127 88 77 68 61
30
22
2.50
*
*
*
* 150 109 77 68 61
30
22
2.75
* *
*
* 173 109 95 68 61
30
22
3.00
* *
*
* 195 129 95 84 61
30
22
3.25
* *
*
*
*
148 112 84 61
30
22
3.50
* *
*
*
*
167 112 84 76
40
22
3.75
* *
*
*
*
185 129 100 76
40
22
4.00
* *
*
*
*
* 146 100 89
40
22
5.00
* *
*
*
*
*
* 158 116
40
30
6.00
* *
*
*
*
*
*
*
179
50
30
7.00
* *
*
*
*
*
*
*
*
68
37
__________________________________________________________________
* Sample size is too large to be cost effective for most audit applications. Source: AICPA, Audit and Accounting Guide, Audit Sampling .
Table 11-5 Statistical Sample Results Evaluation Table for TOC
____________________________________________
5% ARO (ARACR)
__________________________________________________________________
Actual Number of Exception Found
___________________________________________________________
Sample
Size
0
1
2
3
4
5
6
7
8
9
10
__________________________________________________________________
25
11.3 17.6 *
*
*
*
*
*
*
*
*
30
9.5 14.9 19.6 *
*
*
*
*
*
*
*
35
8.3 12.9 17.0 *
*
*
*
*
*
*
*
40
7.3 11.4 15.0 18.3 *
*
*
*
*
*
*
45
6.5 10.2 13.4 16.4 19.2 *
*
*
*
*
*
50
5.9 9.2 12.1 14.8 17.4 19.9 *
*
*
*
*
55
5.4 8.4 11.1 13.5 15.9 18.2 *
*
*
*
*
60
4.9 7.7 10.2 12.5 14.7 16.8 18.8 *
*
*
*
65
4.6 7.1 9.4 11.5 13.6 15.5 17.4 19.3 *
*
*
70
4.2 6.6 8.8 10.8 12.6 14.5 16.3 18.0 19.7 *
*
75
4.0 6.2 8.2 10.1 11.8 13.6 15.2 16.9 18.5 20.0 *
80
3.7 5.8 7.7 9.5 11.1 12.7 14.3 15.9 17.4 18.9 *
90
3.3 5.2 6.9 8.4 9.9 11.4 12.8 14.2 15.5 16.8 18.2
100
3.0 4.7 6.2 7.6 9.0 10.3 11.5 12.8 14.0 15.2 16.4
125
2.4 3.8 5.0 6.1 7.2 8.3 9.3 10.3 11.3 12.3 13.2
150
2.0 3.2 4.2 5.1 6.0 6.9 7.8 8.6 9.5 10.3 11.1
200
1.5 2.4 3.2 3.9 4.6 5.2 5.9 6.5 7.2 7.8 8.4
_________________________________________________________________
* Over 20 %. Source: AICPA, Audit and Accounting Guide, Audit Sampling.
291
292
Sequential (Stop-or-Go) Sampling Technique in TOC

As illustrated above, the attribute estimation sampling technique is a single-stage process where one sample is
audited and a conclusion is reached based on that sample. In sequential (stop-or-go) sampling technique, the audit
sampling is a multi-stage process. The auditor starts with the smallest possible sample. If the results of this initial
sample do not provide enough information to make a decision about the control procedures, the auditor expands the
sample size and repeats the process until a decision about the control procedures can be made.
Sequential sampling technique is most suitable when it is relatively easy to expand the sample size, and
either zero or very few population exceptions are expected. However, for a few exceptions found in the sample
items, large expansions of sample sizes are required, thus rendering the stop-or-go process of drawing samples at
several stages an inefficient audit procedure.
The sequential sampling technique follows the same 14 steps for the AES technique in Table 11-3.
However, unlike the AES technique, step 8, the EPER, needs not be specified because sequential sampling
technique is applied only when an auditor expects zero or very few population exceptions rate. In addition, step 7 on
risk, step 9 on sample size determination, and step 12 on sample results evaluation differ from the AES technique as
follows:
Step 7 Specify acceptable reliability instead of ARO
Acceptable reliability is the complement of the ARO, that is, 100% - % of ARO. In sequential sampling
technique, the auditor commonly specifies a relatively low ARO, such as 1 %. The acceptable reliability is therefore
99% (i.e. 1.00 - 0.01). Note that the higher the acceptable reliability, the lower the ARO, and the larger the sample
size.
Example:
ARO = 5% and TER = 5%. The acceptable reliability is (1.00 0.05 ARO) = 0.95 or 95%
Step 9 Sample size determination
In sequential sampling technique, a sample size can be determined from standard tables such as Table 11-6,
which is also used to evaluate the sample results . The steps to determine the sample size are: 1. Locate the column
corresponds to the TER. 2. Locate the row corresponds to zero exception. 3. Read the smallest sample size
corresponds to the intersection of the specified TER and zero exception that yields the acceptable reliability.
Example:
The acceptable reliability = 95%. The intersection of the 5% TER and zero exception yields a reliability level of
97.24. This is an acceptable reliable level because it meets the requirement of at least 95% reliability level.
Therefore, the sample size is 70 (read from the left most column of the table). Note that 70 is the smallest sample
size because if the auditor selects 50 (the next smaller sample size on the table), the intersection of the 5% TER and
zero exception will yield a reliability level of 92.31, which is below the requirement of at least 95% reliability level.
Step 12 Sample results evaluation
After the initial sample size is determined and the sample items tested for control effectiveness, the auditor
then decides from the sample result whether to stop or go on with a new expanded sample and repeat the TOC. If no
exception is found in testing the sample, the auditor can conclude that the MPER is less than the TER, and therefore
will stop going on to select a new expanded sample size and repeated the testing process. If one exception is found,
the acceptable reliability level may or may not be met. If the acceptable reliability level is not met, the auditor will
expand the sample size and test the additional sample items for exceptions. Again, depending on the result of the
additional tests, the auditor may either accept the effectiveness of the prescribed control; or expand the sample size
and repeat the testing process, or stop the sequential sampling technique and reduce the acceptable of reliability
level.
Example:
a. If no exception is found after testing the initial sample size of 70, the auditor can conclude that there is a 97.2%
reliability level that the MPER is less than the 5% TER and accept the prescribed control to be effective.
b. If one exception is found after testing the initial sample size of 70, the intersection for one exception and 5% TER
yields a reliability level of 87.03%, which is below the requirement of at least 95% reliability level. From Table
11-6, the sample size should be expanded to 100 where the intersection of 5% TER and one exception yields an
acceptable reliability level of 99.41%. Accordingly, an additional 30 sample items will be selected and tested. If
no additional exception is found in the additional 30 sample items, the auditor can conclude that there is a 99.41%
reliability level that the MPER is less than the 5% TER. However, if one additional exception is found in the
additional 30 sample items, the reliability level is 96.29 % (the intersection of one exception and 5% TDR for 100
samples). Accordingly, the auditor can still conclude that the MPER is less than the 5% TER and accept the
effectiveness of the prescribed control. Note that if two additional exceptions are found in the additional 30
sample items, the reliability level is 88.17% which is below the requirement of at least 95% reliability level. The
auditor may expand the sample size to 120 or stop the sequential sample technique and reduce the acceptable
reliability level to say 89% (i.e. increase the ARO from 5% to 11%).
Table 11-6 Statistical Sampling Tables for Sample Size Determination and Sample Results Evaluation in
Sequential Sampling Technique
________________________________________________________________
Tolerable Exception Rate
Sample Number of
Size
Exception
1% 2% 3%
4%
5%
6% 7% 8%
________________________________________________________________
50
0
39.50 63.58 78.19 87.01 92.31 95.47 97.34 98.45
1
8.94 26.42 44.47 59.95 72.06 81.00 87.35 91.73
2
1.38 7.84 18.92 32.33 45.95 58.38 68.92 77.40
3
0.16 1.78 6.28 13.91 23.96 35.27 46.73 57.47
4
0.02 0.32 1.68 4.90 10.36 17.94 27.10 37.11
5
0.05 0.37 1.44 3.78 7.76 13.51 20.81
6
0.01 0.07 0.36 1.18 2.89 5.83 10.19
________________________________________________________________
70
0
50.52 75.69 88.14 94.26 97.24 98.69 99.38 99.71
1
15.53 40.96 62.47 77.51 87.03 92.81 96.10 97.93
2
3.34 16.50 35.08 53.44 68.63 79.87 87.59 92.60
3
0.54 5.19 15.87 30.71 46.61 61.15 73.07 82.10
4
0.07 1.32 5.93 14.85 27.21 41.13 54.77 66.80
5
0.28 1.86 6.12 13.72 24.27 36.58 49.24
6
0.05 0.50 2.18 6.04 12.61 21.75 32.70
________________________________________________________________
100 0
63.40 86.74 95.25 98.31 99.41 99.80 99.93 99.98
1
26.42 59.67 80.54 91.28 96.29 98.48 99.40 99.77
2
7.94 32.33 58.02 76.79 88.17 94.34 97.42 98.87
3
1.84 14.10 35.28 57.05 74.22 85.70 92.56 96.33
4
0.34 5.08 18.22 37.11 56.40 72.32 83.68 90.97
5
0.05 1.55 8.08 21.16 38.40 55.93 70.86 82.01
6
0.01 0.41 3.12 10.64 23.40 39.37 55.57 69.68
________________________________________________________________
120 0
70.06 91.15 97.41 99.25 99.79 99.94 99.98 100.0
1
33.77 69.46 87.82 95.53 98.45 99.48 99.83 99.95
2
11.96 43.13 70.16 86.28 94.25 97.75 99.17 99.71
3
3.30 22.00 48.67 71.13 85.56 93.40 97.19 98.87
4
0.74 9.38 29.24 52.67 72.18 85.27 92.83 96.75
5
0.14 3.41 15.29 34.83 55.86 73.23 85.23 92.47
6
0.02 1.07 7.03 20.57 39.37 58.50 74.26 85.35
________________________________________________________________
Source: Ernst & Young, Audit Sampling (Ernst & Young, 1979)
Discovery sampling in TOC

As indicated earlier, a discovery sampling technique is typically used for special audit, for example, fraud
investigation. This technique is most suitable when the expected rate of exception is very low, for example, zero or
near zero, and when the auditor's objective is to find at least one exception to indicate possible manipulation of
records supporting the financial statements. In this technique, a single exception in a sample is sufficient to
conclude that the actual population exception rate exceeds or equals a predetermined critical exception rate (CER).
Like the AES and the sequential sampling techniques, the discovery sampling technique follows the same
14 steps in Table 11-3. However, step 6 on TER specification; step 7 on ARO specification; step 9 on sample size
determination and step 12 on sample results evaluation differ from the two previous techniques as follows:
Step 6 Specify critical exception rate (CER) instead of TER
The CER is the minimum population exception rate that must exist if one exception is to be observed at a
specified probability. The auditor exercises professional judgment in determining this rate, which partly depends on
CR and partly on materiality of the population under consideration. The CER bears a direct relationship to sample
size, that is, increasing the critical exception will increase sample size.
Example:
CER = 1% of 6000 payroll checks (population) to discover at least one fictitious check.
293
294
Step 7 Specify desired probability of observing at least one exception instead of ARO
The desired probability of observing at least one exception is comparable to the acceptable reliability in
sequential sampling technique. Thus, like the acceptable reliability, the desired probability is the complement of the
ARO. The auditor exercises professional judgment in specifying this probability. Note that the higher the desired
probability, the lower the ARO, and the larger the sample size.
Example:
ARO = 5%, therefore, the desired probability of observing at least one fictitious check = 95% (i.e. 1.00 - 0.05)
Step 9 Sample size determination
Sample size can be determined from standard tables such as Tables 11-7. The steps are: 1. Locate the column
corresponds to the CER. 2. Read down the column to the desired probability. 3. Read across the row to the sample
size corresponds to the critical exception rate and desired probability.
Example:
First locate the table for population between 5,000 to 10,000 items, that is, Table 11-7. The sample size can then be
determined by: 1. Locate the column corresponds to 1% CER. 2. Read down the column to the 95% desired
probability. 3. Read across the row corresponds to the CER and desired probability, the sample size is therefore 300.
Step 12 Sample results evaluation
A random sample selection method should be used to select the sample items for testing. If no exception is
found, the auditor can conclude that the desired probability of observing at least one exception in the population is
less than or equal to the CER (or minimum population exception rate) for one such exception to be observed. If one
exception is observed, the auditor will not conclude a statistical statement but will likely stop testing and investigate
the cause of exception.
Example:
a. If the auditor discovers no fictitious payroll check, his/her statistical conclusion would be that the desired 95%
probability of observing at least one bogus payroll check in the population is less than or equal to the 1% CER (or
minimum population exception rate) for one such exception to be observed.
b. If the auditor discovers one fictitious payroll check, s/he will not make a statistical conclusion such as the one in
a. above, rather, s/he will likely stop testing and investigate the cause of the fictitious payroll check.
Table 11-7 Statistical Sampling Tables for Sample Size Determination in Discovery Sampling Technique
____________________________________
For population between 5,000 and 10,000:
______________________________________________________
Critical Exception Rate
Sample
Size
.1% .2% .3% .4% .5% .75% 1% 2%
______________________________________________________
50
5% 10% 14% 18% 22% 31% 40% 64%
60
6 11
17 21 26
36 45 70
70
7 13
19 25 30
41 51 76
80
8 15
21 28 33
45 55 80
90
9 17
24 30 36
49 60 84
100
10 18
26 33 40
53 64 87
120
11 21
30 38 45
60 70 91
140
13 25
35 43 51
65 76 94
160
15 28
38 48 55
70 80 96
200
18 33
45 56 64
78 87 98
240
22 39
52 62 70
84 91 99
300
26 46
60 70 78
90 95 99+
340
29 50
65 75 82
93 97 99+
400
34 56
71 81 87
95 98 99+
460
38 61
76 85 91
97 99 99+
500
40 64
79 87 92
98 99 99+
600
46 71
84 92 96
99 99+ 99+
700
52 77
89 95 97
99+ 99+ 99+
800
57 81
92 96
98
99+ 99+ 99+
900
61 85
94 98 99
99+ 99+ 99+
1,000
65 88
96 99 99
99+ 99+ 99+
1,500
80 96
99 99+ 99+ 99+ 99+ 99+
2,000
89 99
99+ 99+ 99+ 99+ 99+ 99+
_______________________________________________________
Source: Ernst & Young, Audit Sampling (Ernst & Young, 1979)
Table 11-8 summarizes the relationships among the factors in an attribute sampling plan.
Table 11-8 Relationships between Factors in an Attribute Sampling Plan
Factor
CR
CR
ARO (ARACR)
ARO (ARACR)
TER
TER
MPER (CUER)
EPER
Acceptable Reliability
Acceptable Reliability
CER
Desired probability of observing at least one
exception
Desired probability of observing at least one
exception
Population
Relationship*
ARO (ARACR)
Sample Size
MPER (CUER)
Sample size
CR
Sample Size
Sample Size
Sample Size
ARO (ARACR)
Sample Size
Sample Size
ARO (ARACR)
Direct
Direct
Inverse
Inverse
Direct
Inverse
Inverse
Direct
Inverse
Direct
Direct
Inverse
Sample Size
Direct
Sample Size
Population has no effect on determining

sample size unless the population is small
(less than 5000)
*Read each row of relationship independent of the relationships in other rows. Table 11-8 is simply a memory aid; it
is not meant to link all factors across all rows.
295
296
11-1
In audit sampling, the auditor acknowledges the presence of inevitable sampling risk that results from
a. using a systematic instead of a random sample item selection method.
b. specifying an inappropriate risk of assessing control risk too low (ARO or ARACR).
c. testing less than the entire population.
d. the sample size being too small.
11-2
Which the following is not a necessary condition for selecting a sample item through a random number table?
a. Establish correspondence between the population and random number table.
b. Determine the selection pattern or route.
c. Consistently following a sample interval.
d. Selecting a random starting point.
11-3
The risk that the auditor is willing to accept a control as being effective when, in fact, it is not, is known as
a. acceptable risk of over-reliance, ARO.
b. tolerable exception rate, TER.
c. expected population exception rate, EPER.
d. computed upper exception rate, CUER.
11-4
Assuming everything else remains constant, a larger tolerable exception rate, TER, will result in
a. a lager sample size.
b. a smaller sample size.
c. no effect.
d. sometimes larger, sometimes smaller sample size.
11-5
Assuming everything else remains constant, the relationship between maximum population exception rate (MPER or CUER) and
sample size is
a. direct.
b. indirect.
c. no effect.
d. inverse.
11-6
In attribute estimation sampling technique, which of the following factors is not necessary for evaluating the results of a sample?
a. Computed upper exception rate (CUER).
b. Risk of assessing control risk too low (ARACR).
c. Number of sample exceptions found.
d. Sample exception rate (SER).
11-7
If the sample items are not consecutively prenumbered, which of the following sample selecting methods is most appropriate?
a. Systematic sample selection method.
b. Random sample selection method.
c. Judgmental sample selection method.
d. Random sample selection without replacement method.
11-8
If a random number that is drawn from a random number table is outside the range of the population, such non-corresponding number
is
a. noted in the audit working papers.
b. used if it is large enough to be material.
c. ignored and scan for the next number.
d. set aside if it is sampling without replacement.
11-9
In discovery sampling technique, an increase in the critical exception rate (CER) will result in an increase in the
a. maximum population exception rate (MPER).
b. sample size.
c. risk of assessing control risk too low (ARACR).
d. control risk (CR).
11-10
In sequential sampling technique, which of the following is not a true statement?

a. Acceptable reliability is inversely related to the acceptable risk of over-reliance (ARO).
b. Acceptable reliability is inversely related to the sample size.
c. Critical exception rate (CER) is directly related to the sample size
d. Acceptable reliability is directly related to the sample size.
11-11
In the evaluation of the results of an attributes sample, if the exception rate in the sample (SER) is 2%,
then the population exception rate will most likely be
a. about the same 2%.
b. exactly equal to 2%.
c. much greater than 2%.
d. cannot be determined from the information given.
11-12
Which combination of the following factors determines the initial sample size in an attribute sampling plan?
a. TER, ARO, and EPER.
b. TER, ARO, and Population Size.
c. TER, ARO, EPER, and Population Size.
11-13
When audit procedures have been completed for an attributes sampling application, the auditor must generalize from the
sample to the population. Which of the following statements would be incorrect regarding this process?
a. The auditor would use an attributes sampling table to determine the computed upper exception rate.
b. The computed upper exception rate is the lowest exception rate in the population that the auditor is willing to accept.
c. It would be wrong for the auditor to conclude that the population exception rate is exactly the same as the sample
exception rate.
d. In selecting the table corresponding to the risk of over-reliance, it should be the same as the ARACR used for
determining the initial sample size.
11-14
Which of the following need not be known to evaluate the results of a sample for a particular attribute?
a. Exception rate in the sample.
b. Size of the sample.
c. Acceptable risk of assessing control risk too low.
d. Actual number of exceptions in the sample.
11-15
An increase in the sample size has the effect of decreasing the computed upper exception rate (CUER) if the
a. actual sample exception rate increases.
b. actual sample exception rate does not increase.
c. number of exceptions in the sample increase.
d. number of exceptions in the sample does not increase.
11-16
The acceptable risk of assessing control risk too low (ARACR) has a significant effect on sample size. The relationship of
ARACR to sample size is
a. variable (sometimes larger, sometimes smaller)
b. direct
c. inverse
d. no effect.
11-17
Which of the following is an advantage of systematic sampling selection over random number sampling?
a. It provides a stronger basis for statistical conclusions.
b. It enables the auditor to use the more efficient sampling tables.
c. There may be correlation between the location of items in the population, the feature of sampling interest, and the
sample interval.
d. It does not require establishment of correspondence between random numbers and items in the population.
297
298
11-18
Which of the following is a valid criticism of the use of non-statistical sampling methods?
a. Many audit tests, such as footing of journals, must be performed outside a statistical sampling context.
b. The cost of performing random selection or testing often exceeds the benefits.
c. Non-statistical sampling does not differ substantially from statistical sampling methods.
d. Conclusions may be drawn in more precise ways when using statistical sampling methods.
11-19
When the computed upper exception rate (CUER) is marginally greater than the tolerable exception rate (TER), it is
necessary for the auditor to take specific action. Which of the following courses of action would be most difficult to
defend if the auditor is ever subject to review by a court?
a. Revise and relax the tolerable exception rate (TER) or the acceptable risk of assessing control risk too low (ARACR).
b. Expand the sample size.
c. Revise the assessed control risk.
d. Write a letter to management.
11-20
The risk which the auditor is willing to take of accepting a control as being effective when it is not is the
a. finite correction factor.
b. tolerable exception rate.
c. acceptable risk of over-reliance.
d. estimated population exception rate.
11-21
In determining the number of documents to select for a test to obtain assurance that all sales returns have been properly
authorized, an auditor should consider the tolerable exception rate (TER) from the control activity. The auditor should also
consider the
I. assessed level of control risk (CR).
II. acceptable risk of assessing control risk too high (ARACR too high).
a. I only.
b. II only.
c. Both I and II.
d. Either I or II.
11-22
An advantage of statistical sampling over non-statistical sampling is that statistical sampling helps an auditor to
a. quantify the sampling risk.
b. use professional judgment.
c. provide sufficient appropriate evidential matter.
d. reduce the failure to detect errors and fraud.
11-23
An auditor who uses statistical sampling for attributes in testing internal controls should reduce the planned reliance on a
prescribed control when the
a. sample exception rate (SER) is less than the expected population exception rate (EPER).
b. sample exception rate (SER) plus the allowance for sampling risk equals the tolerable exception rate (TER).
c. sample exception rate (SER) plus the allowance for sampling risk is less than the tolerable exception rate (TER).
d. sample exception rate (SER) plus the allowance for sampling risk is more than the tolerable exception rate (TER).
11-24
For which of the following audit tests would an auditor most likely use attribute sampling plan?
a. Selecting accounts receivable for confirmation of account balances.
b. Inspecting employee time cards for proper approval by supervisors.
c. Making an independent estimate of the amount of a LIFO inventory.
d. Examining voucher packets to determine the valuation and allocation of fixed asset additions.
11-25
Which of the following statements is correct concerning statistical sampling in tests of controls?
a. As the population size increases, the sample size should increase proportionately.
b. As the assessed level of control risk (CR) increases, the sample size increases.
c. There is an inverse relationship between the expected population exception rate and the sample size.
d. In determining tolerable exception rate, an auditor considers detection risk (DR) and the sample size.
11-26
Which of the following factors is (are) considered in determining the sample size for a tests of controls?
a.
b.
c.
d.
11-27
Expected Population Exception Rate (EPER)

Yes
No
No
Yes

Yes
No
Yes
No
A principal advantage of statistical method of attribute sample over non-statistical is that the statistical method provides a
scientific basis for planning the
a. risk of assessing control risk too low.
b. tolerable rate.
c. expected population exception rate.
d. sample size.
11-28
The risk of over-reliance on internal controls (ARO) or the risk of assessing control risk too low ARACR) relate to the
a. effectiveness of the audit.
b. efficiency of the audit.
c. preliminary estimates of materiality levels.
d. tolerable misstatements.
11-29
Which of the following combinations results in a decrease in sample size in attribute sample?
a.
b.
c.
d.
11-30
ARO (ARACR)
Increase
Decrease
Increase
Increase
TER
Decrease
Increase
Increase
Increase
EPER
Increase
Decrease
Decrease
Increase
In planning a statistical sample for a test of controls, an auditor increased the EPER from the prior years rate because of
the results of the prior years tests of controls and the overall control environment. The auditor most likely would then
increase the planned
a. tolerable exception rate (TER).
b. allowance for sampling risk (ASR).
c. risk of assessing control risk too low (ARACR).
d. sample size.
11-31
The sample size of a test of controls varies inversely with

a.
b.
c.
d.
11-32
Expected Population Exception Rate (EPER)

Yes
No
Yes
No

Yes
No
No
Yes
For which of the following audit tests would an auditor most likely use attribute sampling?
a. Making an independent estimate of the amount of a LIFO inventory.
b. Examining invoices in support of the classification of fixed assets additions.
c. Selecting accounts receivable for confirmation of account balances.
d. Inspecting employee time cards for proper approval by supervisors.
11-33
Which of the following factors is usually not considered in determining the sample size for a test of controls?
a. Population size, when the population is large.
b. Tolerable exception rate.
c. Risk of assessing control risk too low.
d. Expected population exception rate.
299
300
11-34
Which of the following factors does an auditor usually need to consider in planning a particular audit sample for a test of
controls?
a. Number of items in the population.
b. Total dollar amount of the items to be sampled.
c. Acceptable level of risk of assessing control risk too low.
d. Tolerable misstatement.
11-35
Which of the following statements is true concerning statistical sampling in tests of controls?
a. The population size has little or no effect on determining sample size except for very small populations.
b. The expected population exception rate has little or no effect on determining sample size except for very small
populations.
c. As the population size doubles, the sample size also should double.
d. For a given tolerable exception rate, a larger sample size should be selected as the expected population exception rate
decreases.
11-36
As a result of sampling procedures applied as tests of controls, an auditor incorrectly assesses control risk (CR) lower than
appropriate. The most likely explanation for this situation is that
a. the exception rates of both the auditors sample (SER) and the population (PER) exceed the tolerable exception rate
(TER).
b. the exception rates of both the auditors sample (SER) and the population (PER) are less than the tolerable exception rate
(TER).
c. the auditors sample exception rate (SER) is less than the tolerable exception rate (TER), but the population exception
rate (PER) exceeds the tolerable exception rate (TER).
d. the auditors sample exception rates (SER) exceeds the tolerable exception rate (TER), but the population exception rate
(PER) is less than the tolerable exception rate (TER).
11-37
In addition to evaluating the frequency of exceptions in tests of controls, an auditor should also consider certain qualitative
aspects of the exceptions. The auditor most likely would give qualitative consideration of an exception if it was
a. the only exception discovered in the sample.
b. identical to an exception discovered during the prior years audit.
c. caused by an employees misunderstanding of instructions.
d. initially concealed by a forged document.

11-1 c. 11-2 c. 11-3 a. 11-4 b. 11-5 d. 11-6 d. 11-7 a. 11-8 c. 11-9 b. 11-10 b. 11-11a.
11-12 c. 11-13 b. 11-14 a. 11-15 b. 11-16 c. 11-17 d. 11-18 d. 11-19 a. 11-20 c. 11-21 a.
11-22 a. 11-23 d. 11-24 b. 11-25 b. 11-26 a. 11-27 d. 11-28 a. 11-29 c. 11-30 d. 11-31 d.
11-32 d. 11-33 a. 11-34 c. 11-35 a. 11-36 c. 11-37 d.

California.
The Sampling Issues
Bon Jovi has just joined the CPA firm of Yao Ming & Associates LLP. His first audit engagement was Voyage Import & Export Inc.
(hereafter VIE). Bon was assigned the specific audit objective of completeness and was to apply an attribute sampling plan to ascertain whether
all the VIE shipments had been properly billed. He started out by considering the control risk (CR) of the design and operation of the VIE
shipping and billing functions. Based on the evidence gathered on internal controls, Bon assessed the CR to be low. He reasoned that since CR
was low, he could tolerate more departures from proper internal controls of the shipping and billing functions. Thus, he set his tolerable exception
rate (TER) at a high percentage. For the same reason, Bon also set his acceptable risk of over-reliance (ARO) at a high percentage.
Since Bon was new on the job, he looked up prior years audit working paper to formulate his expectation of the current years
population exception rate (EPER). Based on what was documented in the prior years audit working paper, he set the current years EPER to be
the same at 1%. Bon then looked up the statistical sample sizes table to determine the sample size. But the sample size table showed a * symbol
for the given ARO, TER, and EPER. At the bottom of the table, the * indicated that the sample size was too large to be cost effective. Bon was
unsure how to proceed. He decided to look up prior years working paper and set the sample size to be the same, which were 100.
Bon then used a random number table to select 100 shipping documents for testing. He randomly read 100 numbers from the random
number table. Next, he went to the VIEs shipping department to search for the 100 bill of lading that matched the 100 random numbers from the
random number table. However, he could only found 92 matching bill of lading. He decided to make up the 8 un-matched random numbers by 8
randomly selected bill of lading.
Next, Bon vouched sales transactions in sales journal to the 100 selected bill of lading and customer orders. He found 2 shipments
were not billed and 3 sales invoices were overstated by a total of $35,000. He documented a total of 5 exceptions and assumed they were all
unintentional mistakes of the clients shipping clerk.
Finally, Bon looked up the statistical sample results evaluation table to determine the maximum population exception rate (MPER) for
the 5 exceptions found. He then compared the MPER to the EPER and found the MPER to be marginally more than the EPER. He remembered
the decision rule that if MPER was more than EPER, he should just reject the managements completeness assertion. Accordingly, Bon
documented in his audit working paper that the specific audit objective of completeness was not meet.
Required
1. Assume you are the manager-in-charge of the VIE audit engagement. Review Bons work to identify any incorrect assumption, statement, and
computation in his application of the attribute estimation sampling technique in testing the completeness of bill of lading at VIE. You should
identify at least a total of 10 such incorrect assumption, statement, and computation.
2. Based on your review in question 1, draft a review note to Bon pointing out his incorrect assumption, statement, and computation. Your review
note should provide constructive criticism and feedback; for example, show Bon how to use the random number table properly.

Simulation Question 11-2 is an adaptation with permission from an article by Lanza, R. B. in the The White Paper , a publication of the
Association of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and
lamented.
and sales voids.
Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 11-2
(Excel file) in iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file,
Bruce planned to analyze the data to find out if Helen was in fact posting large number of phony discounts, sales voids and refunds. Bruce made
cross-reference to his working papers on payroll cycle to identify Helens employee number 0000000003, and he planned to:
1. Extract sales with discounts over 90% and summarize by employee;
2. List the top 10 employees by register adjustments (discounts, refunds, and sales voids), and
3. Identify employees that have produced register adjustments (discounts, refunds, and sales voids) over 300 % more than the average employee.
Bruce conducted what he had planned to do and produced three reports as follows:
Report No.1 Extract sales with discounts over 90% and summarize by employee.
Report No.2 List the top 10 employees by register adjustments (discounts, refunds, and sales voids).
Report No.3 Identify employees that have produced register adjustments over 300% more than the average employee.
301
302
You should access Data File 11-2 (Word file) in iLearn for Bruces Reports 1, 2, and 3. After reviewing the three Reports, Bruce was
confident that Helen (employee number 0000000003) is the number one suspect in the retail store.
In light of this discovery, Bruce planned to use the attribute estimation sampling (AES) technique to test the retail stores internal
control (i.e., control procedure or control activity) over authorization of sales transactions (an entry of 1=Yes with authorization and 0=No with
no authorization in the sales register data file).
Required
Access Data File 11-2 (Excel file) in iLearn for the sales register data file, which shows a column of sales authorization with an entry of
1=Yes with authorization and 0=No with no authorization.
1. Refer to the 14 steps for implementing the AES technique in Chapter 11 and document how Bruce used the technique to test whether the retail
stores internal control (i.e., control procedure or control activity) over authorization of sales transactions was acceptable. Some information for
using the AES techniques are given, you are to use them to complete the documentation.
Documenting Bruces Application of the AES Technique
1. State the objective of Bruces test.

Bruce chose individual sales receipt number as the sample unit.
6. Specify the tolerable exception rate (TER).
Bruce related his TER to the assessed level of CR as follows:
CR
TER
low
2-6%
moderate
7-10%
high
11-20%
The assessed level of CR is low and the TER was specified at 4%.
7. Specify the acceptable risk of over-reliance (ARO).
Bruce related his ARO to the assessed level of CR as follows:
CR
ARO
low
5%
moderate
10%
high
20%
The assessed level of CR was low and the ARO was specified at 5%.
8. Estimate the expected population exception rate (EPER).
Based on the exception rate found in a preliminary sample of 50, Bruce estimated the EPER to be 1%.

Bruce used the systematic sample selection method as follows:
The random start sales receipt number was 1000000020
11. Perform the TOC procedure on sample items.
Bruce found _______ sales receipts without proper authorization, i.e., sales receipts with 0=No with no authorization in the sales
register data file.

Bruce analyzed and found no qualitative characteristics of concern.
14.Draw a conclusion about the population.
2. Do you think the result of Bruces AES sampling test supports the fact that Helen probably embezzled from the retail store due to its weak
internal control over proper authorization of sales transactions?
a. If yes:
i. Should Bruce take further actions such as expand the sample size and/or revise CR, TER, and ARO? Explain.
ii. Should Bruce use an alternative sample selection method such as the random number sample selection method? Explain.
iii. Should Bruce use an additional statistical sampling technique such as the discovery sampling technique? Explain.
b. If no:
i. Should Bruce take further actions such as expand the sample size and/or revise CR, TER, and ARO? Explain.
iii. Should Bruce use an additional statistical sampling technique such as the discovery sampling technique? Explain.

California.
The Sampling Issues
Curry, CPA, was engaged to audit Warriors Companys financial statements for the year ended September 30. After studying
Warriors internal control, Curry decided to obtain evidence about the effectiveness of both the design and the operation of the controls that may
support a low assessed level of control risk (CR) concerning Warriors shipping and billing functions. During the prior years audits, Curry had
used nonstatistical sampling approach, but for the current year Curry used a statistical sampling approach in the tests of controls to eliminate the
need for judgment.
Curry wanted to asses control risk (CR) at a low level, so a tolerable exception rate (TER) of 20 percent was established. To determine
the maximum population exception rate (MPER), Curry decided to apply an attribute estimation sampling (AES) technique that would use an
expected population exception rate (EPER) of 3 percent for the 8,000 shipping documents and to defer consideration of the acceptable risk of
over-reliance (ARO) until the sample results were evaluated. Curry used the tolerable exception rate (TER), the population size, and the expected
population exception rate (EPER) to determine that a sample size of 80 would be sufficient. When it was subsequently determined that the actual
population was about 10,000 shipping documents, Curry increased the sample size to 100.
Currys objective was to ascertain whether Warriors shipments had been properly billed. Curry took a sample of 100 invoices by
selecting the first 25 from the first month of each quarter. Curry then compared the invoices to the corresponding prenumbered shipping
documents.
When Curry tested the sample, 8 exceptions were discovered. Additionally, one shipment that should have been billed at $10, 443 was
actually billed at $10,434. Curry considered this $9 to be immaterial and did not count it as an error.
In evaluation the sample results, Curry made the initial determination that a 5 percent risk of acceptable risk of over-reliance (ARO)
was appropriate and, using the appropriate statistical sampling table, determined that for 8 observed exceptions from a sample size of 100, the
maximum population exception rate (MPER) was 14 percent. Curry then calculated the difference between the actual sample exception rate
(SER) of 8 percent and the expected population exception rate (EPER) of 3 percent. Curry reasoned that the actual sample exception rate (SER)
of 8 percent was less than the maximum population exception rate (MPER) of 14 percent; therefore, the sample supported a low level of control
risk (CR).
Required
1. Assume you are the manager-in-charge of the Warriors Company audit engagement. Review Currys work to identify any incorrect
assumption, statement, and computation in his application of the attribute estimation sampling technique in testing the shipping and billing
functions at Warriors. You should identify at least a total of 5 such incorrect assumption, statement, and computation.
2. Based on your review in question 1, draft a review note to Curry pointing out his incorrect assumption, statement, and computation. Your
review note should provide constructive criticism and feedback; for example, show Curry how to evaluate the sample results properly.
303
304
Chapter 12
Audit Sampling for Tests of Balances
LO12-1 Distinguish between Classical Variable Sampling (CVS) technique and
Monetary Unit Sampling (MUS) technique in TOB.
LO11-2 Apply the 14 steps of a Monetary Unit Sampling (MUS) technique in TOB.
Chapter12 Audit Sampling for Tests of Balances

Figure 12-1 shows where the audit sampling for tests of balances fits in the audit process.
Figure 12-1 Audit Sampling for Tests of Balances
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
305
306
Variable Sampling Plan

As explained in Chapter 11, the auditor can use one of two audit sampling approaches in tests of balances (TOB).
These are statistical and non-statistical sampling approaches. If the auditor uses the statistical sampling approach,
the sampling plan for testing the misstatement rate of an account balance or a class of transactions is called the
variable sampling plan. Under the variable sampling plan, there are a number of audit sampling techniques for the
TOB. These audit sampling techniques can be divided into two categories depending on which of the two statistical
sampling theories from which they are derived. The two categories of audit sampling techniques are:
Classical variable sampling (CVS) technique.
Classical variable sampling (CVS) techniques include mean-per-unit estimation, difference estimation, and
ratio estimation. These techniques are derived from the normal distribution theory and they were popular in the past.
In general, the CVS techniques are used when many errors are expected in the population. The population is defined
as an account balance or a class of transactions.
Monetary unit sampling (MUS) technique.
Monetary unit sampling (MUS) is a sampling technique that is derived from the attribute sampling theory and
it is presently the most popular sampling technique for TOB. This technique is also known as probabilityproportional-to-size (PPS), Dollar Unit Sampling (DUS), and Cumulative Monetary Amount Sampling (CMA). In
general, MUS is used only when a few misstatements are expected in the population. The population is defined as
the individual dollar unit comprising the population's book value (PBV).
Only the MUS technique is discussed here.
Monetary Unit Sampling (MUS) Technique in TOB
A MUS technique uses the individual dollar in the population as a sampling unit. Each dollar in the population has
an equal chance of being selected. However, when a dollar in the population is selected, the entire account balance
or class of transactions of the selected dollar is subjected to TOB. This procedure results in a large account balance
in the population having a greater probability of being selected, that is, the likelihood of selecting an account
balance for testing is directly proportional to its size, hence, its other name "probability-proportional-to-size
sampling technique" (PPS).
Since a larger account balance or class of transactions have a higher probability of being selected, the MUS
technique automatically stratifies the population, thereby rendering it the most appropriate technique for audit
populations that are stratified. In addition, since larger account balance or class of transactions have a higher
probability of being selected, the MUS is more likely to select overstatements than understatements, thereby
rendering it the most appropriate technique for auditors desire to test material overstatements.
The MUS technique for TOB involves 14 main steps as presented in Table 12-1.
Table 12-1 Fourteen Steps in a MUS Technique for Tests of Balances
Steps in Monetary Unit Sampling (MUS) Technique
1. State the objective of the test.
The objective of TOB is to determine whether a recorded account balance is fairly stated. The auditor chooses a variable sampling plan either to
obtain evidence that a recorded account balance is not materially misstated (use MUS technique) or to develop an independent estimate of the
true book value of the recorded account balance (use CVS technique). Depending on which type of variable sampling technique is used, the
objective of the test will be stated accordingly. When MUS technique is used, the auditor is interested in testing whether the recorded account
balance is fairly stated, and the characteristic of interest is the presence of monetary misstatement, that is, monetary difference between recorded
and audited dollar amounts of the account balance. On the other hand, when CVS technique is used, the objective of the test is to develop an
independent check of the accuracy of the recorded book valued by estimating its true book value.
Example:
An auditor is interested in testing that the recorded inventory account balance is not materially misstated. The auditor documents in the working
paper:
Audit Objective: To determine the proper valuation and allocation of the inventory account balance in terms of the monetary differences between
the recorded and the audited dollar amounts of the inventory account balance. The TOB procedure is to use MUS sampling technique to select a
sample of inventory accounts for the purpose of inventory unit-price compilation. The entire inventory account balance, as at December 31st is
$1,723,254. The population of 50 individual inventory accounts is documented as shown in Table 12-2.

The auditor examines the audit program (recall Chapter 10) and identifies account balances for which audit sampling technique applies.
Example:
The TOB procedure requires the application of the MUS technique to the recorded $ 1,723,254 book value of the inventory account balance.

A characteristic of the account balance or class of transactions that is of interest to the auditor is called a variable (hence the term a variable
sampling plan). When this characteristic of interest to the auditor is absent, it is called an exception.
Example:
The characteristic of interest to the auditor is any misstatement in the recorded $1,723,254 book value of the inventory account balance.

There are three basic factors to be considered in defining the population. (a) The defined population must be appropriate for the specific audit
objective. For example, if an auditor's objective is to uncover unrecorded accounts payable, it will not be appropriate to define the population as
all recorded accounts payable, since the population would not include unrecorded accounts. (b) The period covered by the population for TOB
must be noted. (c) The defined population must contain the appropriate sampling unit. Depending on the audit objective, a sampling unit in a
variable sampling plan may be a customer account balance, an individual transaction, an inventory account, and so on. In MUS technique, the
population is defined as the total number of dollar units of the entire account balance or class of transactions, which is referred to as the
population book value (PBV).
Example:
The auditor wants to perform the TOB procedure on the inventory account balance; hence, the audit population will be 1,723,254 dollar units,
and the selected dollar units will subject individual inventory accounts for the TOB procedure. The individual inventory accounts may consist of
debit balances, credit balances, and zero balances. In practice, credit balances (that is, negative balances) are often excluded from the sample and
tested separately because they often contain characteristics not present in debit balances (that is, positive balances). In addition, zero balances
(zero dollar balances) often require special consideration because they will never be selected.

The sampling unit for TOB is almost always the item or individual accounts making the account balance.
Example:
The sampling unit is individual inventory accounts consisting of individual inventory names and balances.
6. Specify the tolerable misstatement rate (TMR).

The tolerable misstatement rate (TMR) is the maximum monetary error that can exist in an account balance without causing the financial
statements to be materially misstated. TMR is related to the auditors assessment of materiality (recall Chapter 9), and depending on which of the
two categories of the variable sampling techniques is used, the TMR is specified as follows:
In MUS technique, the auditor uses the preliminary judgment about materiality (PJAM) at the overall financial statement level and its
allocation (i.e., tolerable misstatement, TM) to individual account balances to determine the tolerable misstatement rate. To illustrate, assume that
the auditor quantifies the PJAM (based on materiality threshold, MT, recall Chapter 9) to be $500,000 for the financial statements taken as a
whole and allocates $50,000 of TM to an inventory account balance. The TMR for the inventory account balance is therefore 10%
($50,000/500,000 x 100) of the population book value (PBV) ($1,723,254) of the inventory account balance.
In CVS technique, the $ amount of the auditors allocation (TM) to individual account balances from the PJAM for the financial
statement taken as a whole is the TMR (in $ amount). To illustrate, assume that the auditor decides to allocate $50,000 of TM from the PJAM of
$500,000 to an inventory account balance, the TMR expressed in $ amount for the inventory account balance is therefore $50,000.
The TMR is inversely related to the sample size. An increase in TMR will result in a decrease in the sample size, and a decrease in TMR rate
will result in an increase in the sample size. The auditors must also consider that a smaller sample size reduces the probability of detecting a
misstatement, and an unnecessary large sample size results in an inefficient use of audit time; thereby increasing audit costs.
Example:
The PJAM = $500,000. The auditor decides to allocate $50,000 of TM to the inventory account balance. The TMR for the inventory account
balance = 10%.
7. Specify the acceptable risk of incorrect acceptance (ARIA).
Two aspects of the sampling risk are critical in the TOB:

Acceptable risk of incorrect rejection (ARIR).
The acceptable risk of incorrect rejection (ARIR) is the risk that a sample supports the conclusion that a recorded account balance is
materially misstated; when unknown to the auditor, the account is not materially misstated. Like the ARU in an attribute sampling plan discussed
in Chapter 11, the ARIR relates to the efficiency of an audit. If an auditor makes an initially erroneous conclusion that an account balance is
misstated, the auditor might unnecessary increase sample size, perform more TOB, and gather more evidence to conclude that the account is
ultimately not materially misstated. Alternatively and less likely, the auditor might unnecessary propose an audit adjustment, thereby materially
misstating an otherwise fairly stated account. In MUS technique, the ARIR is not specified (controlled). On the other hand, in CVS technique
such a risk must be specified.
Acceptable risk of incorrect acceptance (ARIA).

The acceptable risk of incorrect acceptance (ARIA) is the risk that a sample supports the conclusion that a recorded account balance is not
materially misstated; when unknown to the auditor, the account is materially misstated. Like the ARO in an attribute sampling plan, the ARIA
relates to the effectiveness of an audit, that is, the incorrect acceptance lessens the effectiveness of the audit as a means of detecting material
misstatement by limiting the extent of TOB. If an auditor incorrectly accepts an account balance, the auditor will ordinarily not perform further
tests or gather more evidence, thereby rendering the audited financial statements materially misstated and misleading. Both the MUS and CVS
techniques require the ARIA to be explicitly specified.
The auditor uses the following form of the audit risk model that is suggested AU 530 Audit Sampling to quantify the ARIA:
AR = IR X CR X DR
where DR (detection risk) = the risk of misstatements not detected by the auditor's specific TOB procedures. Since the auditor's TOB procedures
may involve a sampling or non-sampling approach, the DR component can be further divided into sampling risk and non-sampling risk.
Sampling risk arises when the auditor uses a sampling approach for TOB, and it represents the risk of the sample characteristics not representing
the population characteristics. Non-sampling risk (NSR) includes the risk of applying inefficient or ineffective analytical and TOB procedures. In
addition, the sampling risk component can be further divided into the risk of incorrect rejection (ARIR) and the risk of incorrect acceptance
307
308

(ARIA). The audit risk model can therefore be expanded as follows:
AR = IR X CR X DR
______________|______________
|
|
Sampling Risk
Non-sampling Risk (NSR)
__|____________
|
|
ARIR
ARIA
In MUS technique, the ARIR component is not specified, therefore, the audit risk model can be expanded by the remaining components as
follows:
AR = IR X CR X NSR X ARIA
Given this form of the audit risk model, the ARIA is therefore
ARIA = AR / (IR X CR X NSR)
Example:
The AR = 5%, IR = 100%, CR = 50%, and NSR = 67%. The acceptable risk of incorrect acceptance will be
ARIA = 0.05 / (1.0 X 0.50 X 0.67) = 0.15 (or 15%).
8. Estimate the expected population misstatement rate (EPMR).

As stated earlier, the MUS technique is most appropriate only when a few misstatements are expected. Zero expected population misstatement
rate (EPMR) is commonly specified. Note, zero EPMR is commonly specified even when misstatements are expected in the population. Note
also, this zero EPMR is always used for determining the reliability factor of the sample size formula in step 9.
Example:
EPMR = 0.

In MUS technique, the formula for determining sample size is
PBV X RF
n = __________________
TMR - (EPMR X EF)
Where
n
= sample size
PBV = population book value
RF
= reliability factor for specified ARIA
TMR = tolerable misstatement rate
EPMR = expected population misstatement rate
EF
= expansion factor
Reliability Factor (RF) for Specified ARIA.

As explained above, in the MUS technique, the ARIA is quantified using the expanded audit risk model:
AR = IR X CR X NSR X ARIA
The reliability factor measures the reliability (or confident level) of the auditor's assessment of the ARIA for a given number of misstatements
detected in the sample. The reliability factor is determined from a reliability factor table (see Table 12-3) after the auditor derives the ARIA from
the audit risk model and specifies the EPMR.
Expansion factor (EF)

Since in the MUS technique, the EPMR is ordinarily set at zero (even when misstatements are expected in the population, zero EPMR is
commonly specified), the (EPMR X EF) part of the sample size formula is not required because it will all be zero. Accordingly, the formula for
determining sample size is reduced to:
PBV X RF
n = __________________
TMR
The EF is related to the auditors ARIA. The EF is required only when the EPMR is set higher than zero and it is determined from a standard EF
table.
Example:
ARIA = 15% and EPMR = 0. From Table 12-3, the RF is 1.9 being the intersection of the column associated with a 15% ARIA and the row for
zero EPMR. After the RF is identified, the sample size (n) is calculated using the reduced formula of n = (PBV x RF)/TMR. Given PBV =
$1,723,254 and TMR = 10% of PBV, the sample size, n = ($1,723,254 x 1.9)/(0.10 x 1,723,254) = 19.

In MUS technique, the auditor commonly uses the systematic sample selection method. Since the population is defined as the individual dollar
unit comprising the population book value (PBV), the sample interval (SI) is also based on the individual dollar unit and is calculated as follows:
PBV
Sample interval (SI) = _____________________
Sample Size

To facilitate the sample selection process, the auditor customarily lists the individual account balances (known as logical units) in the population
and compiles a cumulative listing based on their individual dollar balances. Individual account balances are then selected from the cumulative
listing for the TOB procedure. Note, when a specific dollar unit in the cumulative list is selected, the entire account balance associated with that
dollar unit is selected for testing.
Example:
The SI = PBV / n = 1,723,254/19 = $90,698.
The first 10 inventory items to be selected by using the systematic sample selection method with an initial random start of $50,000 are shown in
Table 12-4.
11. Perform the TOB procedure on sample items.

For testing the selected sample items, the auditor examines each sample item for the variables of interest according to the predetermined audit
program detailed in the audit working papers. In some instances, the supporting documents of certain sample items that are selected for testing
may be missing. The auditor will need to exercise professional judgment on whether the missing documents for these sample items are misstated
and whether they will affect the overall evaluation of the account balance or class of transactions. If the auditor judges that the missing
documents for these sample units are misstated and that they will affect the overall evaluation of the account balance or class of transactions, the
auditor will apply alternative TOB procedures to compensate for the lack of evidence caused by the missing documents.
Example:
The auditor performs unit-price compilations to determine the value for each sample inventory account. The auditors TOB on the sample
inventory accounts reveal three overstatements. They are inventory account #019 (scanner), #039 (Excel), and #041 (Motherboard). The audited
values for these three inventory accounts are $60,000, $10,000, and $240,000, respectively.

After performing the TOB procedure on the sample items, and items containing misstatements tabulated, the auditor evaluates the sample results
by projecting the detected sample misstatement (SM) to the entire population. However, the projected misstatement may not be a good
representation of the true misstatement in the population. Accordingly, the auditors must also consider sampling risk, the risk that the sample
characteristics are not representative of the population characteristics. Both categories of the variable sampling technique (CVS and MUS)
project the SM to the population (PPM) by considering the sampling risk (ASR). The way SM is projected to the PPM depends on whether the
auditor uses the MUS technique for observing only overstatement misstatements or for observing both overstatement and understatement
misstatements.
Using MUS technique to observe only overstatement misstatements.

In evaluating the sample results for overstatements, the auditor calculates a computed upper misstatement rate (CUMR), which is also known as
upper misstatement limit (UML), upper error bound (UEB), upper precision limit (UPL), and estimated upper error limit (EUEL). The CUMR is
calculated as follows:
CUMR
=
PPM
+
ASR
______|______
_________|_________
|
|
|
|
SM
(TP x SI)
BP = (SI x RF)
BP + IA
[For BV>SI] [For BV<SI] [For BV>SI]
[For BV<SI]
Where
CUMR = computed upper misstatement rate.
PPM = projected population misstatement.
SM
= sample misstatement.
TP
= tainting percentage.
SI
= sample interval.
ASR = allowance for sampling risk.
BP
= basic precision.
RF
= reliability factor for the specified ARIA.
IA
= incremental allowance.
BV
= book value of misstated sample item.
The computed upper misstatement rate (CUMR) is analogous to the computed upper exception rate (CUER) in attribute sampling. The CUMR is
an estimate of the maximum population misstatement rate, that is, an estimate of the maximum amount of misstatement in the account under
consideration. CUMR is calculated by adding up two components, the projected population misstatement (PPM) in the population added to the
allowance for sampling risk (ASR).
The projected population misstatement (PPM) is determined by the sample misstatement (SM) for each misstated sample items. The SM for each
misstated sample items is calculated differently depending on whether the account balance or recorded book value (BV) of the SM is (1) equal to
or greater than the sample interval (SI) or (2) less than the sample interval (SI).
(1) When the BV of the SM is equal or greater than the SI
When the BV of the SM is greater than the SI, any misstatement (i.e. book value, BV - audited value, AV) of the SM represents the misstatement
rate of the entire SI and is projected in its entirety to the PPM as follows:
Misstatement (BV - AV) of SM = PPM.
To illustrate, assume the BV of a SM is $1,000, the AV is $800, and the SI is $50, the PPM = (BV AV) = $200 ($1,000 - $800 = $200).
(2) When the BV of the SM is less than the SI
When the BV of the SM is less than the SI, any misstatement (i.e., book value, BV audited value, AV) of the SM only represents certain
percentage, known as tainting percentage (TP), of the entire SI. The TP for SM is determined simply by dividing the misstatement (BV - AV) of
the SM by its recorded or book value, BV. The calculated TP is then projected to the PPM by multiplying it with the SI as follows:
309
310

Misstatement (BV - AV)
Tainting percentage (TP) = _______________________
BV
and TP X SI = PPM
To illustrate, assume the BV of a SM is $6,000, the audited value is $4000, and the SI is $12,000. The TP = 33% [(6,000 - 4,000) / $6,000 =
0.33]. The PPM = TP x SI = 0.33 X $12,000 = $3,960.
The allowance for sampling risk (ASR) consists of two components: (1) basic precision (BP) and (2) incremental allowance (IA).
(1) Basic precision (BP)
The basic precision (BP) is an allowance for the closeness of the estimate of projected sample misstatement to the population misstatement. It is
calculated by multiplying the sample interval (SI) by the reliability factor (RF) for the specified acceptable risk of incorrect acceptance (ARIA).
To illustrate, assume the SI = $100, the ARIA = 10%, and the EPMR = 0. From Table 12-3, the reliability factor is 2.31. Accordingly, the BP =
SI x RF = $100 x 2.31 = $231.
(2) The incremental allowance (IA)
The incremental allowance (IA) for sampling risk is an allowance for the risk arising from not auditing all the sample items in the sample
intervals. The IA for each SM is calculated differently depending on whether the account balance or recorded BV of the SM is (a) equal to or
greater than the SI or (b) less than the SI.
(a) When the BV of the SM is equal or greater than the SI
When the BV of the SM is greater than the SI, any misstatement (i.e., book value, BV - audited value, AV) of the SM represents the misstatement
rate of the entire SI and is projected in its entirety to the PPM. Accordingly, all sampling risk associated with that particular SI has been
considered and it is not necessary to calculate the incremental allowance (IA).
To illustrate, assume the BV of a SM is $1,000, the AV is $800, and the SI is $50, the PPM = $200 ($1,000 - $800 = $200) and no IA for
sampling risk is calculated. Thus, the ASR consists of only the basic BP.
(b) When the BV of the SM is less than the SI
When the BV of the SM is less than the SI, any misstatement (i.e., book value, BV audited value, AV) of the SM only represents certain
percentage, known as tainting percentage (TP), of the entire SI. The IA is determined in four steps:
(i) Rank the PPM for SM in descending order of the TP.
(ii) Multiply the ranked PPM by the incremental change in RF at a specified ARIA.
(iii) Find the sum of the product in (ii).
(iv) Subtract the total adjusted PPM from the initial PPM to obtain the IA for sampling risk.
To illustrate, assume the BV for three SM are $2,000, $3,000, and $6,000, respectively, and the audited values are $1,000, $1,000, and $4,000,
respectively. The SI is $12,000 and ARIA is 5%. The TP and total PPM are:
Misstated Account (SM)
Tainting % (TP)
Projected Misstatement (PPM)
(BV-AV)
(BV-AV)/BV
TP x SI
__________________________________________________________________________
#1 $(2,000-1,000) =1,000
$1,000/2,000 =0.05
0.50 x 12,000 = 6,000
#2 $(3,000-1,000) =2,000
$2,000/3,000 =0.66
0.66 x 12,000 = 7,920
#3 $(6,000-4,000) =2,000
$2,000/6,000 =0.33
0.33 x 12,000 = 3,960
Total PPM $17,880
The IA for sampling risk is computed as follows:
Account
Projected
No. of
Incremental
Projected
No
Misstatement Misstatement
change in
Misstatement x Increment
.
TP
(PPM)
RF
RF
(Adjusted PPM)
_____________________________________________________________________________________________
0
3.00
#2
0.66 $ 7,920
1
4.75 (4.75 3.00) = 1.75
$7,920 x 1.75 = $13,860
#1
0.50
6,000
2
6.30 (6.30 - 4.75) = 1.55
6,000 x 1.55 = 9,300
#3
0.33
3,960
3
7.76 (7.76 6.30) = 1.46
3,960 x 1.46 = 5,782
________
Total adjusted PPM $28,942
17,880
Less total initial PPM $17,880
IA for sampling risk $11,062
The computed upper misstatement rate (CUMR) is the sum of the projected population misstatement (PPM) and allowance for sample risk (ASR)
as follows:
CUMR = PPM + ASR (ASR = BP + IA)
To illustrate, PPM = $249,000, BP = $231, and IA = $11,062, the CUMR is:
CUMR = $249,000 + ($231 + $11,062) = $260,293
Example:
The auditors TOB on the 19 sample inventory accounts reveal three overstatements. They are inventory account #019 (scanner), #039 (Excel),
and #041 (Motherboard). The audited values (AV) for the three accounts are $60,000, $10,000, and $240,000, respectively.
The auditor computes the total PPM as follows:

Inventory
Book
Audited
Tainting
PPM =
Account No. Value
Value
(BV-AV) % (TP) =
SI
(TPXSI)
(BV)
(AV)
(BV-AV)/BV
___________________________________________________________________________
#019
#039
$64,800
11,100
$60,000
10,000
$4,800
1,100
#041
241,112
240,000
1,112
0.07
0.10
N/A*
$90,690
90,690
$ 6,348
9,069
15,417
N/A
1,112
Total PPM $16,529
TP = (BV-AV)/BV
For inventory account #019, TP = $4,800/64,800 = 0.07
PPM = TP X SI
For inventory account #019, PPM = (0.07 X 90,690) = 6,348
For inventory account #039, PPM = (0.10 X 90,690) = 9,069
* For inventory account #041, its BV is greater than the SI, therefore, its (BV-AV) = $1,112 is projected to the PPM = $1,112 in its entirety.
The auditor computes basic precision (BP) as follows:
The BP = SI X RF = 90,698 X 1.9 = $172,326.
The auditor computes incremental allowance (IA) as follows:
For inventory account #041, since its BV, $241,112, is greater than the SI, therefore, no IA is computed.
For inventory account #019 and #039, their BV are less than the SI, the IA is computed as follows:
Account
Projected
No.of
Incremental
Projected
No
change in
.
TP
(PPM)
RF
RF
(Adjusted PPM)
_____________________________________________________________________________________________
0
1.90
#039 0.10 $ 9,069
1
3.38 (3.38 1.90) = 1.48
$9,096 x 1.48 = $13,422
#019 0.07
6,348
2
4.72 (4.72 - 3.38) = 1.34
6,348 x 1.34 = 8,506
________
Total adjusted PPM $21,928
$15,417
Less total initial PPM $15,417
IA for sampling risk $ 6,511
The CUMR is the sum of the PPM and ASR as follows:
CUMR = PPM + ASR (where ASR = BP + AI)
= $16,529 + 172,326 + 6,511 = $195,366
Using MUS technique to observe both overstatement and understatement misstatements.

The application of MUS technique to observe both overstatement and understatement misstatements follows the same procedure as that used only
for overstatement misstatements. Five minor procedural differences are as follows:
(1) Place observed overstatements and understatements into two separate groups - one for overstatements and one for understatements.
(2) Determine the TP for each observed misstatement in the overstatement group and the understatement group.
(3) Determine the total PPM in the overstatement group and the understatement group.
(4) Determine the IA for sampling risk in the overstatement group and the understatement group.
(5) Determine the CUMR for the overstatement group, CUMRo, and the understatement group, CUMRu.
Example:
The auditor's TOB on the sample inventory accounts reveal:
Three overstatements. They are inventory account #019 (scanner), #039 (Excel), and #041 (Motherboard). The audited values for these three
inventory accounts are $60,000, $10,000, and $240,000, respectively.
Two understatements. They are inventory account #011 (Pentium Chip) and #029 (Microsoft Word). The audited values for these two accounts
are $644,270 and $79,890, respectively.
For the overstatement group:
The auditor determines CUMR for the overstatement group, CUMR o, in the same manner as when the MUS technique is used to observe only
overstatement misstatements. That is,
CUMRo = PPM + ASR (ASR = BP + AI)
= $16,529 + 172,326 + 6,511 = $195,366
For the understatement group:
The auditor determines of the CUMR for the understatement group, CUMRu, as follows:
311
312

Compute TP and PPM.
Inventory Book
Audited
Tainting
Projected
Account
Value
Value
(BV-AV)
% (TP)
(SI)
(TPXSI)
_______________________________________________________________________________
#029
#011
$78,890 $79,890
642,270 644,270
$1,000
$2,000
0.01
N/A*
90,690
$ 906.9
N/A
2,000.0
Total PPM $2,906.9
TP = (BV-AV)/BV
PPM = TP X SI
For inventory account #029, PPM =(0.01 X 90,690) = $906.9
* For inventory account #011, its book value is greater than the sample interval, therefore, its (BV-AV) = $2,000 is projected to the PPM =
$2,000 in its entirety.
Compute incremental allowance.
For inventory account #011, since its book value, $642,270, is greater than the sample interval, therefore, no incremental allowance (IA) is
computed.
For inventory account #029, its book value is less than the sample interval, the incremental allowance is computed as follows:
Account
Projected
No. of
Incremental
Projected
No
change in
.
TP
(PPM)
RF
RF
(Adjusted PPM)
_____________________________________________________________________________________________
0
1.90
#029 0.01 $ 906.9
1
3.38 (3.38 1.90) = 1.48
$906.9 x 1.48 = $1,342.2
________
Total adjusted PPM $1,342.2
$ 906.9
Less total initial PPM $ 906.9
IA for sampling risk $ 435.3
The computed upper misstatement rate for the understatement, CUMRu, is the sum of the PPM and ASR as follows:
CUMRu = PPM
+ ASR (where ASR = BP + AI)
= $2,906.9 + 172,326 + 435.3 = $175,668

Like in attribute sampling, the auditor also considers the qualitative characteristics, such as the nature and cause of the detected misstatement. For
example, misstatements that result from intentional misrepresentations (frauds), rather than those that are due to misunderstanding of instructions
or carelessness, will have more impact on the auditors overall evaluation of the sample account balance or class of transactions, and the choice
of alternative TOB procedures.
Example:
Before an overall conclusion about the acceptability of the inventory account balance is made, the auditor should consider the qualitative
characteristics of the sample inventory account misstatements. For example, the auditor should consider whether the sample misstatements (SM)
are errors or frauds. Also, if the SM indicates that the initial assessment of the client's CR used in determining the ARIA is inappropriate, the
auditor should reconsider the ARIA and redesign the sampling plan. Finally, if the SM provides evidence inconsistent with corroborative
evidence gathered from performing analytical procedures and other TOB procedures, the auditor should re-evaluate the assertion supported by
the evidence.

When the MUS technique is used to observe only overstatement misstatements

To draw a conclusion when the MUS technique is used to only observe overstatement misstatement, the auditor compares the CUMR with TMR.
If the CUMR is less than the TMR, the auditor can state statistically that the client's book value is fairly stated at the specified level of ARIA.
However, the precise procedure of comparing CUMR and TMR depends on whether misstatements are found in the sample:
(1) No Misstatement found in the sample.
If the auditor finds no misstatement in the sample, then the CUMR is equal to the basic BP:
Since
CUMR = PPM + ASR,
if
SM = 0, then TP = 0 and PPM = 0,
also
SM = 0, then IA = 0, and ASR = BP,
therefore CUMR = BP.
If no misstatement is found, both the sample misstatement (SM) and tainting percentage (TP) are equal to zero. Therefore, the projected
population misstatement (PPM) is zero. In addition, the allowance for sample risk is equal to the basic precision (BP) because the incremental
allowance (IA) for sampling risk is not computed when there is no misstatement. Accordingly, when no misstatement is found, the computed
upper misstatement rate (CUMR) is simply equal to the basic precision (BP).
The auditor makes a statistical statement about the population book value (PBV) by comparing the CUMR with the TMR.
To illustrate, assume the SI is $100, the ARIA is 10%, and the EPMR is zero. From Table 12-3, the RF is 2.31 for ARIA = 10% and EPMR = 0.
Therefore, the BP = (SI x RF) = ($100 x 2.31) = $231. Since no misstatement is found, SM = 0 and TP = 0. Therefore, the PPM = 0. Moreover,
there is no IA when no misstatement is found. The CUMR is simply:
CUMR = PPM + BP + IA
= 0
+ $231 + 0
= $231.
The auditor makes a statistical statement about the population book value (PBV) by comparing the CUMR with the TMR. Assume the PBV is
$5,000 and the TMR is $500, the auditor can conclude that the PBV, $5,000, is not overstated by more than $231 at a 10% ARIA.
(2) Misstatement found in the sample
When misstatements are found, the auditor determines all the subcomponents of the CUMR: (a) the SM whose book values are equal or greater
than the SI, (b) the TP for misstatements whose book values are less than the SI, (c) the BP, and (d) the IA for SM whose book values are less
than the SI. No IA is computed for SM whose book values are equal or greater than the SI. Finally, the auditor makes a statistical statement
about the PBV by comparing the CUMR with the TMR.
To illustrate, SM = $213,000, (TP x SI) = $36,000, BP = $231, and IA = $11,062, the CUMR is:
CUMR = PPM + ASR
CUMR = [SM + (TPXSI)]
+ (BP + IA)
CUMR = (213,000 + $36,000) + ($231 + $11,062)
= $260,293
Assume the ARIA is 5%, the PBV is $10,000,000, and the TMR is $500,000, the auditor can state statistically that the PBV, $10,000,000, is not
overstated by more than $260,293 at a 5% ARIA.
Example:
To draw a conclusion, the auditor compares the CUMR with the TMR. Since TMR = $172,325, CUMR = $195,366, and CUMR > TMR, the
auditor can state statistically that the client's inventory book value is materially misstated at 15% ARIA.
The auditor draws a final conclusion that the inventory book value is not acceptable if (1) as indicate by the comparison of CUMR and TMR, the
inventory book value is materially overstated at 15% ARIA, (2) evidence gathered from other TOB procedures is consistent with the sample
results, and (3) qualitative analysis of the misstatements indicates no fraud.
When the MUS technique is used to observe both overstatement and understatement misstatements
To draw a conclusion when the MUS technique is used to observe both overstatement and understatement misstatements, the auditor compares
the CUMRo and CUMRu with the TMR for the overstatement group, TMR o and the understatement group, TMRu and makes a statistical
statement about the PBV using the following statistical decision rule:
(1) If both the CUMRo and CUMRu fall between the TMRo for the overstatement and the TMRu for the understatement groups, the auditor can
state statistically that the PBV is not materially misstated.
(2) If either the CUMRo or CUMRu falls outside the TMRo for the overstatement and the TMRu for the understatement groups, the auditor can
state statistically that the PBV is materially misstated.
The decision rule can be depicted as follows:
Both the CUMRo and CUMRu fall between the TMRo and TMRu, the PBV is not materially misstated.
TMRu
0
TMRo
|_________________|____________________|
CUMRu
CUMRo
|_____________________|
313
314

Either the CUMRo or CUMRu falls outside the TMRo and TMRu, the PBV is materially misstated.
TMRu
0
TMRo
|_________________|____________________|
CUMRu
CUMRo
|_____________________________|
Either the CUMRo or CUMRu falls outside the TMRo and TMRu, the PBV is materially misstated.
TMRu
TMRo
|_________________|____________________|
CUMRu
CUMRo
|______________________________________|
Example:
To draw a conclusion, the auditor compares CUMRo and CUMRu with TMRo and TMRu:
CUMRo = $195,399 which is greater than TMRo = $172,325.
CUMRu = $175,668 which is greater than TMRu = $172,325.
Since both the CUMRo and CUMRu fall outside the TMRo for the overstatement and the TMRu for the understatement groups, the auditor can
state statistically that the PBV is materially misstated at 15% ARIA.
The decision rule can also be depicted in the form of a diagram as follows:
TMRu = $172,325
TMRo = $172,325
|__________________|_____________________|
CUMRu
CUMRo
= $175,668
= $195,399
|__________________________________________________|
Table 12-2 A list of Individual Inventory Accounts

Inventory
Description
Recorded
Cumulative
Account
of
Book
Monetary
Number
Inventory
Value
Amount
________________________________________________________________
#001
#002
#003
#004
#005
#006
#007
#008
#009
#010
#011
#012
#013
#014
#015
#016
#017
#018
#019
#020
#021
#022
#023
#024
#025
#026
#027
#028
#029
#030
#031
#032
#033
#034
#035
#036
#037
#038
#039
#040
#041
#042
#043
#044
#045
#046
#047
#048
#049
#050
Bubble jet printer

CD-Rom drive
Keyboard
Multi-media speakers
Port
Laptop
Sound blaster card
Video card
Fax/modem
Surge protector
Pentium chip
Cords
Anti-glare screen
Mouse
Joystick
Dot-matrix printer
Ethernet card
Floppy drive
Scanner
Laserjet printer
Graphic card
Internal battery
Ac/dc adapter
MS-DOS
Windows
QEMM
Lotus 1-2-3
Word Perfect
Microsoft Word
Wordstar
Quicken
Norton Antivirus
Freelance
SPSS+
Flight Simulator
XtreeGold
Desqview
CAD
Excel
Dbase
Motherboard 486
Hard disk drive
SVGA monitor
Connector
Myst
7 Guest
Corel gallery
G encyclopedia
Microsoft pub
Expert maps
$ 24,410
79,130
460
2,355
1,225
28,210
3,380
710
525
755
642,270
550
3,585
8,960
4,520
3,380
5,530
3,995
64,800
117,140
4,865
770
2,305
965
55,600
425
5,663
6,250
78,890
2,440
35,935
5,595
1,830
4,045
9,480
3,360
2,145
6,400
11,100
8,435
241,112
68,000
45,988
432
56,000
40,876
458
3,000
18,000
7,000
Total inventory account balance
$ 24,410
103,540
104,000
106,355
107,580
135,790
139,170
139,880
140,405
141,160
783,430
783,980
787,565
796,525
801,045
804,425
809,955
813,950
878,750
995,890
1,000,755
1,001,525
1,003,830
1,004,795
1,060,395
1,060,820
1,066,483
1,072,733
1,151,623
1,154,063
1,189,998
1,195,593
1,197,423
1,201,468
1,210,948
1,214,308
1,216,453
1,222,853
1,233,953
1,242,388
1,483,500
1,551,500
1,597,488
1,597,920
1,653,920
1,694,796
1,695,254
1,698,254
1,716,254
1,723,254
________
$ 1,723,254 (PBV)
=====
315
316
Table 12-3 Reliability Factor for Specified Risk of Incorrect Acceptance

_____________________________________________________________
Number*
Risk of Incorrect Acceptance
of Mis- _____________________________________________________
statements
1% 5% 10% 15% 20% 25% 30% 37% 50%
_____________________________________________________________
0
4.61 3.00 2.31 1.90 1.61 1.39 1.21 1.00 0.70
1
6.64 4.75 3.89 3.38 3.00 2.70 2.44 2.14 1.68
2
8.41 6.30 5.33 4.72 4.28 3.93 3.62 3.25 2.68
3
10.05 7.76 6.69 6.02 5.52 5.11 4.77 4.34 3.68
4
11.61 9.16 8.00 7.27 6.73 6.28 5.90 5.43 4.68
5
13.11 10.52 9.28 8.50 7.91 7.43 7.01 6.49 5.68
6
14.57 11.85 10.54 9.71 9.08 8.56 8.12 7.56 6.67
7
16.00 13.15 11.78 10.90 10.24 9.69 9.21 8.63 7.67
8
17.41 14.44 13.00 12.08 11.38 10.81 10.31 9.68 8.67
9
18.79 15.71 14.21 13.25 12.52 11.92 11.39 10.74 9.67
10
20.15 16.97 15.41 14.42 13.66 13.02 12.47 11.79 10.67
11
21.49 18.21 16.60 15.57 14.78 14.13 13.55 12.84 11.67
12
22.83 19.45 17.79 16.72 15.90 15.22 14.63 13.89 12.67
13
24.14 20.67 18.96 17.86 17.02 16.32 15.70 14.93 13.67
14
25.45 21.89 20.13 19.00 18.13 17.40 16.77 15.97 14.67
15
26.75 23.10 21.30 20.13 19.24 18.49 17.84 17.02 15.67
16
28.03 24.31 22.46 21.26 20.34 19.58 18.90 18.06 16.67
17
29.31 25.50 23.61 22.39 21.44 20.66 19.97 19.10 17.67
18
30.59 26.70 24.76 23.51 22.54 21.74 21.03 20.14 18.67
19
31.85 27.88 25.91 24.63 23.64 22.81 22.09 21.18 19.67
20
33.11 29.07 27.05 25.74 24.73 23.89 23.15 22.22 20.67
_____________________________________________________________
* Number of misstatement applies to overstatements but not understatements, as negative and zero balances are often excluded from the sample
and tested separately. Source: AICPA, Audit and Accounting Guide, Audit Sampling .
Table 12-4 The Selection of the First 10 Sample Inventory Accounts

The SI = BV / n = 1,723,254/19 = $90,698. The random start is $50,000, the first 10 sample inventory accounts are:
Dollar Unit Selected
Account Selected
Balance to Test
Cumulative Amount
________________________________________________________________________________________________________
50,000th
1. #002 CD-Rom drive
$ 79,130
103,540
50,000+1(90,698) = 140,698
2. #010 Surge protector
755
141,160
50,000+2(90,698) = 231,396
3. #011 Pentium chip
642,270
783,430
50,000+3(90,698) = 322,094
No matching account
50,000+4(90,698) = 412,792
No matching account
50,000+5(90,698) = 503,490
No matching account
50,000+6(90,698) = 594,188
No matching account
50,000+7(90,698) = 684,886
No matching account
50,000+8(90,698) = 775,584
No matching account
50,000+9(90,698) = 866,282
4. #019 Scanner
64,800
878,750
50,000+10(90,698)= 956,980
No matching account
50,000+11(90,698)=1,047,678
5. #025 Windows
55,600
1,060,395
50,000+12(90,698)=1,138,368
6. #029 Microsoft Word
78,890
1,151,623
50,000+13(90,698)=1,229,058
7. #039 Excel
11,100
1,233,953
50,000+14(90,698)=1,319,748
8. #041 Motherboard 486
241,112
1,483,500
50,000+15(90,698)=1,410,438
No matching account
50,000+16(90,698)=1,501,128
9. #042 Hard disk drive
68,000
1,551,500
50,000+17(90,698)=1,591,818
10. #043 SVGA monitor
45,988
1,597,488
______________________________________________________________________________________________________
12-1
It is wrong for the auditor to conclude that the population misstatement rate will be exactly the same as the sample misstatement rate
because
a. sample size is independent of population size.
b. there are not enough items in the sample to make that conclusion.
c. the population is less than 5000.
d. the presence of sampling risk representing the probability that the sample characteristics will not be representative of the
population characteristics.
12-2
When MUS technique is used to examine the book value of inventories, each inventory
a. has an unknown probability of being selected.
b. has an equal probability of being selected.
c. has a probability proportional to its dollar value of being selected.
d. has a probability proportional to one dollar unit.
12-3
When MUS technique is used to examine the book value of inventory, if the 80th dollar of inventory is selected,
a. the entire inventory account associated with the 80th dollar is examined.
b. an inventory account with exactly $80 is examined.
c. an inventory account more than $80 is examined.
d. only the one 80th dollars in an inventory account is examined.
12-4
In MUS technique, assuming all other factors remain constant, which one of the following would lead to a larger sample size?
a. Higher detection risk, DR.
b. Lower acceptable risk of incorrect acceptance, ARIA.
c. Higher tolerable misstatement rate, TMR.
d. Lower reliability factor, RF.
12-5
If MUS technique is used to observe both overstatements and understatement, a book value is rejected if
a. both its computed upper misstatement rate, CUMRo, and computed lower misstatement rate, CUMRu, are within the
tolerable misstatement range.
b. its computed upper misstatement rate, CUMRo is less than the tolerable error for overstatement.
c. either its computed upper or lower misstatement rate is beyond the tolerable misstatement range.
d. the average of its computed upper and lower misstatement rate is within the tolerable misstatement range.
12-6
In MUS technique, assuming all other factors remain constant, which one of the following would lead to a smaller sample size?
a. An increase in both the computed upper and lower misstatement rates bounds.
b. A lower tolerable misstatement rate.
c. A higher reliability factor, RF.
d. A larger population size.
12-7
Which one of the following statements best describes what the auditor meant by incremental allowance in MUS technique?
a. An allowance for the risk arising from auditing all the sample items in the sample intervals.
b. An allowance for the risk arising from not auditing some of the sample items in the sample intervals.
c. An allowance for the risk arising from not auditing the same sample items in the sample intervals.
d. An allowance for the risk arising from not auditing all the sample items in the sample intervals.
12-8
When using MUS technique, evaluating the likelihood of unrecorded items in the population
a. is impossible.
b. is unnecessary.
c. is possible but difficult.
d. is an automatic outcome of the sampling process.
317
318
12-9
In MUS technique, the decision rule to determine whether the population is acceptable is Accept the conclusion that the
book value is not misstated by a material amount if
a. the upper error bound (CUMRO ) falls between the understatement and overstatement tolerable misstatement amounts.
b. both the lower (CUMRU) and upper (CUMRO) error bound falls between the understatement and overstatement
tolerable misstatement amounts.
c. both the understatement and overstatement tolerable misstatement amounts fall between the upper (CUMR O) and lower
(CUMRU) error bound.
d. the overstatement tolerable misstatement amount falls between the lower (CUMR O) and upper (CUMRU) error bound.
12-10
In MUS technique, items containing large understatement errors

a. have an increased probability of being included in the sample.
b. are of less concern than those with large overstatement errors.
c. may have a small recorded value due to those errors.
d. all of the above.
12-11
The relationship between sample size and the acceptable risk of incorrect acceptance (ARIA) is
a. variable (sometimes large, sometimes small).
b. inverse.
c. direct.
d. indeterminate.
12-12
In MUS technique, when using systematic sample selection method on accounts receivable, the sample interval is
determined by
a. consulting a random number table.
b. dividing the population size by the accounts receivable with the largest dollar value.
c. dividing the sample size by the account with the largest dollar value.
d. dividing the population size by the desired sample size.
12-13
For MUS technique, normally the expected population exception rate (EPER) is
a. 0%
b. between 1% and 5%, inclusive.
c. between 6% and 10% inclusive.
d. greater than 10%.
12-14
In confirming a clients accounts receivable in prior years, an auditor found that there were many differences between the
recorded account balances and the confirmation replies. These differences, which were not misstatements, required
substantial audit time to resolve. In defining the sample unit for the current years audit, the auditor most likely would choose
a. small account balances.
b. large account balances.
c. individual overdue balances.
d. individual invoices.
12-15
The acceptable risk of incorrect acceptance (ARIA) is related to the

a. tolerable misstatement (TM) of the audit.
b. preliminary judgment about materiality (PJAM) of the audit.
c. efficiency of the audit.
d. effectiveness of the audit.
12-16
While performing a TOB during an audit, an auditor determined that the sample results supported the conclusion that the
recorded account balance was materially misstated. It was, in fact, not materially misstated. This situation illustrates the risk of
a. acceptable risk of under-reliance (ARU).
b. acceptable risk of over-reliance (ARO).
c. acceptable risk of incorrect acceptance (ARIA).
d. acceptable risk of incorrect rejection (ARIR).
12-17
Which of the following is not true about a probability-proportional-to-size (PPS) sampling technique?
a. PPS automatically stratifies the population; therefore, it is appropriate for audit populations that are stratified.
b. Inclusion of zero and negative balances in PPS often requires special consideration.
c. An estimate of the standard deviation of the normally distributed populations record amounts is required in PPS.
d. In PPS, a larger account balance or class of transactions have a higher probability of being selected for testing.
12-18
When planning a sample for a TOB, an auditor should consider tolerable misstatement rate (TMR) for the sample. This
consideration should
a. be related to the auditors business risk.
b. be related to the preliminary judgment about materiality (PJAM).
c. be directly related to the sample size.
d. be related to the reliability factor (RF).
12-19
Which of the following is correct concerning monetary unit sampling (MUS)?

a. The sampling distribution should approximate the normal distribution in MUS
b. Overstated units have a lower probability of sample selection than understated units in MUS
c. The auditor controls the acceptable risk of incorrect acceptance (ARIA) by specifying that risk level for the MUS
sampling plan.
d. The sample interval is calculated by dividing the number of physical units in the population by the sample size in MUS
12-20
How would increases in tolerable misstatement rate (TMR) and acceptable risk of incorrect acceptance (ARIA) affect the
sample size in a TOB?
a.
b.
c.
d.
12-21
Increase in TMR
Increase sample size
Decrease sample size
Increase in ARIA
Which of the following sampling plans is used to estimate a numerical measurement of a population, such a dollar value?
a. Attribute sampling plan.
b. Stop-or-go sampling plan.
c. Monetary unit sampling plan.
d. Random-number sampling plan.
12-22
When planning a sample for a test of balance, an auditor should consider tolerable misstatement rate (TMR) for the sample.
This consideration should
a. be related to the auditors business risk.
b. not be adjusted for qualitative factor.
c. be related to preliminary judgments about materiality (PJAM) levels.
d. not be changed during the audit process.
12-23
While performing a test of balances during an audit, the auditor determined that the sample results supported the
conclusion that the recorded account balance was materially misstated. It was, in fact, not materially misstated. This
situation illustrates the risk of
a. Incorrect rejection.
b. Incorrect acceptance.
c. Assessing control risk too low.
d. Assessing control risk too high.
12-24
Which of the following sampling planning factors would influence the sample size for a TOB for a specific account?
a.
b.
c.
d.
Expected Amount of Misstatements

No
Yes
No
Yes
Measure of Tolerable Misstatement

No
Yes
Yes
No
319
320
12-25
Which of the following statements is true concerning PPS sampling technique, also known as MUS sampling technique?
a. The sampling distribution should approximate the normal distribution.
b. Overstated balances have a lower probability of sample selection than units that are understated.
c. The auditor controls the risk of incorrect acceptance by specifying that risk level for the sampling plan.
d. The sampling interval is calculated by dividing the number of physical units in the population by the sample size.
12-26
In MUS sampling technique, which of the following is correct for calculating the allowance for sampling risk (ASR) when
the basic precision (BP) is less than the sample internal (SI)?
a. Projected Population Misstatement (PPM) + Incremental Allowance (IA).
b. Basic Precision (BP) + Sample Interval (SI).
c. Book Value of misstated sample item (BV) + Sample Interval (SI).
d. Basic Precision (BP) + Incremental Allowance (IA).

12-1 d. 12-2 c. 12-3 a. 12-4 b. 12-5 c. 12-6 a. 12-7 d. 12-8 a. 12-9 b. 12-10 c. 12-11 b.
12-12 d. 12-13 a. 12-14 d. 12-15 d. 12-16 d. 12-17 c. 12-18 b. 12-19 c. 12-20 d. 12-21 c.
12-22 c. 12-23 a. 12-24 b. 12-25 c. 12-26 d.

California.
The Sampling Issues
You are the manager-in-charge of auditing Bio Med Co. at South Francisco. For its current year audit, you are concerned that Mina
Sung, a new recruit, may not perform her assigned task to the quality control standard of your CPA firm. She is assigned to apply MUS sampling
to test the accounts receivable of Bio Med Co. Since you are responsible for supervising Mina, you ask her for a memo on her application of the
MUS sampling procedures. Below is the memo she wrote to you:
MEMORANDUM
To: Audit Manager-in-Charge
From: Mina Sung
Date: 1/1/2013
Re: My work on applying MUS to Bio Med Co.s Accounts Receivable
I decided to apply an attribute sampling plan in performing tests of balances on Bio Med Co.s accounts receivable. Specifically, I chose the
MUS technique for confirming its accounts receivable because the MUS uses each account in the population as a separate sampling unit.
Moreover, I expected to discover many misstatements, as such, the MUS would be an efficient technique for that purpose.
I reasoned that the MUS would automatically result in a stratified sample because each account would have an equal chance of being selected
for confirmation. Moreover, the selection of negative (credit) balances would be facilitated without special considerations.
I computed the sample size using the materiality threshold (MT) from the preliminary judgment about materiality (PJAM), acceptable risk of
incorrect acceptance (ARIA), the total recorded book amount of the receivables (PBV), and setting the expected population misstatement rate
(EPMR) equal to 2. I then divided the PBV by the sample size to determine the sample interval and calculated the standard deviation of the dollar
amounts of the accounts selected for evaluating the receivables.
My calculated sample size was 100, and the sampling interval was determined to be $10,000. However, only 95 different accounts were
selected because five accounts were so large that the sampling interval caused each of them to be selected twice. I proceeded to send
confirmation requests to 90 of the 95 accounts receivables because five of the 95 selected accounts had insignificant recorded balances under
$10.
The confirmation process revealed two differences. One account with an audited amount of $1,000 had been recorded at $2,000. I projected
this to be a $1,000 overstatement. However, I did not use a tainting percentage to determine the projected overstatement because I did not know
how to do it. Another account with an audited amount of $3,000 had been recorded at $2,000. I did not project this understatement because the
purpose of the MUS test was to detect only overstatements.
In evaluating the sample result, I concluded that the total accounts receivable balance (PBV) was not overstated because the computed upper
misstatement rate for the overstatement (CUMRO) is less than the tolerable misstatement rate for overstatement (TMRO) and the computed upper
misstatement rate for the understatement (CUMRu) is more than the tolerable misstatement rate for understatement (TMRu).
Required
1. Review Minas memo for each incorrect assumption, statement, and computation in her application of the MUS technique in confirming Bio
Med Co.s accounts receivable. You should identify at least a total of 10 such incorrect assumption, statement, and computation.
2. Based on your review in question 1, draft a reply memo to Mina pointing out her incorrect assumption, statement, and computation. Your
memo should provide constructive criticism and feedback; for example, show Mina how to use the tainting percentage to determine the projected
misstatement.

Simulation Question 12-2 is an adaptation with permission from an article by Lanza, R. B. in the The White Paper , a publication of the
Association of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and
lamented.
321
322
and sales voids.
Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 12-2-1
(Excel file) in iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file,
Bruce planned to analyze the data to find out if Helen was in fact posting large number of phony discounts, sales voids and refunds. Bruce made
cross-reference to his working papers on payroll cycle to identify Helens employee number 0000000003, and he planned to:
1. Extract sales with discounts over 90% and summarize by employee;
2.List the top 10 employees by register adjustments (discounts, refunds, and sales voids), and
3.Identify employees that have produced register adjustments (discounts, refunds, and sales voids) over 300 % more than the average employee.
Bruce conducted what he had planned to do and produced three reports as follows:
Report No.1 Extract sales with discounts over 90% and summarize by employee.
Report No.2 List the top 10 employees by register adjustments (discounts, refunds, and sales voids).
Report No.3 Identify employees that have produced register adjustments over 300% more than the average employee.
You should access Data File 12-2 (Word file) in iLearn for Bruces Reports 1, 2, and 3. After reviewing the three Reports, Bruce was
confident that Helen (employee number 0000000003) is the number one suspect in the retail store.
In light of this discovery, Bruce further suspected that Helen probably colluded with Janet, the bank deposit staff, to cover up her
embezzlements by under reporting the daily bank deposits. Bruce obtained from Janet the daily bank deposit slips for the financial year a total
of 313 daily deposits. You should access Data File 12-2-2 (Excel file) in iLearn for the daily bank deposit data file, which shows the
recorded 313 daily deposit amounts for the financial year. Bruce planned to use the monetary unit sampling (MUS) technique to test the total
bank deposits for the financial year was not materially misstated. The audited daily deposit amounts are show in the last column of the daily bank
deposit data file.
Required
Access Data File 12-2-2 (Excel file) in iLearn for the daily bank deposit data file, which shows the recorded 313 daily deposit amounts
and the audited daily deposit amounts for the financial year.
1. Refer to the 14 steps for implementing the MUS technique in Chapter 12 and document how Bruce used the technique to test the total bank
deposits for the financial year was not materially misstated. Some information for using the MUS techniques are given, you are to use them to
complete the documentation.
Documenting Bruces Application of the MUS Technique
1. State the objective of Bruces test.

Bruce used individual daily bank deposit slips as the sample unit.
6. Specify the tolerable misstatement rate (TMR).
Based on the TM that was allocated from PJAM to bank deposits, Bruce calculated the TMR = 5% of the $ 41,712,455 total bank deposits.
7. Specify the acceptable risk of incorrect acceptance (ARIA).
Based on the expanded audit risk model AR = IR X CR X NSR X ARIA, Bruce calculated the ARIA = 15%.
8. Estimate the expected population misstatement rate (EPMR).
Following AICPAs guidance, Bruce specified EPMR = 0%.

Bruce used the systematic sample selection method as follows:
The random start daily bank deposit amount was $ 100,000.
11. Perform the TOB procedure on sample items.
Bruce found _______ daily bank deposits were understated, i.e., sample daily deposit amounts in the audited daily deposit amount
column were less than those in the recorded daily deposit amount column in the daily bank deposit data file.
Bruce calculated the CUMRU = $4,338,246 and CUMRO = $213,000.
Bruce analyzed and found no qualitative characteristics of concern.
2. Do you think the result of Bruces MUS sampling test supports the fact that Helen probably covered up her embezzlements by colluding with
Janet to under report the daily bank deposits of the retail store?
a. If yes, suggest at least three further actions/procedures that Bruce might take to confirm Helens embezzlements:
i. Further actions/procedures
ii. Further actions/procedures
iii. Further actions/procedures
b. If no,
i. Should Bruce take further actions such as expand the sample size and/or revise PJAM/TM or NSR? Explain.
iii. Should Bruce use an additional statistical sampling technique such as the mean-per-unit estimation technique? Explain.

California.
Your MUS Sampling
You have decided to use MUS (Monetary Unit Sampling technique) in testing a clients accounts receivable balance. Few, if any,
misstatements of account balance overstatement are expected.
Required
1. Compare and contrast MUS (Monetary Unit Sampling technique) with CVS (Classical Variable Sampling technique) for TOB (Tests of
Balances).
2. Calculate your sample size using MUS given the following information:
Recorded amount of accounts receivable (PBV) = $330,482.73
Tolerable misstatement rate = 10%
Expected population misstatement rate (EPMR) = 0
Acceptable risk of incorrect acceptance (ARIA) = 15%
3. Calculate your sample interval using systematic sample selection method.
4. Calculate your CUMR (Computer Upper Misstatement Rate) using MUS to observe only overstatement misstatements and given the following
information:
Sample misstatement (SM) = $2,986.54
Projected population misstatement (PPM) = $3,187.80
Allowance for sampling risk (ASR) = $165,976.20
5. Based on your above calculations, draw a statistical conclusion on whether the clients accounts receivable balance is materially overstated at
15% ARIA.
323
324
Chapter 13
Revenue Cycle Tests of Controls and Tests of
Balances
LO13-1 Understand the accounting information system of a typical revenue cycle.
LO13-2 Describe some common TOC procedures for sales.
LO13-3 Describe some common TOC procedures for cash receipts.
LO13-4 Apply the analytical procedures in a revenue cycle.
LO13-5 Describe some common TOB procedures for accounts receivable.
LO13-6 Distinguish between positive and negative accounts receivable confirmations.
LO13-7 Identify the factors for choosing between positive and negative accounts
receivable confirmations.
LO13-8 Understand TOB cut-off procedures for sales and sales returns.
Chapter 13 Revenue Cycle Tests of Controls and Tests of Balances

An overview of the strategy for tests of controls in a revenue cycle is presented in Figure 13-1.
Figure 13-1 TOC Strategy in Revenue Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
325
326
Understand Internal Controls in a Revenue Cycle

TOC strategy in a revenue cycle starts with an understanding of internal controls relating to a revenue cycle. Table
13-1 provides a brief discussion of the various components relating to the understanding of internal controls in a
revenue cycle.
Table 13-1 Understanding Internal Controls in a Revenue Cycle
Understanding Internal Control in a Revenue Cycle
1. Control environment
2. Risk assessment
3. Control activities
5. Monitoring
Table 8-1 in Chapter 8 listed seven factors affecting the control environment. Since these factors affect all
accounting cycles, understanding of the control environment is generally conducted for all the accounting
cycles taken as a whole. The auditor should, however, consider any control environment factors that may
have a special effect on the revenue cycle.
Table 8-1 in Chapter 8 listed the five basic management assertions that must be met by the managements
risk assessment. The auditor must understand how management assesses risks that are relevant to the
revenue cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to
address those risks in order to meet the five basic management assertions.
Table 8-1 in Chapter 8 listed the five basic control activities that must be established in an accounting
cycle. If the auditor plans to conduct both TOC and TOB on the revenue cycle, then s/he needs to identify
the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR).
The auditor usually identifies these control activities from documentations of the understanding using
narrative descriptions, internal control questionnaires, or flowcharts. Figure 13-8 shows an example of a
revenue cycle flowchart.
The auditor must obtain sufficient knowledge of the accounting information system relating to the revenue
cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in
Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown
in Figure 13-2. A brief discussion of these three areas is provided in Table 13-2.
The auditor must understand the managements monitoring processes over the revenue cycle. This includes
understanding how the management monitors the internal controls of the revenue cycle over time and what
corrective action is initiated to improve the design and operation of controls in the revenue cycle.
Figure 13-2 Understanding of Information and Communication in a Revenue Cycle
Key Functions
Understand 8 key functions of a revenue
cycle
Accounts and Classes of

Transactions
Understand how the 8 key functions are
recorded in accounts and grouped in classes
of transactions
Documents and Records

Understand how the accounts and classes of
transactions are supported by documents and
records
Table 13-2 Understanding of Information and Communication in a Revenue Cycle

Transactions
Key Functions
Accounts
(control ledger)
1. Order entry
Accepting and processing
customer orders for goods
and services.
Sales
Accounts
receivable
Classes of
Transactions
Sales
(form, list, schedule, report, book, subsidiary ledger, file)
Customer (Purchase) order

This document contains the details of the type and quantity of
products or services ordered by the customer. It may be forwarded
by a salesperson, received through the mail, fax, or on-line order
over the internet. It is frequently in the form of a purchase order
prepared by the customer's purchasing department. Purchase
orders are generally recorded on sale invoices so that the auditors
can match the purchase order to which a sales invoice relates.
Figure 13-3 shows an example of a purchase order from customer.
Sales order
An internally prepared document that specifies the goods or
services requested in the customer order. The sales order
generally records the customer's purchase order number, a
description of the goods, the quantity, price, credit terms, and
shipping terms. The auditors can check for the numerical
sequence of the sales orders to determine that shipments are made
for all sales orders and that all sales are billed. Figure 13-4 shows
an example of a sales order.
Customer order file

A file of unfilled customer orders. The auditor inspects the
customer order file for explanations of an unusually large number
of unfilled customer orders.
2. Credit authorization
Approving and granting
customer orders.
Credit approval form

A form that approves credit granted to a customer. This form is
also used to establish the credit limit of the customer.
Approved customer list

A list of customers in good standing. Orders from customers on
this list can be accepted without special approval. The auditor
inspects the approved customer list for proper authorization of
credit terms.
3. Shipping
Shipping of goods that
have been authorized.
4. Billing
Billing customers for
goods shipped or services
provided and recording
sales.
Shipping document
A document that specifies the terms (F.O.B. origin or F.O.B.
destination), date, description, and quantity of goods shipped to
customers. The shipping document may be in the form of a bill of
lading, a document governed by the Uniform Commercial Code,
which serves as a contract between a seller and a freight carrier,
and a formal acknowledgment of the receipt of goods for delivery
by the freight carrier. The auditors check for the signature of the
freight carrier on the bill of lading to provide external evidence
that goods have been shipped. Figure 13-5 shows an example of a
bill of lading.
Sales invoice
A document used to bill customers for goods or services,
specifying the description, quantity, and price of goods sold and
the date and terms of sales. The auditors use the sales invoices to
identify credit terms, shipping terms, and prices charged for
merchandise. The auditors also account for the numerical
sequence of the sales invoices to ensure that all sales are recorded.
Figure 13-6 shows an example of a sales invoice.
Sales journal
A book of original entry that records credit sales transactions.
Some clients record each credit sale in the sales journal and others
accumulate a total for a day or a week and record them. The
auditor checks the sales journal for original entries of credit sales.
Accounts receivable subsidiary ledger (file)

A record of sales, cash receipts, and sales returns and allowances
327
328

Transactions
Key Functions
Accounts
(control ledger)

Classes of
Transactions
for each customer. The auditors check the accounts receivable

subsidiary ledger to confirm the closing balance for each
customer.
5. Cash receipts
Processing and recording
of the receipts of cash
from customers.
Cash
Account (Cash in
bank)
Monthly statement
A document sent to customers each month showing opening
balance, transactions for sales, sales adjustments, and cash
collections during the months, and closing balance. The auditors
use the monthly statement to confirm with the customer's
accounts receivable balance.
Cash
receipts
Accounts
receivable
Remittance advice
A document that accompanies the sales invoice mailed to the
customer and for the customer to return with the cash or check
payment. If a customer does not return a remittance advice, the
employee opening the mail usually prepares one. The auditors
check the remittance advice for the date and amount of payment
and the invoices paid.
Daily cash summary

An internal report that summarizes cash collections from
customer accounts and from cash register sales. The auditor
examines the daily cash summary to ensure that all cash receipts
are deposited in the bank.
6. Adjusting sales returns

and allowances
Adjusting sales for sales
returns, discounts, and
returns.
Sales returns
and allowances
Sales
discounts
discounts)
Cash receipts journal

A book of original entry for recording cash receipts transactions.
All cash receipts transactions, including cash sales, collections on
sales, and funds from borrowing or the issuance of stock, are
recorded in the cash receipts journal. The auditor checks the cash
receipts journal for original entries of cash receipts.
Sales returns
and allowances
(Cash
Accounts
receivable
7.
Determining
uncollectible accounts
Analyzing
accounts
receivable and providing
allowance
for
8.
Writing-off
of
uncollectible accounts
Approving and recording
the
writing-off
of
Allowance
for
uncollectible
accounts
Bad
expense
Sales returns and allowances journal

A book of original entry for recording returns of goods or
adjustments to invoice prices. The auditor checks the sales returns
and allowance journal for original entries of sales returns and
allowances.
Accounts
receivable
Credit memo
A document indicating a reduction in the amount due from a
customer because of returned goods or an allowance granted. The
auditor checks the credit memo for evidence that a seller has
reduced the amount previously billed a customer. The auditors
also account for the numerical sequence to ensure that all credit
memos are recorded. Figure 13-7 shows an example of a credit
memo.
debt
Allowance
for
uncollectible
accounts
Allowance
for uncollectible
accounts
Aging schedule of accounts receivable

This report prepared by the computer breaks customer balances
into categories of 30 days, 30-60 days, 60-90 days, and more than
90 days old. It is used to monitor the collection of receivables and
to check that the individual accounts receivable subsidiary ledgers
matches with the accounts receivable control ledger. The auditor
uses this schedule for conducting TOB.
General journal
A book of original entry for recording all transactions for which a
specific journal has not been created. In the revenue cycle, entries
for allowance for uncollectible accounts and write-offs of
uncollectible accounts are often recorded in this journal. The
auditor checks the general journal of original entries of
transactions that do not belong to any specific journals.
Write-off
Write-off authorization form

A document that authorizes the write-off of an accounts
receivable as uncollectible. The auditor accounts for the
numerical sequence to ensure that all write-offs are recorded.
Figure 13-3 An Example of a Purchase Order from Customer

PO #168
PURCHASE ORDER
ABC Company
CA 94132
To: XYZ Company
3rd Street, San Francisco
CA 94132
Customer Reference No. 966
Process Our Order For:
Quantity
10
10
Description
Computer Parts #11128
Contact Person: Fred
Date: Oct. 8, 201x
Price
$100
$200
Ship Via: FedEx Ground
Total
$1000
$2000
Terms: 2/10, n/30
Figure 13-4 An Example of a Sales Order

SO #963
SALES ORDER
XYZ Company
CA 94132
To: ABC Company
CA 94132
Description
Part No.
#11128
#11138
Computer Parts
Computer Parts
Credit Approval Person: Ray
Quantity
10
10
Date: Oct. 16, 201x
Figure 13-5 An Example of a Bill of Lading

BOL #45892
BILL OF LADING
XYZ Company
CA 94132
Consigned To: ABC Company
CA 94132
Sales Order #963
Quantity
2 Boxes
3 Boxes
Description
Weight
12 kilograms
26 kilograms

Shipper: FedEX Ground
Shippers Acceptance: John
Date: Nov. 22, 201x
329
330
Figure 13-6 An Example of a Sales Invoice

SI #82843
SALES INVOICE
XYZ Company
CA 94132
Sold To: ABC Company
CA 94132
Your Purchase Order #168
Quantity
10
10
Description
Price
$100
$200
Tax
Shipped: Nov. 22, 201x
Shipped Via: FedEX Ground
Total
$1000
$2000
240
$3240
Date: Nov 25, 201x.
Figure 13-7 An Example of a Credit Memo

CM #7459
CREDIT MEMORANDUM
XYZ Company
CA 94132
Customer: ABC Company
CA 94132
Sales Invoice #82843
Receiving Report# N/A
Description
Allowance for substandard computer parts
Authorized By: Bill
Date: Dec 7, 201x
Amount
$50
Figure 13-8 An Example of a Revenue Cycle Flowchart

Functions
Enter Sales
Documents & Records

Enter
Purchase
Order
Computer Process
Computer Files & Storage

Customer Master File
ORDER PROGRAM
Perform edit and credit
Checks.
Print sales orders.
Perpetual Inventory File
Sales
Order
Authorized Price List
Open Orders File
Shipping
Of
Goods
Approval
to Ship
Goods
Enter
Goods
Shipped
SHIPPING PROGRAM
Retrieve open orders
Add shipping data.
Transfer to shipping file.
Print shipping documents
back order/unfilled report.
Perpetual Inventory
Shipping File
Shipping
Document
Unfilled &
Back Order
Report
Record
Sales
Sales
Invoice
Report
Sales
Journal
BILLING PROGRAM
Retrieve shipped order data.
Prepare sales invoices.
Perform edit checks.
Enter data in sale
transaction file.
MASTER FILE UPDATE

PROGRAM
Update master files.
Print sales journal, general
ledger, monthly statements,
daily sales report, and error
report.
General
Ledger
Sales Transaction File
General Ledger Master

File
Error
Report
Accounts Receivable
Master File
Monthly
Statements
Daily Sales
Report
331
332
Functions
Process
Cash
Receipts
Documents & Records

Customer
Remittance
CASH RECEIPTS PROGRAM

Print Bank Deposit Control Total
Listing.
Print Credit Memo.
Enter Data in Cash Receipts
Transaction File.
Enter Receipts
Data
Sales Returns
Approval
Computer Process
Cash Receipts Transaction

File
Error
Report
Bank Deposit
Control Total
Listing
Credit Memo
Sales
Journal
MASTER FILE UPDATE

PROGRAM
Print sales journal, general
ledger, cash receipts
journal & error report
General
Ledger

File
Accounts Receivable
Master File
Cash Receipts
Journal
Error
Report
Customer Master
File
Consider Potential Misstatements in a Revenue Cycle

After the auditors have obtained an understanding of the internal controls relating to the revenue cycle and
documented such an understanding; the auditors would consider potential misstatements that could occur due to
weaknesses in internal control. Table 13-3 describes some of these potential misstatements in the revenue cycle.
Table 13-4 describes some potential misstatements that are specific to cash receipts in the revenue cycle.
Note that effective internal control, including personnel practices that stress the hiring of trustworthy
people, does not guarantee against losses from embezzlement and other fraudulent acts committed by a cashier.
Accordingly, an employer may obtain a fidelity bond to insure against losses arising from fraudulent/illegal acts by
the covered cashier. Prior to issuing this form of insurance, the underwriters usually investigate the cashier to be
covered. Also, the cashier should be informed that bonding (insurance) companies are diligent in prosecuting
bonded cashiers who committed fraud/illegal acts. Another way of reducing the risk of cashier misappropriate cash
is to implement a bank lockbox system. A bank lockbox system assures that cash receipts are not abstracted by the
cashier because customer payments are mailed to a post office box and collected directly by the bank.
Table 13-3 Potential Misstatements in a Revenue Cycle due to Weaknesses in Internal Control
Potential Misstatements
Recording unearned revenue.
Recording fictitious sales without

receiving a customer order or shipping the
goods.
Early
revenue.
or
late
Example of Fraud
recognition
Intentional over-shipment of goods.
when
Recording sales when the customer is

likely to return the goods.
Recording
revenues
when
significant services must still be
performed by the seller.
Recording franchise revenues when the

franchises are sold even though an obligation
to perform significant services still exists.
Overestimation of the amount of

revenue earned.
Misstating the percentage of completion

of several projects by a construction company
that uses the percentage-of-completion method
of revenue recognition.
Inaccurate billing and recording of
Recording cash that represents a

liability as revenue (e.g., receipt of an
advance deposit from the customer).
Intentionally holding the sales journal

open to record next years sales as having
occurred in the current year.
Recording sales based on the receipt of

orders from customers rather than on the
shipment of goods.
sales.
of
Recording
revenues
significant uncertainties exist.
Example of Error
Recording of sales in the wrong period

based on incorrect shipping information.
Recording sales when the customers

payment is contingent upon the customer
receiving financing or selling the goods to
another party (e.g., consignment sales).
Amount of revenue
franchises is miscalculated.
earned
on
Overestimating the percentage of

completion on projects by a construction
company using the percentage-of-completion
method of revenue recognition.
Table 13-4 Potential Misstatements of Cash Receipts in a Revenue Cycle due to Weaknesses in
Internal Control
Recording fictitious cash receipts.
Example of Fraud
Overstating cash receipts on the books

by transferring cash between bank accounts
without appropriate recording of the transfer
to cover up an embezzlement of cash. This is
known as kiting (discuss further in Chapter
18).
Failure to record receipts from

cash sales.
A cashier fails to ring up and record cash

sales and embezzles the cash.
Failure to record cash from

collection of accounts receivable.
A cashier embezzles cash payments by

customers on receivables, without recording
the receipts in the customers accounts.
Example of Error
A cashier embezzles cash payments by

customers on receivables by delaying the
recording of cash receipts. This fraud is
known as lapping. To cover up the
embezzlement by lapping, cash collected from
customer A is withheld by the cashier, a
subsequent collection from customer B is
entered as a credit to As account. Bs
account will not be shown as paid until a
payment by customer C is entered as a credit
to Bs account, and so on.
An accounting clerk who has access to

cash receipts embezzles cash collected from
customers and writes off the related accounts
An accounting clerk accidentally omits

the recording of the receipts from one cash
register for the day.
An accounting clerk accidentally fails
to record cash payment by a customer on an
accounts receivable.
333
334
Example of Fraud
receivable. For example, to cover up the
embezzled cash, the accounting clerk creates
fictitious credit memos for the related
Early or late recognition of cash

receipts.
Intentionally holding the cash receipts

journal open to record next years cash
receipts as having occurred in this year.
Example of Error
Recording cash receipts based on

incorrect information about date of receipt.
Assess Control Risk and Perform TOC Procedures

After considering potential misstatements, the auditors assess control risk (CR) and perform TOC procedures as per
the audit program for the revenue cycle. Table 13-5 and Table 13-6 describe some common TOC procedures that the
auditors perform on sales and cash receipts of the revenue cycle.
Table 13-5 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Sales
Existence or Occurrence:
Sales transactions are authorized.
Recorded sales are for goods actually
shipped and services actually rendered.
Completeness:
Sales transactions are recorded.
Internal Controls
Common TOC Procedures
Proper authorization is maintained for granting

of credit, pricing of goods, and shipment of
goods.
Recorded sales are supported by shipping
documents and customer orders.
Inspect credit policies, price lists and bill of

lading for proper authorization.
Sales invoices and shipping documents are

prenumbered.
Shipments of goods have been billed.
Scan for numerical sequence of sales invoices

and shipping documents.
Trace shipping documents to sales transactions
in sales journal.
Trace daily sales summaries to daily postings
to the accounts receivable ledger.
Billed sales are correctly posted to ledger.

Accuracy and Classification:
Sales transactions are accurately recorded
and classified.
Valuation and Allocation:

Sales transactions are recorded at net
realizable value.
Understandability:
Sales transactions are properly recorded in
cash receipts and accounts receivable.
Vouch sales transactions in sales journal to

supporting shipping documents and customer
orders
Internal independent checks on sales invoice

preparation.
A chart of accounts is used.
Recompute information on sales invoices.
Accounts receivable are collectible.
Observe the clients policy of obtaining credit

approval before shipping goods to customers.
Separation of duties between recording of sales

transactions and cash receipts.
Internal independent checks on accounts
receivable subsidiary ledgers agree with
accounts receivable control ledger.
Observe separation of duty procedures.
Read chart of accounts for adequacy.

Scan for sales transactions entered wrongly in
the general journal instead of the usual sales
journal.
Inquiry of management about independent

check and review of sales records.
Table 13-6 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Cash Receipts
Recorded cash receipts are for funds
actually received.
Completeness:
Cash received is recorded in the cash
receipts journal.
Internal Controls
Separation of duties between handling of cash

and record keeping.
Use of bank lockbox system
Remittance advices are used.
Scan for numerical sequence of remittance

advices.
Observe immediate endorsement of incoming
checks.
Observe the consistency of the cashiers use of
cash registers and tapes.
Incoming checks are immediately endorsed.
Inquiry of management about bank lockbox

policy

Accuracy:
Cash receipts are deposited and recorded at
the amounts received.
Classification:
Cash receipts transactions are properly
classified.
Cutoff:
Cash receipts are recorded on the correct
dates.
Internal Controls
Bank accounts and cash
reconciled on a regular basis.
accounts

are
Inspect monthly bank reconciliations.
An adequate chart of accounts is used.

Examine documents supporting cash receipts
for proper classification.
Procedures require recording of cash receipts

on a daily basis.
Examine cash receipts and daily cash summary

for daily bank deposit.
To detect lapping:
Compare dates of daily entries in the cash
receipts journal with dates of daily bank
deposit, and
Compare dates of checks deposited per bank
statements with the dates remittance credits are
recorded.
335
336
An overview of the strategy for tests of balances in a revenue cycle is presented in Figure 13-9.
Figure 13-9 TOB Strategy in Revenue Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
Apply TOB Strategy

Table 13-7 provides a brief discussion of the TOB strategy as it is applied to a revenue cycle.
Table 13-7 TOB Strategy in Revenue Cycle
TOB Strategy Revenue Cycle
2. Derive DR
3. Perform analytical procedures
4. Perform TOB procedures

Apply variable sampling plan
5. Document total misstatements
Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of
transaction level of a transaction cycle. In a revenue cycle, accounts receivable is perhaps the most material
account in the financial statements for companies that sell on credit. In addition, even if the accounts
receivable balance is small, the transactions in the revenue cycle that affect the accounts receivable balance
is usually large. Thus, the auditor considers accounts receivable carefully when allocating TM.
The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk
model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a
transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and
timing of the TOB procedures used by the auditor. In the revenue cycle, inherent risk for the accounts
receivable is usually moderate or high. This is because it is relatively easy for the management to
intentionally misstate accounts receivable.
The auditor performs six common types of analytical procedures (recall Chapter 7): (1) Compare client and
industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5)
Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on
client data. In the revenue cycle, analytical procedures are usually done for the all-key accounts, not only
for accounts receivable. This is because of the close relationship between income statement and balance
sheet accounts in the revenue cycle. For example, if the auditor detects misstatement in sales or sales
returns and allowances in the income statement through analytical procedures, accounts receivable in the
balance sheet will likely be the offsetting misstatement. Table 13-8 describes some analytical procedures
and potential misstatements that may be detected by them in the revenue cycle.
plan to determine the sample size of evidence. Table 13-9 summarizes some specific audit objectives and
common TOB procedures in a revenue cycle.
misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if
adjustments for the misstatements.
Table 13-8 Analytical Procedures for the Revenue Cycle

Analytical Procedure
Revenue:
Comparison of gross profit % by product line with previous years and industry data.
Comparison of reported revenue to budgeted revenue.
Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense:

Comparison of turnover and days outstanding in accounts receivable to previous years.
Comparison of aging categories and aged trial balance of accounts receivable to previous years.
Comparison of bad-debt expense as a % of revenue to previous years.
Comparison of allowance for uncollectible accounts as a % of accounts receivable to previous
years.
Sales Returns and Allowances and Sales Commissions:
Comparison of sales returns as a % of revenue to previous years.
Comparison of sales discounts as a % of revenue to previous years.
Detect Possible Misstatement of:

Unrecorded (understated) revenue.
Fictitious (overstated) revenue.
Changes in pricing policies.
Product-pricing problems.
Understatement
or
overstatement
of
allowance for uncollectible accounts and
bad-debt expense.
Understatement or overstatement of sales

returns and sales discounts.
337
338
Table 13-9 Specific Audit Objectives and Common TOB Procedures for a Revenue Cycle
Accounts receivable balance is not
overstated by including fictitious customer
accounts.
All goods ordered by customers are
shipped correctly.
Completeness:
All accounts receivable balances are
included in the aged trial balance.
Shipments to customers are invoiced
correctly.
Cutoff:
All sales transactions and related accounts
receivable balances are recorded in the
proper period.
Rights and Obligations:

Accounts receivable that have been sold
are not included in the financial
statements.
Accuracy:
Accounts receivable balances in the aged
trial balance agree with the accounts
receivable general (control) ledger.
Accounts receivable are stated at realizable
value.
Classification:
Accounts receivable on the aged trial
balance are properly classified.
Short-term accounts receivable and longterm notes receivable are properly
classified.
Understandability:
All related accounts in the revenue cycle
are properly presented and disclosed in the
Common TOB Procedures

Confirmation of selected accounts receivable by using MUS sampling approach (recall Chapter
12). Confirmation of accounts receivable is an important procedure that the auditors are required to
perform in conformity with AU 505 External Confirmations. Table 13-10 provides further
discussion on the confirmation procedures.
Vouch a sample of shipping documents to sales orders.
Trace a sample of accounts receivable balances to the aged trial balances.

Trace a sample of prenumbered sales invoices to shipping documents.
Examine a sample of sales invoices and shipping documents for a few days before and after yearend for recording sales in proper period.
Review large sales returns and allowances before and after the balance sheet date to determine
whether they are recorded in the correct period.
Table 13-12 provides further discussion on sales and sales returns cut-off procedures.
Review the minutes of the board of directors meeting for any indication of pledged or factored
Inquire of management whether any receivables are pledged or factored.
Foot the accounts receivable balances in the aged trial balance and agree total to accounts
receivable control (general) ledger.
Vouch a sample of accounts receivable balances from the aged trial balance to sales invoices for
proper amount and aging.
Inquiry of credit manager the likelihood of collecting older (>90 days) accounts receivable.
Examine the adequacy of the allowance for uncollectible accounts.
Analyze accounts receivable in the aged trial balance for long-term notes receivable and related
party receivables.
Inquire of management whether there are any long-term notes receivable and related party
receivables included in the aged trial balance.
Inquiry of management about related party receivables and assurance that they are properly
disclosed.
Read the minutes of the board of directors meetings for any indication of pledged or factored
Confirmation of Accounts Receivable

In Table 13-9, confirmation of accounts receivable is an important TOB procedure for achieving the specific audit
objective of existence. There are two types of accounts receivable confirmations: positive (see Figure 13-10) and
negative (see Figure 13-11). A positive confirmation requests that customers indicate whether they agree with the
amount due to the client stated in the confirmation. Thus, a response is required regardless of whether the customer
believes the amount is correct or incorrect. A negative confirmation requests that customers respond only when they
disagree with the amount due to the client. Table 13-10 summarizes the characteristics of positive and negative
confirmations.
Given the different characteristics between positive and negative confirmations in Table 13-10, the auditor
considers several key factors in choosing between positive or negative confirmations. Table 13-11 summarizes the
auditors consideration of these factors in choosing between the two types of confirmation. For example, if the Cost
of auditing factor is High, then choose Negative confirmation instead of Positive confirmation.
Figure 13-10 An Example of a Positive Confirmation

ABC Company
DEF Company
2nd Street, San Francisco
Dear Customers:
Please examine the accompany statement carefully and either confirm its correctness or report any differences to our auditors
XYZ CPA, LLP
P. O. Box 888, San Francisco
who are auditing our financial statements.
Your prompt attention to this request will be appreciated. An envelope is enclosed for your reply. Please do not send your payments to the
auditors.
Sincerely,
___________________________
Mr. A Controller, ABC Company
_________________________________________________________________________________________________________
Confirmation:
The balance receivable from us for $168,188 as of December 31, 200x, is correct except as noted below:
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
DEF Company
Date _____________________
By_______________________
Figure 13-11 An Example of a Negative Confirmation

Auditors Account Confirmation
Please examine this statement carefully. If it does NOT agree with your records, please report any differences to our auditors
XYZ CPA, LLP
who are auditing our financial statements.
Your prompt attention to this request will be appreciated. An envelope is enclosed for your reply. Please do not send your payments to the
auditors.
339
340
Table 13-10 Characteristics of Positive and Negative Confirmation
Positive Confirmation
Negative Confirmation
Positive confirmation is usually prepared in the form of a

computer printout. The name and address of the customers, and their
accounts receivable balances are downloaded and printed directly
from the accounts receivable master file.
Negative confirmation is usually prepared in the form of a

rubber stamp consisting of a short paragraph about a customers
balance and the auditors request for confirmation. It is usually
stamped at the back of each customers monthly statement.
The auditor may ask the client to prepare the positive

confirmations. However, the auditor must mail the confirmations to
prevent interception or alteration of the accounts receivable.
The auditor may ask the client to prepare the negative

confirmations. However, the auditor must mail the confirmations to
prevent interception or alteration of the accounts receivable.
The confirmation should be mailed with the auditors CPA

firm return address to ensure that any confirmations that are
undelivered by the post office are returned to the auditor and not the
client.
The confirmation should be mailed with the auditors CPA

firm return address to ensure that any confirmations that are
undelivered by the post office are returned to the auditor and not the
client.
The confirmation must include a statement that asks the

customers not to send their payment to the auditors. It is important
that the customers do not mistake the confirmation requests as
requests for prompt payment of their accounts.
The confirmation must include a statement that asks the

customers not to send their payment to the auditors. It is important
that the customers do not mistake the confirmation requests as
requests for prompt payment of their accounts.
Recipients of positive confirmation must respond to the auditor

regardless whether the balances stated are correct or incorrect. Since
the auditor makes no assumption about non-responses, the evidence
obtained is stronger in positive than in negative confirmation.
Recipients of negative confirmation need to respond to the

auditor only when the balances stated are incorrect. Since the
auditor must make an assumption that non-responses contain correct
balances, the evidence obtained is weaker in negative than in
positive confirmation.
If recipients of positive confirmation respond by e-mail, the

auditor should ask the e-mail respondents to sign and mail the
original hard-copy confirmation requests to the auditor.
If recipients of positive confirmation respond by fax, the
auditor should verify the sources and contents of the faxes in
telephone calls to the respondents.
If recipients of negative confirmation respond by e-mail, the

auditor should ask the e-mail respondents to sign and mail the
original hard-copy confirmation requests to the auditor.
If recipients of negative confirmation respond by fax, the
auditor should verify the sources and contents of the faxes in
telephone calls to the respondents.
The auditor must follow-up any non-responses with waves of

follow-up positive confirmation requests. Since the auditor must
receive a reply for all positive confirmations that are sent to the
customers, this audit procedure is more expensive in positive than in
negative confirmation.
Even after waves of follow-up positive confirmation requests and
the customers still do not reply, the auditor must apply alternative
procedures to verify the existence of the accounts receivable such as:
(1) Examine subsequent cash receipts for payments of specific sales
invoices included in the customers accounts receivable balances
that were outstanding at the date of the confirmation.
(2) Examine customer orders, shipping documents, and duplicate
sales invoices. This is to verify the actual issuance of a sales invoice
and actual shipment of goods.
(3) Examine other correspondence with the customers to obtain
adequate evidence on existence of the accounts receivable.
The auditor does not need to follow-up any non-responses.

Non-responses are assumed to contain the correct balances. Since he
auditor does not need to receive a reply for all negative
confirmations that are sent to the customers, this audit procedure is
less expensive in negative than in positive confirmation.
The auditor must analyze positive confirmation requests

returned by the customers that indicate the balances are incorrect. A
balance may be reported to be different because:
(1) Payment has already been made by the customer just before the
confirmation date.
(2) Goods have not been received by the customer. Goods in transit
often cause the difference between the customers balance and the
confirmation request balance.
(3) Goods returned by the customer but the client has yet to issue a
credit memo.
(4) Disputed amounts for certain goods purchased or returned by the
customers.
The auditor must analyze negative confirmation requests

returned by the customers that indicate the balances are incorrect. A
balance may be reported to be different because:
(1) Payment has already been made by the customer just before the
confirmation date.
(2) Goods have not been received by the customer. Goods in transit
often cause the difference between the customers balance and the
confirmation request balance.
(3) Goods returned by the customer but the client has yet to issue a
credit memo.
(4) Disputed amounts for certain goods purchased or returned by the
customers.
The auditor sometimes uses a special form of positive

confirmation referred to as blank-balance confirmation. This type of
positive confirmation does not state the balance owed. Instead, the
confirmation requests that the recipient fill in the amount or furnish
other information. It also usually requests additional information on
notes payable and consigned inventory. The auditor uses this special
form of positive confirmation when the recipients are likely to sign
Not applicable for negative confirmation requests.
Positive Confirmation
Negative Confirmation
and return them without paying much attention to what information

is requested.
Table 13-11 Choosing Between Positive and Negative Confirmations
Factor*
Tolerable Misstatement (TM)
Reliability of evidence
Cost of auditing
Number of accounts receivable with small balances
Number of accounts receivable with large balances
IR and CR
Response rate
High
Low
Negative confirmation
Positive confirmation
*Read each factor in each row independent of other factors in other rows. Table 13-11 is simply a memory aid; it is not meant to link all factors
across all rows.
Table 13-12 Sales and Sales Returns Cut-off Procedures

Account
Sales:
If there is not a proper cut-off of sales transactions; both revenue and
accounts receivable will be misstated for the current and following
years. In most instances, errors related to sales cut-off are
unintentional and are due to delays in recognizing the shipment of
goods or the recognition of the sales. In other instances, the client
may intentionally fail to recognize sales transactions in the current
period or may recognize sales from the next period in the current
period.
Sales Returns:
GAAP requires that sales returns be matched with related sales if the
amounts are material. For most clients, however, sales returns are
recorded in the accounting period in which they occur, under the
assumption of approximately equal, offsetting amounts at the
beginning and end of each accounting period. This is acceptable as
long as the amounts are not material.
Cut-off Procedures
The auditor first identifies the number of the last shipping document
issued in the current period. Then a sample of sales invoices and their
related shipping documents is selected for a few days just prior to, and
subsequent to, the end of the period. Assuming that sales are recorded at
the time of shipment, sales invoices representing goods shipped prior to
year-end should be recorded in the current period, and invoices for
goods shipped subsequent to year-end should be recorded as sales in the
next period.
The auditor examines supporting documents for a sample of sales
returns recorded during several weeks subsequent to the closing date to
determine the date of the original sales. If the amounts recorded in the
subsequent period are significantly different from unrecorded returns at
the beginning of the period, an adjustment must be considered.
341
342
13-1
Which one of the following major activities is not in a typical revenue cycle?
a. Cash collection.
b. Purchase requisitions.
c. Sales adjustments.
d. Sales transactions.
13-2
A sales document which specifies the terms (FOB), date, description, and quantity of goods shipped to customers is known as a
a. sales invoice.
b. monthly statement.
c. bill of lading.
d. sales order.
13-3
A sales document which indicates a reduction in accounts receivable is known as a

a. customer order file.
b. accounts receivable subsidiary ledger.
c. remittance advice.
d. credit memo.
13-4
A common test of controls in a revenue cycle is to check that sales invoices have the necessary support documents and customer
orders. This is a test of
a. the existence assertion.
b. the completeness assertion.
c. the valuation and allocation assertion.
d. the understandability assertion.
13-5
For an effective internal control, the cashier who receives remittance from the mail room should not
a. prepare a bank deposit slip.
b. endorse the incoming checks.
c. post the receipts in the accounts receivable subsidiary ledger.
d. deposit the remittance at a bank.
13-6
For an effective internal control, the person that is responsible for the posting of accounts receivable subsidiary ledger should not also
handle
a. acceptance of customer orders
b. credit granted to customers.
c. filling and shipping customer orders.
d. cash payment functions.
13-7
For an effective internal control, the billing function should be performed by which of the following departments?
a. Credit department.
b. Sales order department.
c. Shipping and warehousing department.
d. Accounting department.
13-8
Assuming cashier embezzled cash received over the counter from a customer and covered it up by writing off the accounts receivable
as bad debt. Which of the following internal control procedures is effective in preventing such an occurrence?
a. All customer order are properly prenumbered.
b. All credit memos are properly authorized by a separate person.
c. All journal entries and recording of transactions are done by a separate person.
d. Daily cash receipts are deposited by a separate person.
13-9
Which of the following is not an auditors concern about a key authorization point in the revenue cycle?
a. The receiving room must have authorization before releasing items to inventory control.
b. Credit must be authorized before the sale.
c. Goods must be shipped after the authorization.
d. Prices must be authorized.
13-10
An effective TOC procedure to test for unbilled shipments is to

a. vouch from the sales journal to the shipping documents.
b. trace from the shipping documents to the sales journal.
c. trace sales journal to the accounts receivable ledger.
d. trace sales journal to the general ledger sales account.
13-11
For most companies, the function of indicating credit approval is recorded on the
a. sales order.
b. customer order.
c. sales invoice.
d. remittance advice.
13-12
A document sent to each customer showing his/her beginning accounts receivable balance and the amount and date of each
sale, cash payment received, credit memo issued, and the ending balance is the
a. accounts receivable subsidiary ledger.
b. remittance advice.
c. monthly statement.
d. sales invoice.
13-13
An auditor suspects that a clients cashier is misappropriating cash receipts for personal use by lapping customer checks
received in the mail. In attempting to uncover this embezzlement scheme, the auditor most likely would compare the
a. dates checks are deposited per bank statements with the dates remittance credits are recorded.
b. daily cash summaries with the sums of the cash receipts journal entries.
c. individual bank deposit slips with the details of the monthly bank statements.
d. dates uncollectible accounts are authorized to be written off with the dates the write-offs are actually recorded.
13-14
An auditor most likely would limit TOC of sales transactions when control risk (CR) is assessed as low for the existence or
occurrence assertion concerning sales transactions and the auditor has already gathered sufficient evidence supporting
a. opening and closing inventory balances.
b. shipping and receiving activities.
c. cutoffs of sales and purchases.
d. cash receipts and accounts receivable.
13-15
Which of the following audit procedures would an auditor most likely perform to test controls relating to managements
assertion concerning the completeness of sales transactions?
a. Comparing the invoiced prices on prenumbered sales invoices to the clients credit granting policies.
b. Inquire about the clients credit granting policies and the consistent application of credit checks.
c. Inspect the clients reports of prenumbered shipping documents that have not been recorded in the sales journal.
d. Footing and cross-footing of the clients monthly customer statements.
13-16
Which of the following internal control procedures most likely would deter lapping of collections from customers?
a. Independent internal verification of dates of entry in the cash receipts journal with dates of daily cash summaries.
b. Authorization of write-offs of uncollectible accounts by a supervisor independent of credit approval.
c. Segregation of duties between receiving cash and posting the accounts receivable ledger.
d. Supervisory comparison of the daily cash summary with the sum of the cash receipts journal.
343
344
13-17
An auditor scans for the numerical sequence of sales invoices and shipping documents to support managements financial
statements assertion of
a. existence or occurrence.
b. rights and obligations.
c. valuation or allocation.
d. completeness.
13-18
A clients financial statements were misstated over a period of years because large amounts of revenue from sales were intentionally
debited and credited to an illogical combination of accounts. The auditor would most likely have been alerted of this fraud by
a. scanning the general journal for unusual entries.
b. performing a sales cut-off test at year end.
c. tracing a sample of journal entries to the general ledger.
d. examining documentary evidence of sales returns and allowances recorded after year-end.
13-19
Which of the following audit procedures concerning accounts receivable would an auditor most likely perform to obtain
evidential matter in support of an assessed level of control risk below the maximum level?
a. Observing proper authorization is maintained for granting of credit to principal customers.
b. Sending confirmation requests to principal customers to verify the existence of accounts receivable.
c. Analyzing accounts receivable for unusual balances.
d. Comparing uncollectible accounts expense to actual uncollectible accounts receivable.
13-20
Which of the following internal control procedure is most likely to prevent the improper disposition of equipment?
a. A separation of duties between those authorized to dispose of equipment (asset custody) and those authorized to approve
removal work orders on disposed equipment (authorization).
b. The use of serial numbers to identify equipment that could be sold.
c. Periodic comparison of removal work orders with authorizing documentation.
d. A periodic analysis of the scrap sales and the repairs and maintenance accounts.
13-21
At which point in an ordinary sales transaction of a wholesaling business is a lack of specific authorization of least concern
to the auditor in the conduct of an audit?
a. Granting of credit.
b. Shipment of goods.
c. Determination of discounts.
d. Selling of goods for cash.
13-22
During the consideration of a small business clients internal control, the auditor discovered that the accounts receivable
clerk approves credit memos and has access to cash. Which of the following internal control procedures would be most effective in
offsetting this weakness?
a. The owner reviews errors in billings to customers and postings to the subsidiary ledger.
b. The controller receives the monthly bank statement directly and reconciles the checking accounts.
c. The owner reviews credit memos after they are recorded.
d. The controller reconciles the total of the detail accounts receivable accounts to the amount shown in the ledger.
13-23
Which of the following internal control procedures most likely would be effective in offsetting the tendency of sales
personnel to maximize sales volume at the expense of high bad debt write-offs?
a. Employees responsible for authorizing sales and bad debt write-offs are denied access to cash.
b. Shipping documents and sales invoices are matched by an employee who does not have authority to write off bad debts.
c. Employees involved in the credit-granting function are separated from the sales function.
d. Subsidiary accounts receivable records are reconciled to the control account by an employee independent of the
authorization of credit.
13-24
An auditor tests a clients policy of obtaining credit approval before shipping goods to customers in support of
managements financial statement assertion of
a. valuation or allocation.
b. completeness.
c. existence or occurrence.
d. rights and obligations.
13-25
Which of the following internal control procedures most likely would assure that all billed sales are correctly posted to the
accounts receivable ledger?
a. Daily sales summaries are traced to daily postings to the accounts receivable ledger.
b. Each sales invoice is supported by a prenumbered shipping document.
c. The accounts receivable ledger is reconciled daily to the control account in the general ledger.
d. Each shipment on credit is supported by a prenumbered sales invoice.
13-26
Which of the following internal control procedures most likely would not be designed to reduce the risk of errors in the
billing process?
a. Comparing control totals for shipping documents with corresponding totals for sales invoices.
b. Using computer programmed controls on the pricing and mathematical accuracy of sales invoices.
c. Matching shipping documents with approved sales orders before invoice preparation.
d. Reconciling the control totals for sales invoices with the accounts receivable subsidiary ledger.
13-27
Which of the following controls most likely would help ensure that all credit sales transactions of a client are recorded?
(Hint: Completeness assertion)
a. The billing department supervisor sends copies of approved sales orders to the credit department for comparison to
authorized credit limits and current customer account balance.
b. The accounting department supervisor independently reconciles the accounts receivable subsidiary ledger to the
accounts receivable control account monthly.
c. The accounting department supervisor controls the mailing of monthly statements to customers and investigates any
differences reported by customers.
d. The billing department supervisor matches prenumbered shipping documents with entries in the sales journal.
13-28
An auditor would consider a cashiers job description to contain compatible duties if the cashier receives remittances from
the mail room and also prepares the
a. prelist of individual checks.
b. monthly bank reconciliation.
c. daily deposit slip.
d. remittance advices.
13-29
Effective internal control procedures require that, immediately upon receiving checks from customers by mail, a
responsible employee should
a. add the checks to the daily cash summary.
b. verify that each check is supported by a prenumbered sales invoice.
c. prepare a duplicate listing of checks received.
d. record the checks in the cash receipts journal.
13-30
Upon receipt of customers checks in the mail room, a responsible employee should prepare a remittance listing that is
forwarded to the cashier. A copy of the listing should be sent to the
a. internal auditor to investigate the listing for unusual transactions.
b. treasurer to compare the listing with the monthly bank statement.
c. accounts receivable bookkeeper to update the subsidiary accounts receivable records.
d. clients bank to compare the listing with the cashiers deposit slip.
13-31
Cash receipts from sales on account have been misappropriated. Which of the following acts would conceal this
defalcation and be least likely to be detected by an auditor?
a. Understating the sales journal.
b. Overstating the accounts receivable control account.
c. Overstating the accounts receivable subsidiary ledger.
d. Understating the cash receipts journal.
13-32
Employers bond employees who handle cash receipts because fidelity bonds reduce the possibility of employing dishonest
individuals and
a. protect employees who make unintentional errors from possible monetary damages resulting from their errors.
b. deter dishonesty by making employees aware that insurance companies may investigate and prosecute dishonest acts.
c. facilitate an independent monitoring of the receiving and depositing of cash receipts.
d. force employees in positions of trust to take periodic vacations and rotate their assigned duties.
345
346
13-33
Which of the following internal control procedures would reduce the risk of diversion of customer receipts by a clients
employees?
a. A bank lockbox system.
b. Prenumbered remittance advices.
c. Monthly bank reconciliations.
d. Daily deposit of cash receipts.
13-34
Which of the following procedures would an auditor most likely perform to test controls relating to managements
assertion about the completeness of cash receipts for cash sales at a retail outlet?
a. Observe the consistency of the employees use of cash registers and tapes.
b. Inquire about employees access to recorded but un-deposited cash.
c. Trace the deposits in the cash receipts journal to the cash balance in the general ledger.
d. Compare the cash balance in the general ledger with the bank confirmation request.
13-35
Which of the following most likely would be the result of ineffective internal control in the revenue cycle?
a. Final authorization of credit memos by personnel in the sales department could permit an employee defalcation scheme.
b. Fictitious sales transactions could be recorded, causing an understatement of revenues and an overstatement of
receivables.
c. Fraud in recording sales transactions in the subsidiary accounts could result in a delay in goods shipped.
d. Omission of shipping documents could go undetected, causing an understatement of inventory.
13-36
Effective internal control procedures dictate that defective merchandise returned by customers be presented initially to the
a. accounts receivable supervisor.
b. receiving clerk.
c. shipping department supervisor.
d. sales clerk.
13-37
Proper authorization of write-offs of uncollectible accounts should be approved in which of the following departments?
a. Accounts receivable.
b. Credit.
c. Accounts payable.
d. Treasurer.
13-38
An online sales order processing system most likely would have an advantage over a batch sales order processing system
by
a. detecting errors in the data entry process more easily by the use of edit programs.
b. enabling shipment of customer orders to be initiated as soon as the orders are received.
c. recording more secure backup copies of the database on magnetic tape.
d. maintaining more accurate records of customer accounts and finished goods inventories.
13-39
Company C uses a batch processing method to process its sales transactions. Data on Cs sales transaction tape are
electronically sorted by customer number and are subjected to programmed edit checks in preparing its invoices, sales journals, and
updated customer account balances. One of the direct outputs of the creation of this sales transaction tape most likely would be a
(Hint: The key word is edit checks)
a. report showing exceptions and control totals.
b. printout of the updated inventory records.
c. report showing overdue accounts receivable.
d. printout of the sales price master file.
13-40
When an auditor has determined that accounts receivable have increased as a result of slow collections in a tight money
environment, the auditor would be likely to
a. increase the balance in the allowance for bad debt expense.
b. review its impact on going concern status of the client.
c. review the credit granting policy.
d. expand tests of collectability.
13-41
Negative confirmation of accounts receivable should be used except when

a. internal control of accounts receivable is considered to be effective.
b. a large number of small balances are involved.
c. the response rate is low.
d. individual account balances are relatively large.
13-42
Negative confirmation of accounts receivable is less effective than positive confirmation of accounts receivable because
a. a majority of recipients usually lack the willingness to respond objectively.
b. some recipients may report incorrect balances that require extensive follow-up.
c. the auditor cannot infer that all non-respondents have verified their account information.
d. negative confirmation do not produce evidential matter that is statistically quantifiable.
13-43
An auditor should perform alternative procedures to substantiate the existence of accounts receivable when
a. no reply to a positive confirmation request is received.
b. no reply to a negative confirmation request is received.
c. the collectability of the receivables is in doubt.
d. pledging of the accounts receivables is probable.
13-44
Which of the following is most likely to be detected by an auditors sales cut-off test?
a. Unrecorded sales for the year.
b. Lapping of year-end accounts receivable.
c. Excessive sales discounts.
d. Unauthorized goods returned for credit.
13-45
When evaluating the adequacy of the allowance for uncollectible accounts, an auditor examines the age of accounts receivable to
support managements assertion of
b. valuation or allocation.
c. completeness.
13-46
Which of the following audit procedures would best uncover an understatement of sales and accounts receivable?
a. Test a sample of sales transactions, selecting the sample from pre-numbered shipping documents.
b. Test a sample of sales transactions, selecting the sample from sales invoices recorded in the sales journal.
c. Confirm accounts receivable.
d. Analyze the aged accounts receivable trial balance.
13-47
Positive confirmation of accounts receivable should be used when

a. internal control of accounts receivable is considered to be effective.
b. a large number of small balances are involved.
c. the response rate is low.
d. a substantial number of accounts receivable may be in dispute.
13-48
When positive confirmations are used, which of the following would not be considered an alternative procedure to
positive confirmations?
a. Send a second confirmation request.
b. Examine subsequent cash receipts to determine if the receivable has been paid.
c. Examine shipping documents to verify that the merchandise was shipped.
d. Examine customers purchase order and the duplicate sales invoice to determine that the merchandise was ordered.
13-49
The most important TOB procedure for accounts receivable is

a. re-calculation of the aged receivables and un-collectible accounts.
b. tracing credit memos for returned merchandise to receiving room reports.
c. confirmations.
d. tracing from shipping documents to journals to the accounts receivable ledger.
13-50
When the clients internal control is adequate, the specific objective of cutoff can usually be achieved by
a. reading clients representation letter.
b. inquiring the clients controller.
c. obtaining the last shipping document number of the year and comparing it with current and subsequent period recorded
sales.
d. confirmation of the receivable for the last recorded sale.
347
348
13-51
An auditor discovers that the client records sales returns and allowances in the accounting period in which they occur,
under the assumption of approximately equal offsetting errors at the beginning and end of each period. The auditor would
consider this accounting practice to be
a. acceptable.
b. not acceptable.
c. acceptable as long as the amounts are not significant.
d. not acceptable as long as the amounts are not significant.
13-52
Which of the specific audit objectives is performed first when doing the TOB procedures for accounts receivable?
a. Recorded accounts receivable exist.
b. Accounts receivable in the aged trial balance agree with related master file amounts, and the total is correctly added and
agrees with the general ledger.
c. Existing accounts receivable are included.
d. Accounts receivable are owned.
13-53
An auditors purpose in reviewing credit ratings of customers with delinquent accounts receivable most likely is to obtain
evidence concerning managements assertions about
b. presentation and disclosure
13-54
Which of the following most likely would be detected by an auditors review of a clients sales cut-off?
a. Shipments lacking sales invoices and shipping documents.
b. Excessive write-offs of accounts receivable.
c. Unrecorded sales at year end.
d. Lapping of year-end accounts receivable.
13-55
In auditing accounts receivable, the negative form of confirmation request most likely would be used when
a. the total recorded amount of accounts receivable is immaterial to the financial statements taken as a whole.
b. response rates in prior years to positive confirmation requests were high.
c. recipients are likely to return positive confirmation requests verifying the accuracy of the information.
d. the combined assessed level of inherent risk (IR) and control risk (CR) relative to accounts receivable is low.
13-56
To reduce the risks associated with accepting e-mail responses to requests for confirmation of accounts receivable, an
auditor most likely would
a. ask the e-mail respondents to sign and mail the original hard-copy confirmation requests to the auditor.
b. examine subsequent cash receipts for the accounts in question.
c. consider the e-mail responses to the original hard-copy confirmation requests to be exceptions.
d. mail second hard-copy confirmation requests to the e-mail respondents.
13-57
Under which of the following circumstances would the blank-balance form of positive confirmation requests of accounts
receivable most likely be used?
a. Analytical procedures indicate that few exceptions are expected.
b. Subsequent cash receipts are usually difficult to verify.
c. The recipients are likely to sign the confirmations without devoting proper attention to them.
d. The combine assessed level of inherent risk and control risk is low.
13-58
When an auditor does not receive replies to positive confirmation requests for year-end accounts receivable, the auditor
most likely would
a. inspect the allowance account to verify whether the accounts were subsequently written off.
b. ask the client to contact the customers to request that the confirmation requests be returned.
c. increase the level of detection risk for the valuation and allocation, and completeness assertions.
d. increase the level of inherent risk for the revenue cycle.
13-59
To reduce the risks associated with accepting fax responses to requests for confirmations of accounts receivable, an auditor
most likely would
a. examine the shipping documents that provide evidence for the existence assertion.
b. verify the sources and contents of the faxes in telephone calls to the respondents.
c. consider the faxes to be non-responses and evaluate them as unadjusted difference.
d. inspect the faxes for forgeries or alterations and consider them to be acceptable if none are note.
13-60
Which of the following statement is correct concerning the use of negative confirmation requests?
a. Negative confirmation requests are effective when understatements of account balances are suspected.
b. Unreturned negative confirmation requests indicate that alternative procedures are necessary.
c. Negative confirmation requests are effective when detection risk is low.
d. Unreturned negative confirmation requests rarely provide significant explicit evidence.
13-61
Which of the following analytical procedures would be most useful to an auditor in evaluating the results of a clients
operations?
a. Prior year accounts payable to current year accounts payable.
b. Prior year payroll expense to budgeted current year payroll expense.
c. Current year revenue to budgeted current year revenue.
d. Current year warranty expense to current year contingent liabilities.
13-62
If the objective of a TOB procedure is to detect overstatements of sales, the auditor should compare transactions in the
a. cash receipts journal with the sales journal.
b. sales journal with the cash receipts journal.
c. source documents with the accounting records.
d. accounting records with the source documents.
13-63
Tracing balances in shipping documents to balances in prenumbered sales invoices provides evidence that
a. no duplicate shipments or billings occurred.
b. shipments to customers were properly invoiced.
c. all goods ordered by customers were shipped.
d. all prenumbered sales invoices were accounted for.
13-64
Cutoff tests designed to detect credit sales made before the end of the year that have been recorded in the subsequent year
provide assurance about managements assertion of
a. presentation.
b. valuation or allocation.
c. rights and obligations.
d. existence or occurrence.
13-65
Which of the following most likely would give the most assurance concerning the valuation assertion of accounts
receivable?
a. Vouching amounts in the subsidiary ledger to details on shipping documents.
b. Comparing receivable turnover ratios with industry statistics for reasonableness.
c. Inquiring about receivables pledged under loan agreements.
d. Assessing the allowance for uncollectible accounts for reasonableness.
13-66
AU 505, External Confirmations, defines confirmation as the process of obtaining and evaluating a direct
communication from a third party in response to a request for information about a particular item affecting financial statement
assertions. Two assertions for which confirmation of accounts receivable balances provides primary evidence are
a. completeness, and valuation or allocation.
b. valuation or allocation, and rights and obligations.
c. rights and obligations and existence.
d. existence and completeness.
13-67
An auditor confirms a representative number of open accounts receivable as of December

31 and investigates respondents exceptions and comments. By this procedure the auditor would be most likely to learn which of the
following? (Hint: Note the key word open)
a. One of the cashiers has been covering a personal embezzlement by lapping.
b. One of the sales clerks has not been preparing charge slips for credit sales to family and friends (i.e., no accounts
receivable balances).
c. One of the computer control clerks has been removing all sales invoices applicable to his account from the data file. (i.e.,
sales invoices not processed).
d. The credit manager has misappropriated remittances from customers whose accounts have been written off (i.e., no
longer open accounts) .
349
350
13-68
An auditor who has confirmed accounts receivable may discover that the sales journal was held open past year-end if
a. positive confirmations sent to debtors are not returned.
b. negative confirmation sent to debtors are not returned.
c. most of the returned negative confirmations indicate that the debtor owes a larger balance than the amount being
confirmed.
d. most of the returned positive confirmations indicate that the debtor owes a smaller balance than the amount being
confirmed.
13-69
During the process of confirming receivables as of December 31, 2000, a positive confirmation was returned indicating the
balance owed as of December 31 was paid on January 9, 2001. The auditor would most likely
a. determine whether there were any changes in the account between January 1 and January 9, 2001.
b. determine whether a customary trade discount was taken by the customer.
c. reconfirm the zero balance as of January 10, 2001.
d. verify that the amount was received.
13-70
An auditor is auditing the financial statements of a small rural municipality. The receivable balances represent residents
delinquent real estate taxes. Internal control at the municipality is ineffective. To determine the existence of the accounts receivable
balances at the balance sheet date, the auditor would most likely
a. send positive confirmation requests.
b. send negative confirmation request.
c. examine evidence of subsequent cash receipts.
d. inspect the internal records such as copies of the tax invoices that were mailed to the residents.
13-71
Which of the following procedures would an auditor most likely perform for year-end accounts receivable confirmations
when the auditor did not receive replies to second requests? (Hint: Think of the specific audit objective of confirmations)
a. Review the cash receipts journal for the month prior to year-end.
b. Intensify the study of internal control concerning the revenue cycle.
c. Increase the assessed level of detection risk for the existence assertion.
d. Inspect the shipping records documenting the merchandise sold to the debtors.
13-72
In which of the following circumstances would the use of the negative form of accounts receivable confirmation most
likely be justified?
a. A substantial number of accounts may be in dispute and the accounts receivable balance arises from sales to a few major
customers.
b. A substantial number of accounts may be in dispute and the accounts receivable balance arises from sales to many
customers with small balances.
c. A small number of accounts may be in dispute and the accounts receivable balance arises from sales to a few major
customers.
d. A small number of accounts may be in dispute and the accounts receivable balance arises from sales to many customers
with small balances.
13-73
Auditors may use positive and/or negative forms of confirmation requests. An auditor most likely will use
a. the positive form to confirm all balances regardless of size.
b. the negative form for small balances.
c. a combination of the two forms, with the positive form used for trade balances and the negative form for other balances.
d. the positive form when the combined assessed level inherent and control risk for related assertions is acceptably low,
and the negative form when it is unacceptably high.
13-74
The confirmation of customers accounts receivable rarely provides reliable evidence about the completeness assertion
because (Hint: Think of the type of assertions)
a. many customers merely sign and return the confirmation without verifying its details.
b. recipients usually respond only if they disagree with the information on the request.
c. customers may not be inclined to report understatement errors in their accounts.
d. auditors typically select many accounts with low recorded balances to be confirmed.
13-75
In confirming a clients accounts receivable in prior years, an auditor found that there were many differences between the
recorded account balances and the confirmation replies. These differences, which were not misstatements, required substantial time to
resolve. In defining the sample unit for the current years audit, the auditor most likely would choose
a. individual overdue balances.
b. individual invoices.
c. small account balances.
d. large account balances.

13-1 b. 13-2 c. 13-3 d. 13-4 a. 13-5 c. 13-6 b. 13-7 d. 13-8 c. 13-9 a. 13-10 b. 13-11 a.
13-12 c. 13-13 a. 13-14 d. 13-15 c. 13-16 c. 13-17 d. 13-18 a. 13-19 a. 13-20 a. 13-21 d.
13-22 c. 13-23 c. 13-24 a. 13-25 a. 13-26 d. 13-27 d. 13-28 c. 13-29 c. 13-30 c. 13-31 a.
13-32 b. 13-33 a. 13-34 a. 13-35 a. 13-36 b. 13-37 d. 13-38 b. 13-39 a. 13-40 d. 13-41 d.
13-42 c. 13-43 a. 13-44 a. 13-45 b. 13-46 a. 13-47 d. 13-48 a. 13-49 c. 13-50 c.
13-51 c.
13-52 b. 13-53 a. 13-54 c. 13-55 d. 13-56 a. 13-57 c. 13-58 b. 13-59 b. 13-60 d. 13-61 c.
13-62 d. 13-63 b. 13-64 b. 13-65 d. 13-66 c. 13-67 a. 13-68 d. 13-69 d. 13-70 a. 13-71 d.
13-72 d. 13-73 b. 13-74 c. 13-75 b.
351
352

Simulation Question 13-1 is an adaptation with permission from a case by Borthick, A. F., and J. E. Kiger in the Issues in Accounting Education,
a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however,
Overview
Offering Flights to Customers
Creating Reservations
E-Ticket Airlines (ETAs) revenue generation begins when a customer selects a flight for a specific date and time. The process is
similar whether a ticket agent or the customer interacts with the system to make the reservation. If the customer is paying with a credit card, the
system validates the credit card number the customer presents for billing before making the reservation. When it obtains approval of the credit
charge (electronically, from the card issuer), the system records the charge and other details of the reservation. The customer gets a confirmation
number and itinerary immediately, and gets a boarding pass at the gate only by presenting picture identification.
Daily, the system batches each days charges by credit card issuer and transmits them electronically to credit card issuers. Until a
flight occurs, ticket sales are recorded as unearned revenue. After a flight, the system records earned revenue based on the reservations for the
flight and decreases unearned revenue accordingly. Furthermore, ETAs bank provides electronic bank statements.
In addition to offering flights to customers and allowing customers to make reservations, ETAs system accommodates changing
reservations, handling cash and credit card receipts, boarding passengers, and booking revenues. The system includes procedures for setting fares
and for passengers flying free. In addition, the system includes monitoring activities designed to ensure the effectiveness of operations and
information analysis that management uses to maximize revenue per seat-mile.
You should access Data File 13-1 in iLearn for Figure 1, which presents an overview of the system data flow chart, and Figure 2, which
illustrates the system database.
ETA offers flights to customers through a system that customers and agents access through the Internet. Customers and ticket agents
enter the origination and destination cities and the dates and preferred times for travel. The system generates information that permits customers
to choose specific flights.
In collaboration with other ETA units, flight operations establish the flight schedule. To change the schedule, flight operations enters
changes into a flight change edit program. After the flight operations manager has approved schedule changes by attaching an electronic signature
to the schedule change file, the system schedules the changes for application on the right day (at midnight); counts the number of schedule
changes; creates a hash total of the flight numbers; adds a header record to the charge file containing the count, the hash total, and the managers
electronic signature; copies the file to the update queue, and notifies computer operations of the pending update of the flight table. A file of
schedule changes is maintained.
Fares vary based on the route to be traveled, whether travel is during peak or off-peak times, and whether the ticket purchase is an
advance or regular purchase. Tickets bought 14 days before the flight date are advance purchase tickets. Given the destination and whether the
purchase is an advance or regular purchase, the system determines, based on the date and hour of the flight, whether travel is during peak or offpeak times and displays the appropriate fare.
While customers and ticket agents do not actually see the flight table (Figure 2), its contents determine the fare the system displays.
Marketing personnel are responsible for maintaining fares. Once they decide on fare changes, marketing personnel enter approved fare changes
and their effective dates into a fare change edit program. This program verifies the flights exist and determines that the changes meet a
reasonableness criterion such as not falling below minimum fares or exceeding maximum fares and as functions of the destination, type of
purchase, and time of day. Once all changes pass input edits, the fare change edit program creates a fare change file for the marketing managers
approval. After the marketing manager has approved the fare change file by attaching an electronic signature, the system schedules the fare
changes for application on the right day (at midnight); counts the number of fare changes; creates a hash total of the flight numbers, adds a header
record to the charge file containing the count, the hash total, and the managers electronic signature; copies the file to the fare update queue, and
notifies computer operations of the pending update of the flight table. A file of fare changes is maintained.
Once the customer selects an acceptable flight, the system determines whether seats are available by examining the seat inventory
table and the applicable fare. Ticket agents may not override fares. The flight operations department provides data for the seat inventory table
(Figure 2), which contains dates, flight numbers, seat capacity, and the number of seats remaining. The system automatically updates the number
of seats remaining by reducing/increasing it by one each time a reservation is made/canceled.
When making a reservation, the system prompts customers (or ticketing agents) for a customer number, which it uses to look up
information about the customer. If the customer is new, the system prompts for a customer name, address, phone number, email address, credit
card number, credit card issuer, and expiration date and writes the information in the customer table (Figure 2). ETAs system, linked with credit
card issuers, requests approval for the charge. If the charge is not approved, the customer may enter new credit card information and request
approval. If credit authorization is unobtainable, no reservation can be made unless the customer is at the airport with cash to pay for the ticket.
Once credit has been authorized, the system writes information about the charge (a unique charge number generated by the system, the
credit card issuer and card number and expiration date, the amount of the charge, the authorization code from the credit card issuer, and the
charge date) in the charge table. If a customer pays cash at the ticket counter in the airport, the system records the cash receipt in the cash receipts
table.
For complimentary fliers such as employees, members of employees families, or employees of other airlines, the system looks up the
customer number and the affiliation that entitles the person to fly free (such as an employee) in the free flier table. If the customer number and
affiliation match a record in the free flier table, the system writes the appropriate record in the free flights table. Each day, the system generates
reports about changes of the free flier table and free fliers, which the personnel director reviews daily.
After creating an entry in the charge table, the cash receipts table, or the free flights table, the system writes the reservation record in
the reservation table. The record includes a unique confirmation number generated by the system; either the charge number in the charge table,
the cash receipt number in the cash receipts table, or the free flight number in the free flights table; the flight date, the flight number; the customer
number; and the date the reservation was made. The system displays the confirmation number and itinerary and emails a receipt and an itinerary
to the customer.
When the data tables were first created, the charge number field in the reservation table was designated as a foreign key to the charge
table; the cash receipt number in the reservation table was designed as a foreign key to the cash receipts table; and the free flight number in the
reservation table was designated as a foreign key to the free flights table.1 This means that before an entry can be made or updated in a record in
the reservation table, the system verifies that the charge number already exists in the charge table, that the cash receipt number already exists in
the cash receipts table, or that the free flight number already exists in the free flights table. 1 If a corresponding number does not exist in any of the
tables, then either credit has not been approved, cash payment has not been received, or free flying has not been authorized. In this case, the
system will not write a reservation record, and no supervisor can override the prohibition.
Changing Reservations
Boarding Passengers
Recording Revenue
To change a reservation using a website, a customer selects the flight to be changed and then the change function. After the customer
selects the new flight, the system requests credit card authorization and writes the appropriate charges (a $100 change fee and the amount by
which the new fare exceeds the fare amount for the previously purchased flight) in the charge table. The customer forfeits any difference if the
fare for the new flight is less than the earlier one. Then the system writes the new reservation in the reservation table and changes the status of the
old reservation to canceled. The system adjusts the values of seats remaining in the seat inventory table for the old and new flights. Similarly, to
change a reservation, a ticket agent selects the change function and records the change in either the charge table or the cash receipts table.
Flights may be canceled due to weather conditions, the unavailability of suitable aircraft, or other circumstances beyond an airlines
control. Most customers are rerouted on other flights. To cancel a flight, a flight operations supervisor indicated to the system that the flight is
canceled and the reason for the cancellation. Upon receiving the cancellation, the system permits the customer to be rerouted on another flight.
These reservation changes do not incur the $100 change fee.
Handling Cash and Credit Card Receipts
Agents at airports may record cash receipts and credit card transactions while the website may record only credit card transactions.
Each agent has a drawer with a change fund that only he or she operates. At the completion of each shift, agents submit the cash collected to their
supervisors. The system determines the amount of cash a ticket agent should have based on charges for tickets issued, change fees, and credit card
charges. The amount of cash an agent is over or short is recorded. Agents that are careless in handling cash receipts are dismissed. The system
generates a cash receipts total that is reconciled with total cash receipts for all cash drawers each day. If a supervisor in the cashiers office cannot
reconcile the cash receipts within 24 hours, the system notifies the treasurer electronically. For each bank deposit, the employee making the
deposit enters the amount from the deposit ticket receipt into the system. Daily, the system performs a reconciliation of deposits per deposit
tickets to the cash collections determined by the system. If the totals differ, details of the deposit ticket receipts are recorded in a suspense file. A
cash receipts supervisor can remove the amounts from the suspense file only after reconciling the amounts and entering an explanation of the
cause of the discrepancy. Whenever ticket receipts are not reconciled to system-determined totals within one day, the treasurer is notified
electronically.
Daily, the system generates a reconciliation of credit card charges by issuer with total credit card charges for the day. If balancing does
not occur, electronic notification goes to a supervisor and details of the days activity go into a suspense file. If the supervisor fails to reconcile
the amounts and clear the suspense file within one day, the system notifies the treasurer electronically. The actions undertaken to reconcile the
amounts are recorded online.
The system batches each days charges by credit card issuer and electronically transmits charges to credit card issuers. Credit card
charges by issuer by day are reconciled with bank account receipts that occur in the airlines online ticket receipts bank account. If the charges do
not reconcile, electronic notification goes to a supervisor and details of the days activity go into a suspense file. If the supervisor fails to
reconcile the amounts and clear the suspense file within one day, the system notifies the treasurer electronically. The actions undertaken to
reconcile the amounts are recorded online. In effect, the procedure constitutes a daily reconciliation of bank records with the airlines cash
journal. Monthly bank statements are available online from the bank.
Before boarding begins, the system writes records in a manifest table (Figure 2) for the flight that contains an entry for each confirmed
passenger. The manifest table is a real table, not a view, because it is the permanent record of persons on the flight. At the gate, the boarding
agent verifies fliers identification; the system logs the seat occupancy in the manifest table.
Based on the number of boarding passes issued, the system generates a total number of passengers, which must match a count
determined by the on-plane flight attendant. The attendant counts the passengers (or the number of empty seats) and enters the number into the
system. If the numbers differ, the attendant recounts the passengers and reenters the number. If the numbers still differ, the gate agent must enter
an explanation into the system. The plane is permitted to depart after the pilot enters his or her electronic signature into the system.
Ticket sales are recorded as unearned revenue when reservations are recorded, and change fees are recorded as revenue when
reservations are changed. When a plane departs, operations record a time for its departure that triggers the system to record earned revenue.
Revenue for a flight may not be recorded until the system has received notification of the flights departure. Based on the manifests for all the
flights that occur, the system records earned revenue by type (domestic or international, by flight in the flight table) and decreases unearned
revenue accordingly. A flight is designated as domestic or international when the operations manager adds the flight to the flight table. Fortyeight hours after a flights arrival, entries associated with it are removed from the reservation table, the charge table, the cash receipts table, and
the manifest table. Before being archived, the removed entries are added to a flight history data warehouse.
Each days revenue consists of fares for the flights that occurred that day plus the fees charged for reservation changes that day. The
system prepares a summary of revenue by flight, a summary of charges for reservation changes, and a total for the day. This total is posted as
earned revenue. Flight operations personnel have access to the summary, which shows for each flight the number of paying fliers, the number of
complimentary fliers, and the averages for each of those on the same day of the week during the preceding month.
Daily, the system performs a balancing routine that verifies that (1) unearned revenue by type (domestic or international) reconciles to
the charges for which reservations have been made and the flight time had not yet passed, and (2) earned revenue by type (domestic or
1
In database terminology, this way of linking records in two different files is known as referential integrity. That is, before a record containing a
foreign key can be written, the object of the reference must exist as the primary key of the target table. In this case, the charge number is the
primary key of the charge table, the cash receipt number is the primary key of the cash receipts table, and the free flight number is the primary
key of the free flights table. Thus, through the system-implemented referential integrity, the reservation system will not record a reservation for
which there is no charge, payment, or authorized fare waiver.
353
354
international) reconciles to the charges made to unearned revenue for flights that occurred. If the amounts differ, details are recorded in a
suspense file and a supervisor is notified electronically. The supervisor must bring the system into balance, clear the suspense file, and record the
cause of the difference.
Assessing the Effectiveness of Monitoring
Controlling Operations and Improving the System
Maintaining System Integrity and Continuity
The airlines risk management department has the responsibility for assuring the integrity of monitoring activities. Risk management
personnel have read-only access to all files containing: (1) notifications of un-reconciled amounts, e.g., for cash drawers, deposit ticket receipts,
credit card charges, credit card collections, earned and unearned revenue; and (2) explanation of the causes of reconciliation failures and attempts
to reconcile accounts.
The files containing the underlying causes for reconciliation failures are available to department managers, who are responsible for
identifying system changes consistent with more effective operations. Department managers consult with system development personnel on
proposed changes and authorize those that appear to be cost-effective process improvements. For example, a cash receipts manager might suggest
modifications to the system to reduce the incidence of reconciliation failures between system-determined revenue and cash receipts.
Each department has read-only access to system-calculated statistics for financial and operating results and is responsible for using the
information to control its area and to recommend changes with the potential to improve any aspect of the airlines operation. For example,
supervisors are responsible for investigating excessive numbers that fail to be reconciled within one day and recommending corrective action.
Marketing personnel are responsible for evaluating the effectiveness of the fare structure and recommending changes to it. Together, flight
operations and marketing personnel are responsible for evaluating the effectiveness of the flight schedule and recoding changes to it. Executives
also have access to the financial and operating results, which prompt them to suggest changes to be evaluated by one or more departments.
Controlling System Development through Change Control
The airline uses a proprietary program library management system to ensure that all program code and system changes are authorized
and documented. A quality assurance (QA) group provides test data to programmers and migrates programs from development libraries to test
libraries to production libraries after users have authorized changes. Changes and approvals are documented with electronic signatures. For
emergency program changes made in response to system failures, QA personnel monitor subsequent authorization and documentation. Program
development and testing are done on servers that are independent of the production system and large enough to conduct volume tests.
Attaining System Reliability and Access Control
The airline uses a proprietary system to monitor and manage its information technology (IT) infrastructure. From an operations center
room, technicians monitor processes whose degradation or failure would threaten system operability. Aspects subject to monitoring include
application availability, application performance, file availability, application interfaces, data transfers, and response levels. For customer
interfacing applications, the service goal is to detect and correct problems before customers notice them. From their desks, technicians investigate
problem situations, summon hardware, software, and network specialists, and reconfigure the network and servers to avoid problem areas until
full capabilities can be restored. For example, if particular network paths seem prone to failures, technicians shift network traffic to other paths.
Through the use of software and hardware monitors, some of the technicians specialize in analyzing unusual activity on the network
that might be indicative of hacker penetration, denial-of-service attacks, or laxity in administration of passwords or access privileges. These
technicians are also responsible for detecting security lapses in the way hardware, software, and network resources are configured and proposing
system parameter changes and security patches to correct security lapses. Once management authorizes the changes and patches, QA personnel
implement them on the production system.
Recovering from Processing Interruptions
All the groups with a role in the IT infrastructure are responsible for recommending changes to the airlines business continuity plan.
Because the online systems require 24 hours per day, 7 days a week availability, the continuity plan has never been tested in its entirety at one
time. Some aspects of the plan are executed every time a component fails or a component is replaced or added. Individual components are
occasionally disabled to test specific functions. For example, some servers might be varied offline at a non-peak time to enable operating
personnel to practice planned recovery efforts.
Maximizing Revenue per Seat-Mile
Because of fierce competition and large fixed costs, a significant risk to the airline is inability to maintain profit margins. The airlines
approach to managing this risk is to use a load-forecasting model and data mining software to maximize flight profitability. The airlines flight
history data warehouse contains the number of passengers in each fare category for each flight for each day. The forecasting model incorporates
factors such as day of the week, holiday occurrence, time of the year, fuel cost by location, and competitors flights and fares. Analysts
investigate flights whose actual loads are outside the forecasted load ranges, and recommend changes to flight schedules and fares and
abandonment of unprofitable flights.
In addition to using the load-forecasting model, the marketing department looks for revenue enhancement opportunities with
proprietary data mining software. Yield-management analysts make recommendations for allocating seats between cheap leisure travel (off-peak
times and advance purchases) and on-demand business travel (peak times and regular purchases). Based on load forecasting and data mining
results, marketing personnel change fares and flights to maximize revenue per seat-mile. After each set of flight and fare changes, the marketing
department evaluates whether the changes had the intended effect on revenue.
Another significant risk to the airline is unanticipated escalation of fuel costs. The airline manages this risk by placing forward
contracts for fuel and minimizing fuel purchases in the highest-cost areas.
Other risks for the airline are that it will miss deadlines for implementing mandated security checking of passengers and luggage, and
be sluggish relative to its peers in using information technology to enable effective operations or revenue management. In addition to the uses
already cited, information technology could be important in the following ways: matching airport employee schedules to flight arrivals and
departures, routing and tracking baggage and freight to minimize handling and lost item recovery, expediting passenger boarding to minimize
ground time and employee staffing, and rerouting flights and passengers when weather or other conditions disrupt flight schedules to minimize
losses. The airline manages this risk by charging its chief technology officer with the responsibility of recommending new uses and
enhancements to existing information systems on a monthly basis and evaluating the success of each technology implementation project.
Required
Identify specific audit objectives, state related internal controls, and suggest tests of control procedures in the following format, adding rows as
needed. The first row, containing a specific audit objectives, related internal controls, and test of control procedures, illustrates the level of detail
for the entries. You should also refer to Chapter 7 on designing audit procedures when evidence is electronic.
1. Ticket sales or change fee transactions
arising from credit card transactions exist
(and hence are not fictitious).
Internal Controls
Test of Control Procedures
1. Supervisors monitor the daily reconciliation

of credit card charges by issuer by day with
subsequent bank account receipts.
1. Observe that the system performs a valid

daily reconciliation of credit card charges by
issuer by day with subsequent bank account
receipts.
2. Review the reconciliation logs to confirm that
supervisors monitor the control daily.
2.
3.
Completeness:
1.
2.
3.
1.
2.
3.
1.
2.
3.
Classification:
1.
2.
3.
Cutoff:
1.
2.
3.
Accuracy:
1.
2.
3.
Understandability:
1.
2.
3.

Simulation Question 13-2 is an adaptation with permission from a case by Peters, M.F., K.W. Shaw, and R.B. Thompson in the Issues in
Background
ShopShopShop.com, Inc. (hereafter, SSS) is an online grocery shopping service operating in San Francisco. SSS customers order
groceries over the World Wide Web (WWW) using software created by the company. The software draws on a database that is updated daily, and
that contains current prices, product weight and volume data, and nutritional information for all items available in the nearest participating Giant
Supermarket. After selecting a grocery order, which typically requires about 20 minutes of pointing and clicking, the customer specifies a 90minute delivery time slot, and SSS does the rest.
The customers order is transmitted to an SSS shopper at the relevant Giant Supermarket store. The shopper fills the order from stock
in the store at a time just before the customer-specified delivery period, checks the order through a cashier, and helps an SSS driver pack the
order in specially designed containers that keep frozen foods frozen, crushable foods uncrushed, etc. The driver then delivers the order to the
customer. SSS bears responsibility for any losses or damages incurred during grocery delivery.
In exchange for this service, the customer pays SSS a monthly membership fee of $5.95. In addition, for each order the customer pays
(1) the store price of the groceries ordered, (2) a flat fee of &6.95, and (3) 5 percent of the store price of the groceries ordered. The monthly
355
356
membership fee is charged to the customers credit card at the beginning of each month. All per-order amounts are charged to the customers
credit card on the date of purchase.
SSS was formed at the beginning of 1998 by R. Food, and advertising executive, and G. Wine, an ex-supermarket manager and recent
M.B.A. graduate from San Francisco State University. During 1998, SSS developed and tested its WWW-based order-entry system. During the
same period, the company negotiated a cooperative arrangement with Giant Grocers, Inc., the dominant Bay Area super market chain. Under this
agreement, SSS agreed to focus all Bay Area operations exclusively on Giant Supermarket stores, while Giant Grocers, Inc agree to facilitate
SSSs order processing, and to provide daily feeds of inventory and price data for each participating store at a nominal cost.
In January 1999, SSS formally began operations at four participating Giant Supermarket stores in San Mateo and Hayward Counties.
By the end of 2000, the companys operations encompassed 12 participating stores in four counties, providing the capability to reach about 70
percent of the potential customers in Bay Area suburbs. SSS served (on average) about 3,000 customers during 1999, and about 10,000 customers
during 2000. Experience over these two years showed that SSSs customer retention rate is extremely high, partly due to a very positive response
to the companys customer software interface, and partly because customers orders are processed with fanatical care by SSSs highly paid
shoppers and drivers.
By the end of 2000, Food and Wine had plans well underway for expansion into the outer Bay Area. Funds required for expansion
were to be raised through an initial public offering of SSS common shares, scheduled tentatively for May 2001.
Software Development Expenditures
Accounting Issues: Software Development Costs and Recognition of Grocery Revenue
The reliability and user-friendliness of SSSs customer order-entry software play a central role in attracting and retaining the
companys customers. SSS devoted considerable resources to developing and maintaining this software during the 1998-2000 period, as indicated
by the summary below.
1998
The first version of the software was designed, developed, and tested during 1998. The software provides a web-based interface that
allows customers to order groceries over the WWW using SSSs servers. During January and February, Food, Wine, and a staff of programmers
worked exclusively on establishing program specification, and on developing and validating a detailed program design and software interfaces.
During this period, programmers earned salaries of $31,000. From the beginning of March through the end of November, the programming staff
worked exclusively on the coding activities required to produce the program, earning salaries of $154,350. Food worked almost exclusively on
supervising the programming effort during this period, while Wine conducted negotiations with Giant Grocers, Inc. and formulated policies for
the order-filling side of the business. Throughout the month of December, SSS tested the completed software by providing service at no charge to
250 customers. During this stage, the programming staff dealt with last-minute software problems, earning salaries of 414,150, while Food and
Wine supervised the shopping and delivery aspects of the process. Food and Wine estimated that the order-entry software would produce
significant benefits for the company over its first four years of operations.
1999
SSS commenced actual operations at the beginning of January. New Software development continued throughout 1999, as SSS strived
to enhance the security of the order-entry process. SSS devoted one server entirely to the order entry process, and made substantial improvements
to the original order-entry program to ensure data security on this server. This enhanced-security version of the software was launched on
March 30. While this security system enhances the overall functionality of the order-entry program, it does not extend its useful life.
Anticipating potential benefits from collecting detailed data on customer preferences and shopping patterns, SSS also began work on
new customer preferences and shopping patterns, SSS also began work on a new customer management system. This software, used in
conjunction with the secured server, collects voluminous data on customer purchases. SSS hopes to use these data to develop marketing
campaigns and coupon offers that better match individual customer preferences. By the end of the year, the programming staff had developed and
validated a detailed design for SSSs customer management system.
During 1999, neither Food nor Wine was much involved in the software development effort. Of salaries earned by the programming
staff during 1999, about 40 percent, 50 percent, and 10 percent were for the development of the enhanced security version of the software, the
customer management software, and routine maintenance of all versions of the software, respectively.
2000
The programming staff completed development work on the customer management software by the end of September, and brought the
new system online at the beginning of October. Of Salaries earned by the programming staff during the year, 80 percent and 20 percent were
attributable to development of the customer management software and routine maintenance of existing programs, respectively. Food and Wine
estimated that the new customer management system would produce significant benefits for the company over a period of six years.
At the end of 2000, Food and Wine anticipate little additional software development work will be needed over the next two years, and
that most work by the programming staff during that period will deal with routine maintenance problems. As a consequence, the owners expect
that programming staff salaries in 2001 and 2002 will be about 50 percent less than in 2000.
When SSS offers shares to the public in 2001, the companys 1998-2000 financial statements will be an important source of
information for prospective shareholders. Food and Wine know that they are responsible for ensuring that SSSs financial statements fairly
present the companys resources, obligations, and performance. The tow owners agree that standard accrual accounting procedures will result in a
fair portrayal of most of the everyday transactions and events that affect the company. Their two points of disagreement are with (1) the
accounting for costs incurred to develop and enhance the order-entry and customer management software, and (2) the recognition of grocery
revenue. Regarding costs incurred to develop the software, Food believes that the order-entry software is the companys most important assets,
and that fair presentation of SSSs financial performance and position can best be achieved by capitalizing and subsequently amortizing all
readily identifiable software development costs. Wine believes that SSS should adopt a more conservative approach, expensing all software
development costs in the period in which they are incurred. Regarding the recognition of revenue, Food favors a more conservative approach that
nets grocery sales revenue with the cost of those sales, and thus only reports fees and commissions as revenue. Wine, on the other hand, believes
that investors would be better served by reporting revenue from grocery sales and the cost of sales as separate line items (i.e., gross) in the
income statement.
Required
Using the information above and the schedule of SSSs cash receipts and disbursements during 1998-2000 to answer the following requirements
(Ignore income taxes). Access Data File 13-2 in iLearn for SSSs comparative schedules of cash receipts and disbursements, 1998-2000.
Available guidance and resources that may help you include:
(1) For resolving Food and Wines disagreement over the accounting for software development costs
(a) Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed, and
(b) AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use .
(2) For resolving Food and Wines disagreement over the recognition of grocery revenue
(a) SECs Staff Accounting Bulletin No.101, Revenue Recognition in Financial Statements (SEC 1999), available online at
http:// www.sec.gov/interps/account/sab101.htm
1. Prepare a set of financial statements for SSS under the assumptions that
(1) all software development costs are expensed when incurred, and
(2) revenue from grocery sales and associated costs are each reported as separate line items in the income statement.
Your financial statements should include
(a) comparative balance sheets at December 31, 1998, 1999, and 2000;
(b) comparative income statements of cash flows for the years ended December 31, 1998, 1999, and 2000;
(c) comparative statements of cash flows for the years ended December 31, 1998, 1999, and 2000, and
(d) any notes needed to make the financial statements understandable.
Note: Apart from the issue of how to account for software development costs, balance sheets and income statements should be prepared using
standard accrual accounting procedures.
2. Now assume that the companys policy is to capitalize all software development costs. Prepare a schedule showing the types and amounts of
development costs that should be capitalized in connection with
(a) the original customer order-entry software,
(b) the enhanced security version of the order-entry software, and
(c) the customer management software.
Note: You must also compute the net (of accumulated amortization) software asset remaining at the end of each of the years 1998-2000.
3. Based on your answers to 1. and 2. above, prepare a table that compares the financial statement items and ratios listed below, assuming that
(a) all software development costs are expensed as incurred, as in 1. above.
(b) all software development costs are capitalized, as in 2. above
(1) Total assets at 12/31/98, 12/31/99, and 12/31/00.
(2) Total stockholders equity at 12/31/98, 12/31/99, and 12/31/00.
(3) Net income for 1998, 1999, and 2000.
(4) Return on assets for 1999 and 2000.
(5) Return on stockholders equity for 1999 and 2000.
(6) Net cash flow from operations for 1998, 1999, and 2000.
(7) Net cash flow from investing activities for 1998, 1999, and 2000.
(8) Ratio of net cash flow from operations to total liabilities at 12/31/99 and 12/31/00.
Note: Refer to the financial-ratio formulae provided in Chapter 7.
4. Forecast SSSs net income and return on stockholders equity for 2001 under
(a) the capitalization accounting treatment for software development costs, and
(b) the immediate expensing accounting treatment for software development costs.
(c) Comment on which of the two earnings forecasts is most likely to reflect SSSs sustainable earnings, that is, the level of earnings that is most
likely to persist in the future.
Note: In formulating your forecasts, (i) ignore the potential effects of both the planned share offering and the projected expansion into the outer
Bay Area, and (ii) assume that sales in the Bay Area suburban market grow at a rate of 10 percent.
5. Comment on which accounting treatment for software development costs capitalization or immediate expensing do SSSs financial
statements provide the fairest presentation of the companys resource, obligations, and performance?
Note: Assume that fairest means the accounting approach that most accurately presents the underlying economic reality associated with the
software development costs.
Note: You must answer all 5 questions above to earn the extra credit point.

Simulation Question 13-3 is an adaptation with permission from a case by M.R. Gujarathi in the Issues in Accounting Education , a publication of
Company Overview
Super Electronics, Inc. (SE or the Company) is a regional specialty retailer of consumer electronics, home office products,
entertainment software, appliances, and related services. The Company has committed to the goals of growth and innovation ever since its
incorporation in 1990. It was among the first few large retailers to sell emerging electronics items such as digital cameras, camcorders, flat-panel
357
358
televisions, and GPS navigation systems to the mass market. SE provides extensive training about the new products to its sales associates so that
they can make it easier for even the least technologically savvy customer to try newer electronic gadgets.
In the last decade, the Company has focused not only on increasing the sales of electronic products but also on capturing a significant
share of the electronics installation market. SE services products purchased from its stores as well as from other retail or online outlets. The
Company's reputation for large attractive stores, technical assistance for product selection, and expert installation and repair services has enabled
it to achieve double-digit growth in revenues and a number of stores over the last several years. In 1999, SE launched an e-commerce site that
sells a full range of the Company's products.
Performance
Recent Initiatives
Financial Reporting for Recent Initiatives
Compared to other firms in the specialty retailing industry, the Company has demonstrated above-average growth in sales and gross
margins in the last decade. The Company's management is optimistic that this trend will continue for the foreseeable future. In fiscal 2008,2 SE
reported the highest comparable stores' sales growth3 in the specialty electronics industry. However, preliminary results for fiscal year 2008
(ending on February 28, 2009) indicate that the Company might not be able to meet the $3.00 per share analysts' earnings estimate.
The Company's Board of Directors has placed SE's performance in the top quintile in the industry on many dimensions. Externally,
too, SE's financial performance is well recognized. Moody's has assigned an investment grade rating (Aa) to the Company's bonds, and SE's stock
trades at a multiple of 16 to its earnings (in comparison with the average of 12 for the industry). Analysts have attributed the high price multiple
to the Company's growth prospects and the strategic direction articulated by its management.
SE's preliminary financial statements for the 2008 fiscal year are provided in Exhibit 1. You should access Data File 13-3 in iLearn for Exhibit
1, which presents SEs preliminary financial statements for the 2008 fiscal year. They are not final; only upon further evaluation and
approval by the external auditing firm will the financial statements be filed with the Securities and Exchange Commission (SEC).
In its 2008 annual report, SE's management has reported implementation of the following new initiatives:
Customer Loyalty Program
SE initiated Super Rewards Program (SRP) in fiscal 2008 to compete with other retailers that have started customer loyalty programs. Such
programs are deemed cost-effective because enticing a new customer tends to be more expensive than getting an existing customer to purchase
more.4 SE's program aims at acquiring information regarding customers' spending habits and motivates them to return often to SE for additional
purchases. By tracking the frequency, amounts, and types of purchases made by the customers, the Company can design more effective sales and
promotion strategies.
For an annual membership fee of $24, customers enrolled in SRP receive announcements of special sales, product coupons, and invitations to
shopping events. The annual membership fee comes with a complete satisfaction guarantee. If a customer is not satisfied with SRP for any
reason, the Company is obliged to refund the fees for the unused period of membership.
Strategic Sourcing (Vendor Allowance)
The Company made concerted efforts in the area of strategic sourcing and aggressive sales promotion of flat-panel televisions and digital
cameras. According to the 2008 annual report, the Company's procurement policies and large size enabled it to secure low prices from its
vendors, which were passed on as savings to the customers. In 2008, the Company has established long-term strategic alliances with select
suppliers, including one with a major vendor of flat-panel televisions. In addition, the management of the Company expects to finalize
negotiations with several additional vendors in the near future.
Price Protection Plan
To secure an edge over the competition, SE introduced a price protection plan for big-ticket items (priced at $499 and above) in fiscal 2008. If
an item purchased by a customer goes on sale at SE at a lower price within 60 days of sale, the customer can present the original sales receipt and
get a refund for the difference between the price paid and the new lower price.
During the annual audit for fiscal 2008, the audit team asked SE's management about the financial transactions relating to the new
initiatives of the Company and the financial reporting policies it has followed for them. A summary of this discussion is given below:
Customer Loyalty Program
The Company sold 25,000 SRP memberships per month in fiscal year 2008, resulting in proceeds of $7,200,000 (25,000 memberships 12
months $24 membership price) in net sales. SRP members earn two points for each qualifying purchase of $1 of products and services of the
Company. Points earned enable members to receive a certificate that can be redeemed on future purchases. SE issues a $5 certificate for every
100 points earned by a member. The certificate expires one year after issuance.
SRP members made qualifying purchases totaling $330 million during 2008. With no historical experience with point redemption, the Company
recorded the entire retail value ($33 million) of the certificates issued as a reduction in sales and an increase in accrued liabilities. Customers
spent (i.e., used) $23 million of the certificates in fiscal 2008, and $5 million of the certificates expired before February 28, 2009. When SRP
certificates are used or expired, they have been recorded as a sale and a decrease in accrued liabilities.
Strategic Sourcing (Vendor Allowance)5
Because of the strategic sourcing initiative, the Company was able to negotiate significant allowances from a major vendor of flat-panel
televisions. The vendor agreement stipulates that SE receives a 7 percent refund on all purchases if it commits to purchase at least $100 million of
flat-panel televisions over a three-year period. If the purchase commitment exceeds $150 million, the vendor will give an additional 1 percent
refund, making the total refund 8 percent. The vendor granted higher allowances and flexible payment terms to SE in order to lock in the multi-
The Company's fiscal year begins on March 1 and concludes at the end of February.
Comparable stores sales growth is a commonly used measure in the retail industry to measure the growth in revenue from the existing stores.
4
In the United States, it is estimated that almost 75 percent of consumers own at least one loyalty card, with over a third of all shoppers owning
two or more. The popularity of customer loyalty programs is on the rise. Even luxury hotel chains such as Ritz-Carlton have added such programs
recently (Wall Street Journal 2010).
5
Vendor allowances, widely prevalent in the retailing industry, are the amounts manufacturers or dealers pay to the retailers in exchange for a
promise of guaranteed volume of purchases and for benefits such as premium shelf space or an end-of-aisle display at the retail outlets. Typically,
the vendor allowance amounts are paid in advance of the purchases promised by the retailer.
year purchase commitment. Obtaining such commitments has lately become challenging to vendors because of the poor economic environment in
the retailing industry.
The vendor has agreed to pay SE 5 percent of the amount of the total three-year purchase commitment at the end of the first year and 1 percent at
the end of the second year. In the third year, the vendor will pay the remaining amount depending on the total purchases made by SE over the
three-year period. If the cumulative purchases do not meet the agreed-upon targets, SE will need to return the unearned portion of the refund to
the vendor.
In 2008, the Company made a commitment to purchase at least $150 million of flat-panel televisions from the vendor. It has made purchases of
$45 million in fiscal 2008, and expects to make purchases of $55 million and $60 million, in 2009 and 2010, respectively. Almost all of the $45
million of flat-panel televisions purchased from the vendor have been sold by SE during 2008. They are recorded in the statement of operations as
cost of sales, buying, and warehousing. The Company has recorded the entire cash refund of $7.5 million (5 percent $150 million) received
during fiscal 2008 as sales.6
Price Protection Plan
SE's net sales in fiscal year 2008 included $240 million of big-ticket products (priced at $499 and above) covered under the price protection
plan. The Company has refunded $7,000,000 in 2008 under the price protection plan and has recorded these as reductions in sales. During the
coming year, the Company expects further reductions in prices of big-ticket products in light of the deteriorating economic conditions in the
consumer electronics markets.
Management Proposals during the audit Process
During the process of annual audit for fiscal 2008, the senior management of the Company has proposed making the following
adjustments to SE's accounts. These adjustments are not reflected in the preliminary financial statements given in Exhibit 1. You should access
Data File 13-3 in iLearn for Exhibit 1, which presents SEs preliminary financial statements for the 2008 fiscal year.
Unredeemed SRP Certificates
SE's management proposes to record as sales the estimated amount of SRP certificates that will not be redeemed. Management estimates that 15
percent of the remaining $5 million of outstanding certificates will not be redeemed. Thus, the expected amount of non-redemption would be
$750,000.
Vendor Allowances
SE's management wants to recognize the $5.3 million difference between the total expected refund of $12.8 million (8 percent $160 million)
and the amount received from the vendor of $7.5 million (5 percent $150 million) in fiscal 2008 as sales and as a receivable from the vendor.
Management believes that such recognition is appropriate given the high likelihood that the refund will be earned; it expects total purchases over
the three-year period to be $160 million, exceeding the threshold of $150 million needed to earn a refund of 8 percent.
Executive Compensation
To attract, retain, and motivate key executives, the Board of Directors of SE has approved a generous executive compensation package
to its senior management. The compensation package consists of a base salary (which is not performance-based), a short-term incentive bonus
plan (for achieving the specified performance targets), and long-term incentive stock option plan (to incentivize senior management for
increasing shareholder value). Pertinent details of the short-term incentive bonus plan for fiscal 2008 are given in Exhibit 2. You should access
Data File 13-3 in iLearn for Exhibit 2, which presents SEs short-term incentive bonus plan for the 2008 fiscal year.
Required
Assume that you are an audit senior assigned to SE. The audit partner has asked you to provide an analysis of the Company's existing accounting
policies for the three new initiatives and an evaluation of the proposals made by SE's management during the annual audit process. Your answers
should (1) provide an assessment of whether the policies comply with Generally Accepted Accounting Principles (GAAP), and (2) Explain your
rationale and support your position with citations from the applicable authoritative pronouncements using the FASB Accounting Standards
Codification, and other relevant resources, if an authoritative pronouncement is unavailable. Specifically, address the following questions:
1. Membership fees received for the Super Rewards Program.
a. Is it appropriate for SE to record the entire membership proceeds of $7,200,000 as revenue of fiscal 2008? If yes, why? If not, explain why
and compute the amount of membership fees revenue that should be recognized in fiscal 2008. (Note: For ease of calculations, assume that each
membership fee is received at the midpoint of the month and that the actual and estimated cancellations of membership are immaterial.)
b. Should the membership revenue be presented as sales or as other income in SE's statement of operations? If the net effect of the two
alternatives on income is the same, should this matter? Why?
c. If the membership does not come with the complete satisfaction guarantee (i.e., if membership fees are non-refundable), determine the
amount of membership fees revenue that SE should recognize in fiscal 2008.
2. SRP certificates issues, used and expired.
a. Explain whether SE's accounting for SRP certificates issued, used and expired complies with GAAP. Identify at least one other company
whose accounting for customer loyalty program is similar to SE's accounting for the Super Rewards Program. Describe how that company has
reported its accounting for the customer loyalty program in its annual report.
b. Is SE's financial reporting for the SRP certificates (issued, used and expired) the only GAAP-compliant method to account for a customer
loyalty program? If not, (a) describe the alternative(s) and cite authoritative support for the alternative(s), and (b) identify at least one company
that follows the alternative(s) and describe how that company reported its accounting for the customer loyalty program in its annual report.
c. If alternative accounting methods are acceptable per GAAP, what are some factors that will affect SE's management's choice of an
accounting method? What adjustments to the statement of operations in Exhibit 1 will SE need to make if it chooses an alternative method to
account for the SRP certificates issued, used and expired?
3. Vendor allowances.
a. Does SE's recording of the cash refund of $7.5 million from the vendor as sales of fiscal 2008 comply with GAAP? Why? Explain.
6
SE recognizes revenue when the customer takes possession of the merchandise. Although SE uses separate accounts (such as gross sales, sales
discounts, sales returns, and sales allowances) to record individual transactions, net sales reported in the statement of operations represent an
aggregate sum of those accounts.
359
360
b. Determine the amount of vendor allowance that should be recognized in fiscal 2008 and indicate where in the financial statements it should
be presented. Does the presentation matter if the effect on net income is the same? Why? Explain.
4. Price protection plan.
What adjustments, if any, should be made to the statement of operations in Exhibit 1 to ensure that SE's financial reporting for the price
protection plan complies with GAAP? (Note: Assume that the sales of big-ticket products have occurred uniformly over fiscal 2008, i.e., $20
million per month). Since this is the first year of initiating a price protection plan, SE cannot reliably estimate eventual refunds from the plan.
Based on your research and interviews with SE's management, you have determined that the history of price changes on big-ticket items (when
the price protection plan was not in use) is unavailable for the Company or the industry.
5. Effect of GAAP adjustments on statement of operations.
As an audit senior, you want to ensure that SE's existing financial reporting policies for the new initiatives are GAAP-compliant.
What adjustments, if any, would you suggest to the Company's reported net sales, cost of sales, gross profit, operating income, other (loss)
income, net earnings, and earnings per share? Provide your answer in the format given in Exhibit 3. Assume the average income tax rate to be 40
percent. You should access Data File 13-3 in iLearn for Exhibit 3, which provides the format for the adjustments.
361
362
Chapter 14
Expenditure Cycle Tests of Controls and Tests of
Balances
LO14-1 Understand the accounting information system of a typical expenditure cycle.
LO14-2 Describe some common TOC procedures for purchases.
LO14-3 Describe some common TOC procedures for cash disbursements.
LO14-4 Apply the analytical procedures in an expenditure cycle.
LO14-5 Describe some common TOB procedures for accounts payable.
LO14-6 Identify some characteristics of accounts payable confirmation.
LO14-7 Describe some common TOB procedures for property, plant, and equipment
account.
LO14-8 Describe some common TOB procedures for legal expense.
LO14-9 Describe some common TOB procedures for 3 industry-specific-accounts of the
expenditure cycle: intangible assets, natural resources, and leases
Chapter 14 Expenditure Cycle Tests of Controls and Test of Balances

An overview of the strategy for tests of controls in an expenditure cycle is presented in Figure 14-1.
Figure 14-1 TOC Strategy in Expenditure Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
363
364
Understanding Internal Control in an Expenditure Cycle

TOC strategy in an expenditure cycle starts with an understanding of internal controls relating to an expenditure
cycle. Table 14-1 provides a brief discussion of the various components relating to the understanding of internal
controls in an expenditure cycle.
Table 14-1 Understanding Internal Controls in an Expenditure Cycle
Understanding Internal Controls in an Expenditure Cycle
2. Risk assessment
5. Monitoring
have a special effect on the expenditure cycle.
expenditure cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action
to address those risks in order to meet the five basic management assertions.
cycle. If the auditor plans to conduct both TOC and TOB on the expenditure cycle, then s/he needs to
identify the control activities relating to specific audit objectives and for the purpose of assessing control
risk (CR). The auditor usually identifies these control activities from documentations of the understanding
using narrative descriptions, internal control questionnaires, or flowcharts. Figure 14-8 shows an example
of an expenditure cycle flowchart.
The auditor must obtain sufficient knowledge of the accounting information system relating to the
expenditure cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit
objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in
three areas as shown in Figure 14-2. A brief discussion of these three areas is provided in Table 14-2.
The auditor must understand the managements monitoring processes over the expenditure cycle. This
includes understanding how the management monitors the internal controls of the expenditure cycle over
time and what corrective action is initiated to improve the design and operation of controls in the
expenditure cycle.
Figure 14-2 Understanding of Information and Communication in an Expenditure Cycle
Key Functions
Understand 4 key functions of an expenditure
cycle

Transactions
of transactions

records
Table 14-2 Understanding of Information and Communication in an Expenditure Cycle

Transactions
Key Functions
Accounts
(control ledger)
1. Purchasing
Processing request to
purchase
goods
and
services from authorized
employee.
Classes of
Transactions
Inventory
Purchases
Property,
plant, and equipment

Purchase requisition
This document requests goods or services for an authorized
individual or department. Figure 14-3 shows an example of a
purchase requisition.
Prepaid
expenses
Purchase order
This document includes the description, quality, and quantity of
the goods and services being purchased. The purchase order also
indicates who authorizes the acquisition of goods and services.
The purchase order may be mailed, faxed, or placed by phone or
internet with the supplier or vendor. Figure 14-4 shows an
example of a purchase order.
Leasehold
improvements
Accounts
payable
Manufacturing
expenses
Selling
expenses
Administrative
expenses
2. Receiving
Receiving, counting, and
inspecting goods received
from vendors.
3.
Processing
and
recording liability
Processing
vendor
invoices for the receipts
of goods and services.
Recording of accounts
payable.
Purchase
returns
allowances
Purchase
discounts
and
Purchase
returns
and
allowances
Receiving report
This document records the date, description, and quantity of the
goods received. It is usually just a copy of the purchase order with
the dollar amount omitted. Figure 14-5 shows an example of a
receiving report.
Vendor invoice
This document is the bill from the vendor, which includes the
description and quantity of the goods shipped or services
provided, the price including freight and trade discounts, and the
date of billing. Figure 14-6 shows an example of a vendor invoice.
Voucher
This document establishes a formal means of recording and
controlling purchases. It includes a cover sheet or folder to create
a voucher packet containing the purchase order, copy of the
packing slip, receiving report, and vendor invoice. After payment,
a copy of the check is added to the voucher packet.
Purchases journal
A purchases journal is used to record all goods and services
purchased. It usually includes several classifications for the major
types of purchases, such as the purchase of inventory, repairs and
maintenance, supplies, the entry to accounts payable, and
miscellaneous debits and credits. The purchases journal may also
include purchase returns and allowances for which a separate
journal has not been created. Details from the purchases journal
are posted to the accounts payable subsidiary ledger. An
alternative to the purchases journal is a voucher register that is
used to record all vendor invoices for goods and services
purchased.
Accounts payable subsidiary ledger (file)

An accounts payable subsidiary ledger is used for recording
individual purchases, cash disbursements, and purchase returns
and allowances for each vendor. The total of the accounts payable
subsidiary ledger is post to the accounts payable in the general
(control) ledger. When a voucher register is used instead of a
purchases journal, the total of unpaid vendor invoices in the
voucher register is the total accounts payable.
Accounts payable trial balance (list)

An accounts payable trial balance lists the amount owed to each
vendor at a point in time and is prepared from the accounts
payable subsidiary ledger.
365
366

Transactions
Key Functions
Accounts
(control ledger)
Classes of
Transactions
4. Cash disbursement
Processing and recording
of the payment of cash to
vendors.
Cash account
(cash in bank)

Vendor Statement
This statement is sent monthly by the vendor to indicate the
beginning balance, current-period purchases and payments, and
the ending balance. The vendor statement may differ from the
clients records because of errors or timing differences. The
auditor can verify the accuracy of the clients records by
comparing vendor statements with the accounts payable subsidiary
ledger. Figure 14-7 shows an example of a vendor statement.
Disbursem
ents
Accounts
payable
Check
This document, signed by an authorized employee, pays for goods
or services. When the check is cashed by the vendor and cleared
the clients bank, it is called a cancelled check. Some clients make
payment to the vendor electronically through an electronic funds
transfer (EFT) between the companys bank and the vendors
bank.
Cash disbursements journal

This journal records disbursements made by check. It is
sometimes referred to as a check register. The cash disbursements
journal contains columns for recording credits to cash and debits
to accounts payable and cash discounts. Columns may also record
miscellaneous debits and credits. Payments recorded in the cash
disbursements journal are also recorded in the voucher register (if
this is used instead of the purchases journal) and in the accounts
Figure 14-3 An Example of a Purchase Requisition

PR #582
PURCHASE REQUISITION
XYZ Company
CA 94132
Department: Accounting, 3rd Floor, Room No.300
Quantity
2
1
Description
Office Furniture: Wood Furnish, Black Color, Saunder#68342
Photocopy Machine: Duplex, Energy Saving, Canon#401
Requisition Approval Person: Kim
Date: January 1, 201x
Figure 14-4 An Example of a Purchase Order

PO #329
PURCHASE ORDER
XYZ Company
CA 94132
To: ABC Company
CA 94132
Process Our Order For:
Quantity
2
1
Description
Contact Person: Mary
Date: January 3, 201x
Price
$ 500
$6000
Ship Via: You delivery
Total
$1000
$6000
Terms: 2/10, n/30
Figure 14-5 An example of a Receiving Report

RR #761
RECEIVING REPORT
XYZ Company
CA 94132
Department: Receiving, Basement Floor, Room No.100
Quantity
2
1
Purchase Order #329
Description
Shipped Via: Deliver by Vendor
Goods Receiving Person: Lisa
Date: February 6, 201x
Figure 14-6 An Example of a Vendor Invoice

SI #37561
SALES INVOICE
ABC Company
CA 94132
Sold To: XYZ Company
CA 94132
Your Purchase Order #329
Quantity
2
1
Description
Price
$ 500
$6000
Tax
Shipped: February 6, 201x
Shipped Via: Deliver by Vendor
Date: February 8, 201x.
Total
$1000
$6000
560
$7560
367
368
Figure 14-7 An Example of a Vendor Statement

VS #37561
VENDOR STATEMENT
ABC Company
CA 94132
To Customer: XYZ Company
CA 94132
Date
February 1
February 8
February 10
February 12
February 23
February 26
February 28
Amount
Beginning Balance
Invoice #37561
Payment
Credit #324
Invoice #37690
Payment
Ending Balance
Statement Prepare Person: Jane
$7560
- $7560
- $ 140
$1000
- $ 500
Date: February 28, 201x.
Balance
$3000
$7560
$3000
$2860
$3860
$3360
$3360
Figure 14-8 An Example of an Expenditure Cycle Flowchart

Functions
Documents & Records
Initiate
Purchases
Purchase
Requisition
Computer Process
Vendor Master File
Enter
Purchase
Requisition
ORDER PROGRAM
Perform limit test and
check authorization.
Print purchase order.
Purchase
Order
Receive
Of
Goods
Open Order File
Retrieve
Authorization to
Receive Shipment
& Enter Goods
Received
Difference in
Quantity Ordered
& Received
RECEIVING PROGRAM
Retrieve open Orders.
Add receiving data.
Transfer to receiving file.
Print receiving report
& outstanding purchase
orders report.
Receiving Report
Perpetual Inventory
Receiving File
Outstanding
Purchase Orders
Record
Liabilities
Vendor
Invoice
Enter
Invoice
Voucher
Error
Report
Voucher
Register
General
Ledger
Error
Report
ACCOUNTS PAYABLE
PROGRAM
Retrieve receiving data and
match with vendor invoices.
Perform edit checks.
Enter data in purchase
transaction file.
MASTER FILE UPDATE

PROGRAM
Print voucher register,
general ledger, weekly
purchase report, and
error report.
Purchase Transaction File
General Ledger Master File
Accounts Payable Master File

Weekly Purchases
Report
369
370
Functions
Process
Cash
Payment
Documents & Records
Computer Process
Vendors
Invoice
Enter Vendors
Invoice Data
Error
Report
CASH DISBURSEMENTS PROGRAM

Match purchase, receiving, and invoice
data.
Print authorized disbursement listing.
Print pre-signed/unsigned checks.
Enter data in cash disbursement
transactions file.
Authorized
Disbursement
Listing
Cash Disbursement Transaction

File
Checks
Voucher
Register
MASTER FILE UPDATE
PROGRAM
Update master file.
Print voucher register,
general ledger, cash
disbursements journal,
and error report.
General
Ledger
Cash
Disbursements
Journal
Accounts Payable Master File

Error
Report
Vendor Master File
Consider Potential Misstatements in an Expenditure Cycle

After the auditors have obtained an understanding of the internal controls relating to the expenditure cycle and
weaknesses in internal control. Table 14-3 describes some of these potential misstatements in the expenditure cycle.
Table 14-4 describes some potential misstatements that are specific to cash disbursements in the expenditure cycle.
Table 14-3 Potential Misstatements in an Expenditure Cycle due to Weaknesses in Internal Control
Example of Fraud
Recording inaccurate purchases.
An accounting clerk colludes with a

major supplier and records fictitious purchases
from that supplier.
Misappropriation of purchases.
Goods are ordered but delivered to an

inappropriate address and stolen.
Duplicate recoding of purchases
Example of Error
Recording a purchase for goods that

have not been approved for ordering.
A purchase is recorded when an

invoice is received from a vendor, and
recorded again when a duplicate invoice is
sent by the vendor.
Early
purchases.
or
late
recording
of
Example of Fraud
Example of Error
Intentionally closing purchases journal

early to record this periods purchases as
having occurred in subsequent period.
Table 14-4 Potential Misstatements of Cash Disbursements in an Expenditure Cycle due to Weaknesses in
Internal Control
Recording
disbursements.
inaccurate
cash
Example of Fraud
An accounting clerk prepares a check to

himself/herself and records it as having been
issued to a major supplier.
Example of Error
A disbursement is made to pay a

vendors invoice for goods that have not
been received.
Disbursements
for
travel
and
entertainment are mistakenly included with
goods purchases.
Duplicate payments.
Unrecorded disbursements
A payment is made when an invoice is

received from a vendor, and paid again
when a duplicate invoice is sent by the
vendor.
An accounting clerk writes and cashes

an unrecorded check for the identical amount
of an unrecorded and deposited cash receipts.

After considering potential misstatements, the auditors assess the control risk (CR) and perform TOC procedures as
per the audit program for the expenditure cycle. Table 14-5 and Table 14-6 describe some common TOC procedures
that the auditors perform on purchases and cash disbursements of the expenditure cycle.
Table 14-5 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Purchases
Recorded purchases are for goods and
services actually ordered and received.
No fictitious purchases or goods and
services not ordered or received are
recorded.
Internal Controls
Purchases are approved at the appropriate level.
Examine documents in voucher packet for

existence.
Vouch a sample of entries in the voucher
register to the supporting documents in the
voucher packet.
Inspect a sample of vouchers for the proper
authorization purchase orders.
Inquiry of the management for internal
verification of vendor invoices, receiving
reports, purchase orders, and purchase
requisitions.
Vouch a sample of receiving reports to their
respective vendor invoices and vouchers.
Examine a sample of canceled checks to
ascertain that the related receiving reports are
dated no later than the checks.
Vendor invoices, receiving reports, purchase

orders, and purchase requisitions are subjected
to internal independent checks.
No purchases or goods and services not

received are paid.
Completeness:
Purchases transactions are recorded. This
is the most important audit objective for
the expenditure cycle.
Accuracy and Classification:

Purchases transactions are accurately
recorded and classified.
Understandability:
Purchase orders, receiving reports, and vouchers

are prenumbered and accounted for.
Scan for numerical sequence of purchase

orders, receiving reports, and vouchers.
Trace a sample of purchase orders (or
vouchers) to the purchases journal (or voucher
register).
Internal independent checks

preparation.
A chart of accounts is used.
Recompute information on vouchers for prices

and discounts.
Compare the classification of a sample of
vouchers with the classification in the chart
of accounts.
on
vouchers
371
372
Internal Controls
Purchases transactions are properly

recorded in the purchases journal and
accounts payable.
Separation of duties between recording of

purchases transactions and cash disbursements
journal.
Internal independent checks on accounts payable
subsidiary ledgers agree with accounts payable
control ledger.

Inquiry of management about independent
check and review of purchases records.
Table 14-6 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Cash
Disbursements
Internal Controls
Recorded cash disbursement are for goods
and services actually received.
Completeness:
Cash disbursements are recorded.
Accuracy:
Cash
disbursements
accurately.
Classification:
Cash disbursements
properly classified.
are
recorded
transactions
are
Cutoff:
Cash disbursements are recorded on the
correct dates.
Separation of duties between custody of signed

checks and record keeping.
Approvals of payment on supporting documents
at the time checks are signed.
Disbursement documents are defaced to prevent
duplicate payments.
Checks are prenumbered and accounted for.

Separation of duties between monthly bank
reconciliation
and
recording
of
cash
disbursement.
Scan for numerical sequence of checks.
Internal independent checks on calculations and

amounts of cash disbursements.
An independent person prepares the monthly
bank reconciliation.
Inquiry of the management about independent

checks on the preparation of cash
disbursements.
Inspect monthly bank reconciliations.

Compare the classification of a sample of cash
disbursements with the classification in the
chart of accounts.
Procedures require recording of cash

disbursements as soon as the checks have been
signed.
Compare dates on cancelled checks with the

cash disbursements journal.
Compare dates on cancelled checks with the
bank cancellation date.
Inquiry of management about approval on

voucher packet.
Observe the official, who signs check, matches
the check with the supporting disbursement
documents in the voucher packet and defaces
(i.e., punches a hole) the supporting
documents.
Examine bank reconciliations and observe

their preparation.
An overview of the strategy for tests of balances in an expenditure cycle is presented in Figure 14-9.
Figure 14-9 TOB Strategy in Expenditure Cycle

The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
373
374
Apply TOB Strategy

Table 14-7 provides a brief discussion of the TOB strategy as it is applied to an expenditure cycle.
Table 14-7 TOB Strategy in Expenditure Cycle
TOB Strategy Expenditure Cycle
2. Derive DR

transaction level of a transaction cycle. In an expenditure cycle, the accounts payable balance is often made
up of a large number of accounts and the balance is large. For these reasons, the auditor typically allocates
a small TM (i.e., less tolerance) to accounts payable.
timing of the TOB procedures used by the auditor. In the expenditure cycle, inherent risk for the accounts
payable is usually moderate or high. This is because it is usually made up of a large number of accounts
and the balance is usually large.
client data. In the expenditure cycle, analytical procedures are used especially to uncover misstatements of
accounts payable. One of the most effective analytical procedures for uncovering misstatements of
accounts payable is comparing current-year expense totals with prior year. This is because expenses from
year to year are typically relatively stable. Table 14-8 describes some analytical procedures and potential
misstatements that may be detected by them in the expenditure cycle.
common TOB procedures in an expenditure cycle. The auditor is especially concerned about the specific
audit objectives of completeness and cut-off in the expenditure cycle.
Table 14-8 Analytical Procedures for the Expenditure Cycle

Purchases:
Comparison of purchases-related expense account balances with prior years.
Accounts Payable:
Comparison of individual accounts payable with previous years.
Comparison of accounts payable turnover and days outstanding to previous years.

Purchase Returns and Allowances:
Comparison of purchase returns as a % of purchases to previous years.
Comparison of purchase allowances as a % of purchases to previous years.

Misstatement of purchases-related expenses.
Unrecorded (understated) accounts payable.
Fictitious (overstated) accounts payable.
Understatement or overstatement of liabilities
and expenses.
Understatement or overstatement of purchase

returns and purchase allowances.
Table 14-9 Specific Audit Objectives and Common TOB Procedures for an Expenditure Cycle
Recorded accounts payable are valid.
Completeness:
All accounts payable are recorded
(unrecorded liabilities). This is the most
important audit objective for accounts
payable.
All merchandise for which the client is

billed is received.
Cutoff:
All purchases transactions and related
accounts payable balances are recorded in
the proper period.

Clients is obliged to pay for liabilities
recorded in the accounts payable.
Accuracy:
Accounts payable in the accounts payable
trial balance are accurate.
Classification:
Accounts payable in the accounts payable
trial balance are properly classified.
Long-term accounts payable and long-term
notes payable are properly classified.
Understandability:
All related accounts in the expenditure
cycle are properly presented and disclosed
in the financial statements.
All renewals of notes payable after the
balance sheet date are properly disclosed.

Confirmation of selected accounts payable by using MUS sampling approach (recall Chapter 12).
Table 14-10 provides further discussion on the confirmation of accounts payable procedure. Table
14-11 provides further discussion on the use of vendor invoice and vendor statement in the TOB
and confirmation of accounts payable.
Vouch selected balances from the accounts payable trial balance (list) to the voucher packets and
vendor invoices.
Inquire the management for unrecorded liabilities.
Reconcile the amounts in vendor monthly statements with the amounts in the clients accounts
Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any
unrecorded liabilities.
Trace a sample unmatched receiving report file in the current accounting period to accounts
payable entries recorded in the next accounting period.
Trace a sample of large-dollar amounts from vendor invoices to receiving reports, then to the
purchases journal and cash disbursement journal in the next accounting period to determine if the
liabilities relate to the current accounting period.
Confirm a sample of accounts payable including accounts with small or zero balance.
Examine a sample of receiving reports before year-end for recording purchases and accounts
payable in proper period.
Review large purchase returns and allowances before and after the balance sheet date to determine
whether they are recorded in the correct period.
Table 14-11 provides further discussion on the purchases and purchases returns cutoff procedures.
As a rule of thumb, there is a very low risk for this specific audit objective because a client has no
incentive to record liabilities that it is not obliged to pay.
Scan a small sample of the voucher packets for supporting documents such as purchase orders.
Foot the accounts payable trial balance (list) and agree total to accounts payable control (general)
ledger.
Vouch a sample of accounts payable balances from the accounts payable trial balance to the
voucher packets.
Analyze accounts payable trial balance for long-term notes payable and long-term accounts
payable.
Inquire of management whether there are any long-term notes payable and long-term accounts
payable included in the aged trial balance.
Inquire management about related party payables and assure that they are properly disclosed.
Read the minutes of the board of directors meetings for any long-term purchase commitments or
contracts that must be adequately disclosed as a footnote in the financial statements.
Review all renewals of notes payable after the balance sheet date but before the audit report issue
date (referred to as subsequent events) to determine that they are properly disclosed as a footnote
in the financial statements.
Confirmation of Accounts Payable

The characteristics of positive and negative confirmation described in Table 13-10 of Chapter 13 apply to the
confirmation of accounts payable as well. However, there are some additional characteristics of the confirmation of
accounts payable that are not shared by the confirmation of accounts receivable. These additional characteristics are
summarized in Table 14-10. Table 14-11 further discusses the use of vendor invoice and vendor statement in TOB
and confirmation of accounts payable.
375
376
Table 14-10 Additional Characteristics of Accounts Payable Confirmation
Additional Characteristics of Accounts Payable Confirmation
Less frequently used than accounts receivable confirmation

Accounts payable confirmations are used less frequently than accounts receivable confirmations because the auditor can perform TOB on
accounts payable by examining vendor invoices and vendor monthly statements. These documents originated from sources external to the client,
so they are viewed as reliable evidence.
Accounts payable with zero balance are confirmed to search for unrecorded liabilities.
Accounts payable with zero balance are confirmed because the client may owe such vendors for purchases but the amounts may not be
recorded. In addition, if the clients internal control is weak, the auditor may also include balance with large-dollar amount for confirmation.
A special form of positive confirmation is generally used.

In accounts payable confirmation, the auditor generally uses a special form of positive confirmation referred to as blank-balance
confirmation. This type of positive confirmation does not state the balance owed. Instead, the confirmation requests that the recipient fill in the
amount or furnish other information. It also usually requests additional information on notes payable and consigned inventory.
Table 14-11 Vendor Invoice and Vendor Statement in TOB and Confirmation of Accounts Payable
Vendor Invoice
Provides details of individual purchases transactions
Use in performing TOC on Accounts Payable
Generally not used in Accounts Payable confirmations.
Vendor Statement
Provides a total balance of all purchases transactions
Used in performing TOB on Accounts Payable
Used instead of sending Accounts Payable confirmations.

A rule of thumb:
(1) When vendor statements are available, internal controls are strong,
and clients integrity is high, no need to send accounts payable
confirmations.
(2) When vendor statements are not available, internal controls are
weak, and clients integrity is low, send accounts payable
confirmations.
Table 14-12 Purchases and Purchases Returns Cut-off Procedures

Account
Purchases:
If there is not a proper cut-off of purchase transactions; both
expenditure and accounts payable will be misstated for the current
and following years. In most instances, errors related to purchases
cut-off are unintentional and are due to delays in receiving goods and
services or the recognition of the purchase. In other instances, the
client may intentionally fail to record purchases transactions in the
current period or may record purchases from the next period in the
current period.
Purchases Returns:
Purchases returns seldom represent a material amount in the financial
statements.
Cut-off Procedures
The auditor first identifies the number of the last receiving report issued
in the current period. Then a sample of voucher packets is selected for a
few days just prior to, and subsequent to, the end of the period. The
receiving reports contained in the voucher packets are examined to
determine if the receipt of the goods is consistent with the recording of
liability. Purchases representing goods received prior to year-end should
be recorded in the current period, and purchases for goods received
subsequent to year-end should be recorded as purchases in the next
period.
If the clients internal control is strong, the auditor may use analytical
procedures in Table 14-8 to satisfy the cutoff objective for purchase
returns.
Property, Plant, and Equipment

So far the discussion focuses on accounts payable, a liability account associated with the expenditure cycle. The
following discussion focuses on property, plant, and equipment, an asset account associated with the expenditure
cycle. Table 14-13 describes the application of analytical procedures to the property, plant, and equipment account.
Table 14-14 summarizes some specific audit objectives and common TOB procedures in property, plant, and
equipment account.
Table 14-13 Analytical Procedures for Property, Plant, and Equipment

Compare the ratio of depreciation expense to the related property, plant, and equipment
accounts and comparison to prior years ratio.
Misstatement in depreciation expense and

accumulated depreciation.
Compare the ratio of repairs and maintenance expense to the related property, plant, and
equipment accounts and comparison to prior years ratios.
Compare actual maintenance expense with budgeted maintenance expense for the
reasonableness of the variances within a budgeting system.
Compare the amounts spent on property, plant, and equipment with the amounts in the capital
budget.
Expensing amount that should be capitalized.

Misclassification of capital expense to
maintenance expense.
Possible unauthorized overspending on plant
assets.
Table 14-14 Specific Audit Objectives and Common TOB Procedures in Property, Plant, and Equipment
Account
Specific Audit Objective
Current year purchases of property, plant,
and equipment existed.
Retired fixed assets existed.
Completeness:
Existing purchases of property, plant, and
equipment are recorded.
Existing retired fixed assets are recorded.
Cutoff:
Current year purchases are recorded in the
proper period.
The client has rights to current year
purchases of property, plant, and
equipment.
Accuracy:
Current year purchases as recorded are
accurate.

Costing of plant assets is accurate.
Classification:
Current year purchases of plant assets are
Understandability:
Plant assets are properly presented and
disclosed in the financial statements.

Vouch additions and dispositions to vendor invoices or other supporting documents.
Count the plant assets to verify the physical existence of major additions and dispositions.
Read lease agreement to ensure that lease transactions are accounted for properly.
Inspect the property ledger and the insurance and tax records, and then tour the clients facilities.
Locate and inspect a sample of plant assets and trace to the property, plant, and equipment
subsidiary ledger.
Tour the clients facilities, and then inspect the property ledger and the insurance and tax records.
Examine the purchases of plan assets for a few days before and after year-end.
Confirm deeds or title documents for proof of ownership.
Obtain a lead schedule of property, plant, and equipment; foot schedule and agree totals to the
general ledger.
Obtain a detailed supporting schedule for additions and dispositions of property, plant, and
equipment; agree amounts to totals shown on the lead schedule. Figure 14-10 illustrates an
auditors work on a detailed supporting schedule for property, plant, and equipment.
Vouch additions and dispositions to vendor invoices.
Recompute depreciation calculations for a sample of plant assets in the detailed supporting
schedule for property, plant, and equipment.
Examine vendor invoices in equipment account for items that should be classified as office
equipment or repairs.
Vouch transactions included in repairs and maintenance for items that should be capitalized.
Examine lease transactions for proper classification between operating and capital leases.
Examine note or bond agreements to ascertain whether any capital assets are pledged as collateral
and require disclosure in the footnotes.
377
378
Figure 14-10 An Auditors Detailed Supporting Schedule for Property, Plant, and Equipment
XYZ Company
Schedule: P
Detailed Supporting Schedule for Property, Plant, and Equipment
Prepared by: Tom
Date: 1/23/20x2
December 31, 20x1
Reviewed by: Fred
Date: 2/3/20x2
W/P
Ref
P-1
P-2
P-3
P-4
Account
No.
501
502
503
504
Account
Title
Land
Buildings
Plant
Equipment
Totals
Balance
12/31/x0
500,000
4,500,000
135,000
800,000
5,935,000
Assets
Additions Disposals
151,000
495,000
10,000
110,000
766,000
60,000
60,000
Balance
12/31/x1
651,000
4,995,000
145,000
850,000
6,641,000
Balance
12/31/x0
292,000
13,500
235,000
540,500
ff
Accumulated Depreciation
Provision
Disposals Balance
12/31/x1
142,420r
7,000r
70,600r
220,020
50,600
50,600
434,420
255,000
20,500
709,920
ff
Agreed with general ledger and prior year working papers.
ff
r
Footed and Cross-footed.

Recomputed depreciation; all on straight line method; plant (5%), building (3%), and equipment (10%).
Legal Expense
This section focuses on legal expense, an expense account associated with the expenditure cycle. Table 14-15
describes some common analytical procedures for legal expense. Table 14-16 lists the common TOB procedures for
legal expense.
Table 14-15 Analytical Procedures for Analyzing Legal Expense
Compare individual legal expenses with previous years.
Compare individual legal expenses with budgets.
Look for an exponential growing trend in legal expenses over time.

Overstatement or understatement of a
balance in a legal expense account.
Possible unauthorized overspending on legal
services.
Potential unrecorded contingent liabilities.
Table 14-16 Common TOB Procedures for Legal Expense
Common TOB Procedures for Legal Expense

Examine underlying documents
TOB on legal expense usually starts with the auditor obtaining a detailed supporting schedule for legal expense from the client. This
schedule typically details the name of the law firm, the legal issues involved, the duration of the engagements, and the amount of legal
fees. Based on this schedule, the auditor examines the underlying documents for each transaction, such as the minutes of the board of
directors meeting that authorize the hiring of a specific law firm, and the voucher packet for the payment of the legal fees. Figure 14-11
illustrates an auditors work on a detailed supporting schedule for legal expense.
Analyze legal expense
Based on the detailed supporting schedule for legal expense, the auditor usually analyses legal expense to determine whether there are
potential contingent liabilities, disputes, illegal acts, or other legal issues that may affect the financial statements.
Figure 14-11 An Auditors Detailed Supporting Schedule for Legal Expense

XYZ Company
Schedule: L
Detailed Supporting Schedule for Legal Expense
Prepared by: Sue
Date: 1/23/20x2
December 31, 20x1
Reviewed by: Fred
Date: 2/3/20x2
W/P
Ref
L-1
Account
No.
801
Account
Title
Legal Expense
Paid
To
PPP Law Firm

QQQ Law Firm
RRR Law Firm
Description
Date
Retainer 12 months@$1,000
XYZ Vs ABC patent infringement
suit.
Monthly t
May 3
Oct 10
Amount
Consultation inquiry from Consumer

Protection Bureau
June 5
Aug 23
3,000
5,000
Service assistance in collecting overdue

accounts receivable from CDE company
Dec 12
600
$12,000
8,000
10,000
________
38,600 GL
=========
f
Lawyers letter requested. Received 1/8/20x22. All matters listed are covered therein.
Letter filed in Corresponding Section of the working paper Permanent File.
Lawyers letter not requested. Per phone conversation with RRR Law Firm. The CDE matter
was closed in Dec 20x1.
Examined voucher packets.
Traced to minutes of meeting of Board of Directors 1/5/20x2. PPP Law firm

reappointed general counsel with retainer.
GL
f
Agreed to General Ledger.

Footed.
Tests of Balances for Three Industry-Specific-Account of the Expenditure Cycle

Lastly, this section focuses on the auditors tests of balances on three industry-specific-accounts of the expenditure
cycle are discussed. They are the intangible asset, natural resources, and leases. Table 14-17 provides a brief
discussion on auditing these three industry-specific-accounts of the expenditure cycle.
Table 14-17 TOB for Three Industry-Specific-Accounts of the Expenditure Cycle
A Brief Discussion on Auditing Intangible Asset, Natural Resources, and Leases

Intangible Assets
Intangible assets are the long-term resources of a client, but have no physical existence. They derive their
value from intellectual or legal rights, and from the value they add to the other assets. Intangible assets are
generally classified into two broad categories: (1) Limited-life intangible assets, such as patents, copyrights, and
goodwill, and (2) Unlimited-life intangible assets, such as trademarks. In contrast to tangible assets, intangible
assets normally cannot be used as collateral to raise loans, and some intangible assets (goodwill, for example) can
be destroyed by carelessness, or as a side effect of the failure of a business. Whereas tangible assets add to an
entity's current market value, intangible assets add to its future worth. An approximation of the monetary value of
a firm's intangible-assets is calculated by deducting the carrying value/book value/net value of its tangible assets
from its fair value/fair market value/total market capitalization. In some cases (such as the Coca Cola trademark),
the value of a firm's intangible assets far outweighs the value of its tangible assets. When a client treats
expenditure as creating an intangible asset, the auditor must look for objective evidence that a genuine asset has
come into existence.
The auditors TOB on intangible assets may begin with analysis of the ledger accounts for these assets
Debits to the accounts should be traced to evidence of payment having been made and to documentary evidence
of the rights or benefits acquired. Credits to the accounts should be reconciled with the clients schedule of
amortization or traced to appropriate authorization for the write-off of the asset.
379
380

The auditor should review the reasonableness of the clients amortization schedule. Amortization is
ordinarily computed by the straight-line method over the intangible assets estimated useful lives.
According to FASB No.144, Accounting for the Impairment or Disposal of Long-lived Assets, long-lived
intangible assets should be reviewed for impairment whenever events or changes in circumstances indicate that
the carrying amount of an asset may not be recoverable. The auditor must be alert for any changes in
circumstances that may affect the recoverability of intangible assets and must continually review for their
impairments.
One intangible asset that may be large in amount yet of questionable future economic benefit is goodwill.
Good will arises in accounting for business combinations in which the price paid to acquire another company
exceeds the fair value of the identifiable net assets acquired. When business combinations result in the recording
of goodwill, the auditor should review the allocation of the lump-sum acquisition cost among tangible assets,
identifiable assets, and goodwill. The auditor must also determine whether goodwill is properly allocated to all
the various reporting units acquired in the acquisition. Often, the auditor will have to use the services of a
business valuation specialist to assist them in evaluating the reasonableness of the valuation and allocation.
Additional discussion on goodwill resulting from a business combination can be found in Chapter 19.
Once goodwill is acquired, it remains at its purchase price; it is not amortized. Instead, goodwill assigned to
reporting units should be tested for impairment on an annual basis and between annual tests in certain
circumstances. The auditors goodwill impairment tests involve determining the fair value of the reporting units
for comparison to their carrying value. If the fair value of a reporting unit is less than its carrying value, and
impairment loss is recognized for the difference.
Natural Resources
Natural resources are subject to depletion. Depletion is a term that describes the decrease in value of an
asset that can be physically reduced over time. Unlike depreciation (for tangible assets) and amortization (for
intangible assets), which describe the deduction of expenses of tangible assets and the reduction in carrying value
of intangible assets, depletion is the actual physical reduction of natural resources by companies. In the audit of a
clients operating properties that are subject to depletion, such as mines, oil and gas deposits, timberlands, and
other natural resources, the auditor follows a pattern similar to that used in evaluating the provision for
depreciation expense and accumulated depreciation. The auditor determines whether depletion has been recorded
consistently and in accordance with GAAP, and tests the mathematical accuracy of the clients computation.
The depletion of timberlands is usually based on physical quantities established by cruising. Cruising
means the inspection of a tract of forestland for the purpose of estimating the total lumber yield. The
determination of physical quantities to use as a basis for depletion is more difficult in many mining ventures and
for oil and gas deposits. The auditor often relies upon the opinions of such specialists as mining engineers and
geologists about the reasonableness of the depletion rates being used for such resources. Under these
circumstances, the auditors must comply with the provisions of AU 620 Using the Work of a n Auditors
Specialist.
If the number of tons of ore in a mining property could be accurately determined in advance, an exact
depletion cost per ton could be calculated by dividing the cost of the mine by the number of tons available for
extraction. In reality, the contents of the mine can only be estimated, and the estimates may require significant
revision as mining operations progress.
The auditor tests the ownership and the cost of mining properties (production cost) by examining deeds,
leases, tax bills, vouchers, paid checks, and other records in the same manner that the auditor verifies the
property, plant, and equipment of a manufacturing or trading companies. The costs of exploration and
development work in a mine customarily are capitalized until such time as commercial production begins. After
that date, additional development work generally is treated as an expense. Ordinarily, the large oil companies
capitalize the costs of drilling oil wells only if they are found to be productive. Under this successful efforts
approach, the costs of drilling wells that prove not to be productive are immediately written off. However, some
smaller oil companies use an alternative full-cost approach, under which all drilling costs are capitalized and
depleted over future years.
Environmental protection regulations have increased corporate responsibility to restore land used in mining
to an agreed-upon natural state. In addition, many state laws require safeguards to protect the environment while
the natural resource mining takes place. All costs associated with restoring the property to its original state (i.e.
all reclamation expenses) should be estimated and accrued. The auditor should examine the reasonableness of the
procedures used by management to estimate such expenses. Reclamation expenses should be a part of the
depletion expenses against the use of the natural resources.
Leases
In the United States, there are two categories of leases:

(1) Operating lease - an operating lease is a lease whose term is short compared to the useful life of the asset or
piece of equipment (an aircraft, a ship etc.) being leased. An operating lease is commonly used to acquire
equipment on a relatively short-term basis. Thus, for example, an aircraft which has an economic life of 25 years
may be leased to an airline for 5 years on an operating lease. An operating lease is recorded as rent expense over the
lease term in the income statement by the lessee.
(2) Capital (finance) lease a capital (finance) lease is a lease that meets one or more of the following criteria: the
lease term is greater than 75% of the property's estimated economic life; the lease contains an option to purchase

the property for less than fair market value; ownership of the property is transferred to the lessee at the end of the
lease term; or the present value of the lease payments exceeds 90% of the fair market value of the property. A
capital (finance) lease is recorded and amortized as a purchased asset in the balance sheet by the lessee.
The determination of whether a lease is a capital (finance) lease or an operating lease is defined in the United States
by the Statement of Financial Accounting Standards SFAS No.13. Under the current U.S. standards, an auditor
client (the lessee) may improperly structure a capital (finance) lease contract as an operating lease contract thereby
keeping the assets and liabilities off the balance sheet (i.e. off-balance sheet financing of asset acquisition) to make
the client (the lessee) appears to be less leveraged, or to increase its return on investment. In 2009, the U.S.
Financial Accounting Standards Board and the International Accounting Standards Board have published a joint
discussion paper on the differing treatment of lease contracts under the International Financial Reporting Standards
and U.S. generally accepted accounting principles. The two standards-setters have been working on converging the
standards for lease accounting towards a principles-based approach that recognizes the economic substance of a
lease contract rather than its form in determining whether a lease contract should be recorded as a capital (finance)
lease or an operating lease.
In auditing leases, the audit procedures are as follows:

(1) Obtain copies of lease agreements and carefully read the lease contracts.
(2) Review the lease expense account to determine whether they are entries that are not covered by the lease
contracts.
(3) Review the criteria set forth in SFAS No.13 to determine whether there are improper classification of capital
(finance) leases as operating leases.
(4) For all capital leases, determine that (a) the assets and lease obligations (liabilities) are recorded at their present
value, (b) determine the economic life of the asset, (c) recompute amortization expense and interest expenses, and
(d) note any adjustments needed to correct the financial statements.
(5) Test the clients schedule of all future lease obligations to determine that it is accurate.
(6) Stay alert to the possibility of management using leases for improper off-balance sheet financing of asset
acquisition.
381
382
14-1
Which of the following is an internal control that would prevent paid cash disbursement documents from being presented for payment
a second time?
a. Unsigned checks should be prepared by individuals who are responsible for signing checked.
b. Cash disbursement documents should be approved by at least two responsible management officials.
c. The date on cash disbursement documents should be within a few days of the date that the document is presented for
payment.
d. The official signing the check should compare the check with the documents and should deface the documents.
14-2
When goods are received, the receiving clerk should match the goods with
a. The purchase order and the requisition form.
b. The vendor invoice and the receiving report.
c. The vendor shipping document and the purchase order.
d. The receiving report and the vendor shipping document.
14-3
Internal control is strengthened when the dollar amount of merchandise ordered is omitted from the copy of the purchase order sent to
the
a. Department that initiated the requisition.
b. Receiving department.
c. Purchasing agent.
d. Accounts payable department.
14-4
Which of the following is the most effective TOC procedure to detect vouchers prepared for the payment of goods that were not
received?
a. Counting of goods upon receipt in storeroom.
b. Matching of purchase order, receiving report, and vendor invoice for each voucher in the accounts payable department.
c. Comparison of goods received with goods requisitioned in receiving department.
d. Verification of vouchers for accuracy and approval in internal audit department.
14-5
For effective internal control purposes, which of the following individuals should be responsible for mailing signed checks?
a. Receptionist.
b. Treasurer.
c. Accounts payable clerk.
d. Payroll clerk.
14-6
To determine whether the recording of purchases transactions is complete, an auditor performs a TOC procedure to verify that all
merchandise received is recorded. The population of documents for this test consists of all
a. vendor invoices.
b. purchase orders.
c. receiving reports.
d. canceled checks.
14-7
Mr. A, the purchasing agent of a wholesale hardware company, has a relative who owns a retail hardware store. Mr. A arranged for
hardware to be delivered by manufacturers to the retail store on a C.O.D. basis, thereby enabling his relative to buy at his hardware
companys wholesale prices. Mr. A was probably able to accomplish this because of the wholesale companys poor internal control
over
a. purchase requisition.
b. cash receipts.
c. perpetual inventory records.
d. purchase orders.
14-8
A specific audit objective is to ensure that an approved receiving report is required to accompany every check request for payment of
merchandise. Which of the following TOC procedures provides the greatest assurance that this control is operating effectively?
a. Selection and examination of canceled checks and ascertainment that the related receiving reports are dated no later than
the checks.
b. Selection and examination of canceled checks and ascertainment that the related receiving reports are dated no earlier
than the checks.
c. Selection and examination of receiving reports and ascertainment that the related canceled checks are dated no earlier
than the receiving reports.
d. Selection and examination of receiving reports and ascertainment that the related canceled checks are dated no later than
the receiving reports.
14-9
An auditor learns that his client has paid a vendor twice for the same shipment, once based upon the original invoice and
once based upon the monthly statement. A control procedure that should have prevented this duplicate payment is
a. pre-numbering of receiving reports.
b. use of a limit or reasonable test of payments.
c. pre-numbering of disbursement vouchers.
d. attachment of the receiving report to the disbursement report.
14-10
When an acquisition is on a FOB origin basis, the inventory and related accounts payable must be recorded in the current
period if the goods were
a. received prior to the balance sheet date.
b. shipped prior to the balance sheet date.
c. both shipped and received prior to the balance sheet date.
d. paid for in advance.
14-11
Internal controls which are likely to prevent the client from including as a business expense those transactions that
primarily benefit management satisfy the specific audit objective of
a. acquisitions are correctly valued.
b. existing acquisitions are recorded.
c. acquisitions are correctly classified.
d. recorded acquisitions are for goods and services received.
14-12
Under which of the following circumstances would it be advisable for the auditor to confirm accounts payable with
creditors?
a. Internal control over accounts payable is adequate, and there is sufficient evidence on hand to minimize the risk of a
material misstatement.
b. Confirmation response is expected to be favorable, and accounts payable balances are of immaterial amounts.
c. Creditor statements are not available, and internal control over accounts payable is unsatisfactory.
d. The majority of accounts payable balances are with associated companies.
14-13
Which of the following is an effective internal control over cash payments?

a. Signed checks should be mailed under the supervision of the check signer.
b. Spoiled checks that have been voided should be disposed of immediately.
c. Checks should be prepared only by persons responsible for cash receipts and cash disbursements.
d. A check-signing machine with two signatures should be utilized.
14-14
The internal control which requires that checks are pre-numbered and accounted for satisfies the specific objective of
a. accuracy.
b. existence.
c. completeness.
d. cut-off.
14-15
The point at which most companies first recognize the acquisition and related liability on their records is when the
a. purchase requisition is completed.
b. purchase order is completed.
c. receiving report is completed.
d. vendors invoice is paid.
383
384
14-16
A file for recording individual purchases, cash disbursements, and purchase returns and allowances for each vendor is the
a. cash disbursements transactions file.
b. accounts payable master file.
c. purchase transaction file.
d. summary purchase report.
14-17
An auditor traced a sample of purchase orders to the purchases journal and the cash disbursement journal for the TOC
specific objective of
a. identify unusually large purchases that should be investigated further.
b. verifying that cash disbursements were for goods actually received.
c. determining that purchases were properly recorded.
d. test whether payments were for goods actually ordered.
14-18
In auditing accounts payable, an auditors TOC procedures would focus primarily on managements assertion of
b. presentation and disclosure.
c. completeness.
d. valuation or allocation.
14-19
A clients internal control requires that an approved voucher, a prenumbered purchase order, and a prenumbered receiving
report accompany every check payment. To determine whether checks are being issued for unauthorized expenditures, an auditor most
likely would select items for testing from the population of all
a. purchase orders.
b. canceled checks.
c. receiving reports.
d. approved vouchers.
14-20
In assessing control risk for purchases, an auditor vouches a sample of entries in the voucher register to the supporting
documents. Which assertion would this test of controls most likely support?
a. Completeness.
b. Existence or occurrence.
c. Valuation or allocation.
d. Rights and obligations.
14-21
Which of the following internal control procedures most likely would justify a reduced assessed level of control risk
concerning the existence or occurrence of plant and equipment acquisitions?
a. Periodic physical inspection and verification of plant and equipment by the an internal independent staff.
b. Comparison of current-year plant and equipment account balances with prior-year actual balances.
c. The review of prenumbered purchase orders to detect unrecorded trade-ins.
d. Approval of periodic depreciation entries by a supervisor independent of the accounting department.
14-22
Which of the following statements describes an important distinction between the confirmation of accounts payable with suppliers and
confirmation of accounts receivable with debtors?
a. Confirmation of accounts payable with suppliers is more widely accepted auditing procedure than is confirmation of
accounts receivable with debtors.
b. Statistical sampling techniques are more widely accepted in the confirmation of accounts payable than in the
confirmation of account receivables.
c. As compared with the confirmation of accounts payable, the confirmation of accounts receivable will tend to emphasize
accounts with zero balances at the balance sheet date.
d. It is less likely that the confirmation request sent to the supplier will show the amount owed him than that the request
sent to the debtor will show the amount due from him.
14-23
Which of the following audit procedures is best for identifying unrecorded accounts payable?
a. Examining unusual relationships between monthly accounts payable balances and recorded cash payments.
b. Reconciling vendors statements to the file of receiving reports to identify items received just prior to the balance sheet
date.
c. Reviewing cash disbursements recorded subsequent to the balance sheet date to determine whether the related payables
apply to the prior period.
d. Investigated payables recorded just prior to and just subsequent to the balance sheet date to determine whether they are
supported by receiving reports.
14-24
In auditing accounts payable, an auditors procedures most likely would focus primarily on managements assertion of
c. completeness.
14-25
In testing for unrecorded retirements of equipment, auditor most likely would

a. select items of equipment from the accounting records and then locate them during the plant tour.
b. compare depreciate journal entries with similar prior-year entries in search of fully depreciated equipment.
c. inspect items of equipment observed during the plant tour and then trace them to the equipment master file.
d. scan the general journal for unusual equipment additions and excessive debits to repairs and maintenance expense.
14-26
When using confirmations to provide evidence about the completeness assertion for accounts payable, the appropriate population most
likely would be
a. vendors with whom the client has previously done business.
b. amounts recorded in the accounts payable subsidiary ledger.
c. payees of checks drawn in the month after year-end.
d. invoice filed in the clients open invoice file.
14-27
Which of the following TOB procedure is least likely to detect an unrecorded liability?
a. Analysis and re-computation of interest expense.
b. Analysis and re-computation of depreciation expense.
c. Mailing of standard bank confirmation forms.
d. Reading of the minutes of meetings of the board of directors.
14-28
Which of the following combinations of procedures would an auditor be most likely to perform to obtain evidence about plant-asset
addition?
a. Inspecting documents and physically examining assets.
b. Re-computing calculations and obtaining written management representations.
c. Observing operating activities and comparing balances to prior-period balances.
d. Confirming rights and obligations and corroborating transactions through inquiries of client personnel.
14-29
The audit procedures used to verify accrued liabilities differ from those used to verify accounts payable because
a. accrued liability balances are less material than accounts payable balances.
b. accrued liabilities at year-end will become accounts payable in the following year.
c. evidence supporting accrued liabilities is non-existent, whereas evidence supporting accounts payable is readily
available.
d. accrued liabilities usually pertain to services of a continuing nature, whereas accounts payable are the result of
completed transactions.
14-30
A major consideration in verifying the ending balance in property, plant, and equipment accounts is the possibility of
existing legal encumbrances. TOB procedures to identify possible legal encumbrances would satisfy the specific audit
objective for
a. existence.
b. understandability.
c. occurrence.
d. valuation.
14-31
The starting point for the verification of current year acquisitions of property, plant, and equipment is normally
a. the property, plant, and equipment account in the general ledger.
b. the acquisitions journal.
c. the purchase requisitions file.
d. a schedule obtained from the client of all acquisitions recorded in the general ledger during the year.
14-32
Which of the following TOB procedures would an auditor most likely perform to verify the managements assertions of
existence or occurrence and valuation or allocation of recorded accounts payable?
a. Investigating the open purchase order file to ascertain that prenumbered purchase orders are used and accounted for.
b. Reviewing the clients mail for a reasonable period of time after the year end to search for unrecorded vendors invoices.
c. Vouching selected entries in the accounts payable subsidiary ledger to purchase orders and receiving reports.
d. Confirm accounts payable balances with known suppliers who have zero balances.
385
386
14-33
Which of the following TOB procedures would an auditor most likely perform to search for unrecorded liabilities?
a. Vouch a sample of cash disbursements recorded just after year end to next years receiving reports and vendor invoices.
b. Scan the cash disbursements entries recorded just before year end for indications of unusual transactions.
c. Compare a sample of purchase orders issued just after year end with the year-end accounts payable trial balance.
d. Trace a sample unmatched receiving report file in the current accounting period to accounts payable entries recorded in
the next accounting period.
14-34
The cutoff TOB procedure designed to detect purchases made before the end of the year that have been intentionally
recorded in the subsequent years purchases provides assurance about managements assertion of
a. presentation and disclosure.
b. completeness.
14-35
When using confirmations to provide evidence about the completeness assertion for accounts payable (unrecorded
liabilities), the appropriate population most likely would be
a. amounts recorded in the accounts payable subsidiary ledger.
b. vendors with whom the client has previously done business.
c. payees of checks drawn in the month after the year end.
d. invoices filed in the clients open invoice file.
14-36
In testing plant and equipment balances, an auditor may inspect new additions listed on the analysis of plant and
equipment. This procedure is designed to obtain evidence concerning managements assertions about
Existence or Occurrence
a.
b.
c.
d.
14-37
Yes
Yes
No
No
Yes
No
Yes
No
In performing a search for unrecorded retirements of fixed assets, an auditor most likely would
a. inspect the property ledger and the insurance and tax records, and then tour the clients facilities.
b. tour the clients facilities, and then inspect the property ledger and the insurance and tax records.
c. analyze the repair and maintenance account, and then tout the clients facilities.
d. tour the clients facilities, and then analyze the repair and maintenance account.
14-38
Determining that proper amounts of depreciation for fixed assets are expensed provides assurance about managements
assertions of valuation or allocation and
a. presentation and disclosure.
b. completeness.
c. rights and obligations.
d. existence or occurrence.
14-39
Which of the following explanations concerning plant assets most likely would satisfy an auditor who questions
management about significant debits to the accumulated depreciation accounts?
a. The estimated remaining useful lives of plant assets were revised.
b. Plant assets were retired during the year.
c. The prior years depreciation expense was erroneously understated.
d. Overheads allocations were revised at year end.
14-40
When auditing prepaid insurance, an auditor discovered that the original insurance policy on plant equipment is not
available for inspection. The insurance policys absence most likely indicated the possibility of a(n) (Hint: Think of the beneficiary)
a. insurance premium due but not recorded.
b. deficiency in the coinsurance provision.
c. lien on the plant equipment.
d. understatement of insurance expense.
14-41
In TOB of property and equipment, an auditor vouches significant debits from the repairs and maintenance expense
account to determine
a. noncapitalizable expenditure for repairs and maintenance have been recorded in the proper period.
b. capitalizable expenditure for property and equipment have been properly charged to expense.
c. noncapitalizable expenditure for repairs and maintenance have been properly charged to expense.
d. capitalizable expenditure for property and equipment have not been charged to expense.
14-42
In performing a search for unrecorded retirements of fixed assets, an auditor most likely would
a. inspect certain items of equipment in the plant and trace those items to the accounting records.
b. review the subsidiary ledger to ascertain whether depreciation was taken on each item of equipment during the year.
c. trace additions to the other assets account to search for equipment that is still on hand but no longer being used.
d. vouch select certain items of equipment from the accounting records and locate them in the plant.
14-43
To determine whether accounts payable are complete, an auditor performs a test to verify that all merchandise received is
recorded. The population of documents for this test consists of all
a. payment vouchers.
b. receiving reports.
c. purchase requisitions.
d. vendors invoices.
14-44
An auditor performs TOB to determine whether all merchandise for which the client was billed was received. The
population for this test consists of all
a. merchandise received.
b. vendors invoices.
c. canceled checks.
d. receiving reports.
14-45
An auditor traced a sample of purchases orders and the related receiving reports to the purchases journal and the cash
disbursements journal. The purpose of this TOB procedure most likely was to
a. identify unusually large purchases that should be investigated further.
b. verify that cash disbursements were for goods actually received.
c. determine that purchases were properly recorded.
d. test whether payments were for goods actually ordered.
14-46
An auditors purpose in reviewing the renewal of a note payable shortly after the balance sheet date most likely is to obtain
c. completeness.
14-47
Which of the following procedures would an auditor least likely perform before the balance sheet date?
a. confirmation of accounts payable.
b. observation of physical inventory count.
c. confirmation of accounts receivable.
d. identification of related parties transactions.
14-48
When there are numerous property and equipment transactions during the year, an auditor who plans to assess control risk
at a low level usually performs
a. tests of controls and extensive tests of property and equipment balances at the end of the year.
b. analytical procedures for current year property and equipment transactions.
c. tests of controls and limited tests of property and equipment balances at the end of the year.
d. attribute sampling tests of property and equipment balances at the end of the year.
14-49
Equipment acquisitions that are misclassified as maintenance expense most likely would be detected by an internal control
procedure that provides for
a. segregation of duties for employees in the accounts payable department.
b. independent verification of invoices for disbursements recorded as equipment acquisitions.
c. analysis of variances with a formal budgeting system.
d. authorization by the board of directors of significant equipment acquisitions.
387
388
14-50
Which of the following TOB procedures would an auditor least likely perform to search for unrecorded liabilities?
a. Reconcile the amounts in vendor monthly statements with the amounts in the clients accounts payable subsidiary ledger.
b. Trace a sample of large-dollar amounts from vendor invoices to receiving reports, then trace to the purchases journal
and cash disbursement journal in the next accounting period to determine if the liabilities relate to the current accounting
period.
c. Confirm a sample of accounts payable including accounts with small or zero balance.
d. Vouch selected balances from the accounts payable trial balance to the voucher packets and vendor invoices.
14-51
Which of the following analytical procedures is least effective in uncovering unrecorded tax liabilities?
a. Comparison of sales taxes to sales totals.
b. Comparison of withholding taxes to total income.
c. Comparison of payroll taxes to payroll totals.
d. Comparison of income taxes to total income.
14-52
When a business combination resulted in the recording of goodwill by the client, the auditors should not
a. perform an annual TOB on goodwill impairment.
b. review the allocation of the lump-sum acquisition cost among tangible assets, identifiable assets, and goodwill.
c. determine whether goodwill is properly allocated to all the various reporting units acquired in the acquisition.
d. ask the clients management to assist them in evaluating the reasonableness of the valuation and allocation.
14-53
Natural resources such as oil and gas present some unique problems for the auditor. Which of the following does not
present an unique problem for the auditor?
a. It is often difficult for the auditor to identify the costs associated with the discovery of the natural resources.
b. It is often difficult for the auditor to use a geologist to determine the reasonableness of the depletion rate bring used for
the natural resources.
c. It is often difficult for the auditor to estimate the amount of commercially available resources to be used in determining
a depletion rate.
d. It is often difficult for the auditor to estimate the amount reclamation costs.
14-54
Which of the following is true of capital (finance) leases as compared to operating leases?
a. Only rent expense is reflected in the income statement.
b. The leased asset does not appear o the balance sheet.
c. Liabilities include the lease obligation.
d. Future minimum lease obligations are not required to be disclosed.

14-1 d. 14-2 a. 14-3 b. 14-4 b. 14-5 a. 14-6 c. 14-7 d. 14-8 a. 14-9 d. 14-10 b. 14-11 c.
14-12 c. 14-13 a. 14-14 c. 14-15 c. 14-16 b. 14-17 c. 14-18 c. 14-19 b. 14-20 b. 14-21 a.
14-22 d. 14-23 c. 14-24 c. 14-25 c. 14-26 a. 14-27 b. 14-28 a. 14-29 d. 14-30 b. 14-31 d.
14-32 c. 14-33 d. 14-34 d. 14-35 b. 14-36 b. 14-37 b. 14-38 a. 14-39 b. 14-40 c. 14-41 d.
14-42 a. 14-43 b. 14-44 b. 14-45 c. 14-46 b. 14-47 a. 14-48 c. 14-49 c. 14-50 d. 14-51 b.
14-52 d. 14-53 b. 14-54 c.

Simulation Question 14-1 is an adaptation with permission from a case by Ragothaman, S. C., W. Wilcox, and T.L. Davies in the Issues in
set of facts. However, the years during which the reported activities took place have been changed. Also, some of the names and places have been
changed.
As Jane Sweeny was driving south on Interstate 55 from downtown Chicago, her thoughts centered on her upcoming end of audit
meeting with her boss, Richard Agassi, a partner of Arthur Andersen LLP (hereafter, AA), and Howard Koch, the Controller of Waste
Management Incorporated (hereafter, WMI). Jane, a CPA with seven years of experience, had joined AA just three months earlier, in January
2000, soon after the previous audit manager had quit the firm. Jane was the manager on the WMI audit for the year ended December 31, 1999 and
was in the process of wrapping it up. As Jane thought back over the engagement, she realized that the job had not gone as smoothly as she had
expected.
Background
Selected Financial Information
Auditors Dilemma
WMI, a leading garbage hauler (trash collection business) in the U.S., experienced rapid growth in the late 1990s due to an aggressive
expansion strategy and had achieved a 20 percent national market share. In just the years 1997 and 1998 alone, WMI acquired over 200 local
garbage services. WMI became a Wall Street darling on the basis of a simple yet effective strategy acquire smaller mom and pop operations
across the nation and consolidate them into a giant business enterprise. Local garbage haulers didnt hesitate to sell to WMI, since, by all
appearances; it was a cash-rich corporation experiencing a skyrocketing stock price with no ceiling in sight. WMI had enjoyed ten years of
double-digit growth in its waste disposal business, which was accompanied by a meteoric rise in its stock price.
Even though WMIs profits were soaring, there were still some concerns about the companys business. The company began
struggling to maintain the growth levels that investors had now come to expect. The situation was further exacerbated because the waste
management business was being subjected to increased regulation due to public awareness and environmental concerns. Furthermore,
competition was also up, as opportunistic, customer-oriented independent haulers sought to access local markets. As a result of these factors,
collection fees were down, causing a general decline in the overall profitability of the waste management industry.
During 1999, the company purchased 46 local haulers, a significant drop in its acquisitions pattern when compared to preceding years.
However, during the year, WMI realized a $110 million gain from selling its interest in a business called SM Inc. In its 1999 preliminary
financial statements, the company offset the entire gain from this transaction against unrelated operating expenses and adjustments of prior years
estimates. The effect on its income statement was substantial, as the amount netted equaled 12 percent of the companys 1999 income from
operations. Company management did not believe that the disclosure of this accounting treatment was needed.
Depreciable Assets. As Jane prepared to audit WMI, she knew of managements vow to continue the companys past success. An examination of
the companys records revealed that WMIs property, plant, and equipment (PP&E) represented approximately 50 percent (a significant
component) of the companys assets. This was not atypical of the waste processing and disposal industry, where a typical firm would have
between 45 and 60 percent of its assets in PP&E. You should access Data File 14-1 in iLearn for Table 1, which presents selected balance
sheet data from PP&E.
Records further indicated that the company was depreciating its vehicles and equipment (i.e., trucks and dumpsters) over useful lives
ranging from three to 20 years, usually choosing the longer period. While these recovery periods were longer than the industry average, WMI
management asserted that the longer lives were reflective of the companys actual experience. You should access Data File 14-1 in iLearn for
Table 2, which presents the recovery periods of the industry.
Summary Income Information . In order to permit an evaluation of the financial activities of the company, you should access Data File 14-1 in
iLearn for Table 3, which provides selected income statement summary data. Due to the companys heavy capitalization, the ratio of WMIs
1991 depreciation expense to total revenues was about 8 percent. Janes analysis revealed that this ratio was typically between 10 and 14 percent
for the waste disposal industry as a whole. Because WMI is a publicly traded company, its reported earnings and earnings per share take on added
significance due to their impact on Wall Street expectations and investor buy-sell decisions.
Environmental Liability. A significant component of WMIs business involves its utilization and maintenance of company-owned waste disposal
sites. As part of ongoing operations, the company routinely acquires multiple sites to store and manage waste. After a sites available space has
been used, additional costs are incurred in closing the landfill. Environmental laws and regulations require that WMI monitor a closed site for
potential hazards for an additional 30 years, resulting in a substantial ongoing cost to the corporation. Generally accepted accounting principles
(GAAP) require that all of the costs related to the site be allocated to the operating life of the disposal sites as available space is consumed. In
estimating its future financial obligation, WMI has historically inflated the cost in current dollars at 3 percent until payment was expected, and
then discounted the cost flow to present value using a 7 percent rate. You should access Data File 14-1 in iLearn for Table 4, which discloses
the companys environmental liability for the closure and post-closure costs. According to management, the increase in the amount to be
provided in the future related primarily to additional space having been acquired in anticipation of expected continuing expansion.
After reviewing Table 4, Jane looked at the draft of the companys financial statement notes as they related to these liabilities costs.
The notes stated the following:
The Company provides for closure and post-closure monitoring costs over the operating life of disposal sites as landfill space is
consumed. The accrual for closure and post-closure costs relates to expenditure to be incurred after a facility ceases to accept waste.
The Companys active landfill sites have estimated remaining lives ranging from one to over 100 years based upon current site plans
and anticipated annual volumes of waste.
As the audit progressed, several issues began to concern Jane. A few years earlier, WMI had diversified into recycling, water
treatment, energy, power, and lawn care. Jane was leery about the companys growth through acquisitions strategy for its new lines of business,
as there had been reports in the financial press that WMI had overpaid for these acquisitions. In addition, the companys returns on the recycling
business and other new endeavors were quite low. Also, as WMI became bigger and more diversified, smaller competitors began to lure away
customers in the companys core trash business, which historically was very lucrative. WDI had recently secured a multi-million dollar long-term
line of credit. There were allegations that the company CEO had intimidated small garbage haulers into selling their businesses to WMI. Finally,
389
390
recently instituted company-wide cost-cutting measures had not substantially helped WMIs bottom line. Despite all of these conditions,
management continued to optimistically forecast double-digit earnings growth for the corporation.
WMIs top management owned significant amounts of stock in the company. Its outside directors on the audit committee also owned
WMI stock. Intense pressure to meet its own optimistic return expectations put WMI in a precarious position. If WMI wished to maintain its solid
Wall Street reputation and keep investors happy, drastic action would be necessary. Management continued to implement cost-cutting plans to
decrease operating expenses during 1999. In addition, the company adopted several aggressive earnings-boosting accounting procedures that
involved depreciation expense, revenue recognition, and expense deferral. Through innovation maneuvering, WMI managed to achieve its lofty
profit projections for 1999, but Jane continued to have her doubts about these and other happenings within the corporation.
In an attempt to gain control over the accounting complexities and related issues arising from its substantial expansion activities, WMI
signed a contract in 1999 with a major enterprise resource planning (ERP) software vendor to implement an integrated information system. This
software was designed to integrate the companys functional areas and permit them to maintain only one company wide database. Employees
were not enthused about the new training necessitated by this complex software package, and the implementation had not been as smooth as
expected. Partially due to its phenomenal growth, proper checks and balances in the management and control structure of WMI and its new
information system were conspicuously absent.
Jane was also troubled by the fact that the company had gone through three different CEOs in the last eight months. The companys
long-time chairman and CEO, Mr. Robert Bullock, was an autocrat, and he had run the company his way until his involuntary departure in
early 1999. An investor group that demanded corporate reforms and accountability removed Mr. Bullock, as well as his successor. The next CEO
resigned after discovering accounting concerns. WMI had a few outside directors on its board. However, they possessed little knowledge about
complex accounting rules. Moreover, these same directors received substantial fees and contributions from WMI.
Also of interest to Jane were some aspects of the companys hiring practices. For the previous 25 years (most of WMIs history),
every chief accounting and financial officer hired by WMI had previously worked as an auditor with Janes CPA firm, AA LLP. In total, 14
former AA employees held key accounting positions with WMI during the 1990s. Not surprisingly, AA considered WMI one of its most valuable
clients. The accounting firms engagement partner for the WMI audit was Richard Agassi, a star client service partner. Soon after he took over
the engagement, Richard capped the audit fee charged to WMI at the previous years level in exchange for contracts that enabled the firm to earn
additional fees for special work. During the late 1990s, AA collected $7.5 million in audit fees and $11.8 million in other fees from WMI.
These fees represented a substantial portion of the accounting firms total revenue. In addition, Andersen Consulting (a sister firm of AA)
collected $6 million form WMI for completing a strategic review and other projects for the company. Richard himself served on the steering
committee that conducted the strategic review. Further, Richards compensation at AA was based in part on the firms billings to WMI for audit
and non-audit services.
Janes meeting with Richard and Howard (the Controller of WMI) did not go very well. Jane shared her concern about the company
offsetting the adjustments of prior period estimates and expenses against the gain from the sale of SM Inc. The adjustments, expenses, and the
gain that was netted were individually material. She did not believe this practice conformed to GAAP. While Richard agreed with Jane, he
suggested that the amounts being netted were not material to the financial statements taken as a whole. Richard, to Janes chagrin, further agreed
with Howard that the netting did not need to be disclosed in footnotes to the financial statements since the net results was not material. Richard
subsequently authorized (after consultation with the firms regional Audit Practice Director) the issuance of an unqualified opinion for WMIs
December, 1999 financial statements.
Epilogue
In July 1991, the SEC issued a cease and desist order alleging that management violated U.S. securities laws when they publicly
forecasted results for the quarter ended June 30, 1999, despite being aware of significant adverse trends in its business which made continued
public support of its announced forecasts unreasonable.
In March 2002, the SEC filed suit against the founder and five other top officers of the company charging them with perpetrating a
massive financial fraud lasting more than five years. Our complaint describes one of the most egregious accounting frauds we have seen. For
years, these defendants cooked the books, enriched themselves, preserved their jobs, and duped unsuspecting shareholders.
As for the CPA firm AA, the SEC eventually settled charges with AA and four of its partners related to the 1992 through 1996 audited
financial statements. AA agreed to pay a penalty of $7 million, the largest ever assessed against an accounting firm. According to the SEC
Director of Enforcement, Arthur Andersen and its partners failed to stand up to company management and thereby betraying their ultimate
allegiance to Waste Managements shareholders and the investing public. Given the positions held by these partners and the duration and gravity
of the misconduct, the firm itself must be held responsible for the false and misleading audit reports.
Required
Access Data File 14-1 in iLearn for Tables 1, 2, 3 and 4 on selected financial information to answer the following questions.
1. (a) What aspects of WMIs depreciation expense make it susceptible to earnings management?
(b) Using industry averages, state your assumptions and make an estimate of WMIs depreciation expense for 1997-1999.
(c) How does WMIs reported depreciation expense compare to your calculation for those years, on an after-tax per share basis, assuming a
30 percent tax rate?
(d) Given your estimate in parts (a), (b) and (c), how would depreciation expense for 1999 change if useful lives of the assets are increased by
10 percent and if all property, plant, and equipment is assumed to have a salvage value equal to 10 percent of cost? Show your estimate on a per
share basis, after taxes.
(e) Given your estimate in (d), and if WMI were to make such changes, how should the company disclose these changes in its financial
statements as per the Accounting Principles Board (APB) Opinion No.20 (APB 1971) on Changes in Accounting Estimates?
2. (a) A significant portion of WMIs business is waste handling and disposal. Table 1 of Data File 14-1 provides information on land for
disposal sites. What events cause that account to change, and what opportunities for earnings management exist with that account? You should
research Environmental Protection Agencys regulations on land for disposal sites for this question.
(b) Table 4 of Data File 14-1 summarizes the environmental liabilities for closure and post-closure costs. What events cause this liability to
change, and what opportunities for earnings management exist with this account?
You should research SFAS No. 5 (FASB 1975) Accounting for Contingencies, and AU 540 Auditing Accounting Estimates, Including Fair Value
Accounting Estimates and Related Disclosures for this question.
(c) Describe the types of audit procedures an auditor would expect to perform in support of these environmental liability cost estimates and
allocations. Also, discuss the differential reliability values of this audit evidence.

Simulation Question 14-2 is an adaptation with permission from a case by P. M. Clikeman in the Issues in Accounting Education, a publication of
the American Accounting Association in Sarasota, Florida. This simulation question is based on hypothetical data.
Expense or Asset?
Expenses of Information-Age Companies
Assets of Information-Age Companies
In June 2000 the U.S. Senate Banking committee held hearings entitled, Adapting a 1930s Accounting Model to the 21 st Century.
Five witnesses testified that the current accounting model is inadequate to measure the performance and resources of information-age companies.
Peter Wallison, Resident Fellow at the American Enterprise Institute, told the senators:
According to some estimates, about 80 percent of the value of companies listed in the
S&P 500 is attributable to their intangible assets. These are familiar items such as patents,
trademarks, and software, and less familiar items such as employee skills, customer satisfaction, and
efficiency of product innovation.
However, conventional accounting has no effective means for recording intangible assets
on balance sheets, and thus corporate balance sheets-prepared in accordance with Generally
Accepted Accounting Principles (GAAP)- may simply not contain most of the assets a company
holds. Worse still, since the purpose of accounting is to match costs with revenues-and a major
aspect of cost is the depreciation or amortization of assets-earnings may be overstated or understated
because the assets that are producing the earnings are not on the balance sheet and are thus not being
depreciated or amortized.
Several articles in popular business magazines also have complained that the current accounting model is not appropriate for valuing
information-age companies. These articles claim: (1) earnings do not properly measure the performance of information-age companies because
expenses are not matched with related revenues, and (2) balance sheets do not adequately report the value of information-age companies because
essential determinants of their success such as patents, brand names, customer loyalty, and employee expertise do not meet the accounting
definition of assets.
An important concept in measuring earnings is the Matching Principle, which states that expenses should be matched with related
revenues whenever it is reasonable and practicable to do so (Statement of Financial Accounting Concepts No. 6, FASB 1986, paragraph 146).
Unfortunately, it may be more difficult for industrial and knowledge-based companies than for merchandisers to match expenses with related
revenues.
Merchandisers (e.g., retailers and wholesalers) buy and sell physical goods. They record an asset (i.e., inventory) when goods are
purchased and an expense (i.e., cost of goods sold) when goods are sold. Gross profit measures the difference between the price received from the
sale of the goods and the price paid at the time of their purchase. In the financial statements, the inventory costs are matched closely with the
related revenues.
Industrial companies are characterized by large amounts of long-term assets (e.g., factories, production machinery). Depreciation
attempts to match the costs of long-term assets with the revenues generated from their use, but the matching depend on several estimates and
assumptions. Most U.S. companies record the same amount of expense every year even if the revenue generated from the assets use varies
among years. One study has shown that approximately 80 percent of U.S. companies record depreciation using the straight-line method; only
about 5 percent use the units-of-production method. Unless an assets useful life and salvage value are estimated with perfect accuracy,
depreciation expense will be misstated during each year of the assets life, followed by a one-time gain or loss in the year of disposal.
In the present information-age economy, many knowledge-based companies earn revenue by selling intellectual property. Examples of
knowledge-based companies include software producers and pharmaceutical companies. Such companies are characterized by high upfront
development costs and low production costs. Pharmaceutical and software companies spend billions of dollars on research and development, but
spend pennies to produce each pill or compact disc. The problem accountants facts in measuring the performance of information-age companies
is how to match the expenses with the revenues. Current accounting rules require most research, product development, and marketing costs to be
expensed when incurred. Only the (nominal) production costs are recognized in the same period with the revenues.
Researchers such as Lev and Zarowin complain that current accounting rules do not properly measure the earnings of innovative,
information-age companies:
The large investments that generally drive change, such as restructuring costs and R&D
expenditures, are immediately expensed, while the benefits of change are recorded later and are not
matched with the previously expensed investments. Consequently, the fundamental accounting
measurement processing of periodically matching costs with revenues is seriously distorted,
adversely affecting the informativeness of financial information.
Lev and Zarowin cite the declining association between accounting earnings and stock returns and the declining ability of earnings to explain
stock prices as evidence that accounting information is losing its value relevance. In an extreme situation, Amir and Lev found that earnings and
book values, on a standalone basis, are virtually irrelevant for valuing wireless communication companies.
Merchandisers and manufacturers earn revenue through their physical and financial assets (e.g., inventory, stores and fixtures,
production machinery, customer receivables). These assets are reported on their balance sheets. Information-age companies depend more heavily
on intangible assets. An Internet service providers primary asset is its subscriber base. A pharmaceutical companys primary assets are the
patents to its drugs. A software producers primary assets are the copyrights to its existing products and the employee expertise that enables the
391
392
company to develop new programs. Most of these internally generated assets are not reported on corporate balance sheets or, if reported, are
valued at nominal amounts. AICPA chairman Robert Elliott told the Senate Banking Committee:
The current accounting model is based on the assumption that profitability depends on
physical assets, like plant and machinery; on raw materials, like coal, iron ore, sheet metal, electrical
wire, and plastic; in other words, on the tangible inputs needed to produce tangible products. This is
the accounting model of the industrial age. We now have information companies, companies that do
research and produce findings that they hope to profit from. The role of intellectual inputs that
ultimately lead to sales has multiplied enormously. The range of these inputs runs from patentable
ideas to marketing, process design, computer programs, know-how, brand names, work-force
expertise and training, quality controls, executive strategy, and organizational mechanisms to
generate both quality improvements and innovation. All of these things can add to corporate
revenues. Yet most these kinds of things are not recognized by the accounting model.
In 1982, accounting book values for the S&P 500 averaged 77 percent of market capitalization. In 1998, the average book value was
less than 20 percent of market capitalization. In 1998, the average book value was less than 20 percent of market capitalization. The growing gap
between market and book values suggests that corporate balance sheets fail to report many of the assets that make knowledge-based companies
valuable and successful.
Required
Accounting pronouncements that are helpful for answering the following questions 1-4 include:
Statement of Financial Accounting Standards No.86, Accounting for Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.
Statement of Financial Accounting Standards No.141, Business Combinations.
Statement of Financial Accounting Standards No.142, Goodwill and Other Intangible Assets.
Statement of Financial Accounting Standards, Accounting Standards Statement of Accounting Concept 1-6.
1. Expenses
Expenses are recognized in accordance with the Matching Principle, which states that efforts (expenses) should be matched with
accomplishments (revenues).
a. A vegetable oil wholesaling company bought 10,000 gallons of olive oil on December 1, 2001 for $100,000. The company sold 7,000 gallons
in December 2001 and sold the remaining 3,000 gallons in January 2002. How much expense should the company recognize in each month?
b. An electric utility company commissioned a new gas-fired generating plant on January 4, 2001. The total cost of the plant was $2 billion. The
plant has an estimated useful life of 20 years and no salvage value. The amount of electricity generated each year will vary depending on weather
conditions in the surrounding community. How much expense should the company recognize in each of the next 20 years?
c. During 2001, a software company spent $20 million writing, testing, and debugging a new computer game. The game costs only $3 per copy to
manufacture and package, and can be sold for $25 per copy. The company sold one million copies of the game in 2002 and an additional one
million copies in 2003. How much expense should the company recognize in 2001? 2002? 2003?
d. i. In which of the situations 1a, 1b, and 1c above are expenses matched most closely with the related revenues?
ii. In which of the situations 1a, 1b, and 1c above are expenses matched least closely with the related revenues?
2. Assets
For this question, assets are broadly defined as the items or qualities that make the business valuable. Research the Internet for the following
companies and for each company: i. identify the most valuable assets (i.e., primary assets) of the company (i.e., identify the things that make the
company valuable and successful), ii. indicate whether the assets you identified would be reported on the companys balance sheet, and iii.
identify the market price of the companys common stock you expect would greatly exceed the stocks book value (i.e., compare the companys
common stock share price with its common stock book value).
Use the following format to answer:
Reported on Balance Sheet?
Company
1. Bank of America
2. Sears, Roebuck and Co.
3. Boise Cascade
4. The New York Times
5. Coca-Cola
6. Pfizer
7. Microsoft
Most Valuable Company Assets?
Stock Price Greatly Exceed Book

Value?
3. Expense or Asset?
For each of the following situations, indicate whether (under current U.S. GAAP) the expenditure should be expensed or capitalized.
a. Pharmaceutical company A spends $500 million to purchase the patent to a new drug to treat arthritis.
b. Pharmaceutical company B spends $500 million to research and development costs to develop a new drug to treat arthritis.
c. An insurance company spends $10 million purchasing new computer equipment and software to improve its order-entry system.
d. An insurance company spends $2 million training its 1,000 customer service representatives how to use the new order-entry software.
e. America Online, Inc. (AOL) spends $2 million to mail CDs offering 30 days of free Internet access to 1 million households. The mailing
results in 10,000 new AOL subscribers.
4. Brand Names
The Procter & Gamble Company (P&G) manufactures and distributes more than 300 brands you know and trust. Their products include
Pingles potato chips, Cover Girl makeup, Tide laundry detergent, and Pampers diapers.
a. If P&G were allowed (or required) to record its brand names as assets on its balance sheet, how would it go about estimating the values of its
various brands?
b. Assume P&G did record its brand names as assets on its balance sheet. Do you think P&G should also amortize the brand names?
i. If so, how should they go about calculating the amortization expense?
ii. If not, do you think P&G should be required to test the values periodically for impairment?
c. What challenges would P&Gs auditors face trying to test these values?

Simulation Question 14-3 is an adaptation with permission from a case by Holder-Webb, L., and M. Kohlbeck in the Issues in Accounting
Accounting for Intangible Assets

Overview
Krispy Kreme Doughnuts, Inc. (hereafter, KKD) was founded in 1937 in Winston-Salem, North Carolina. KKDs efforts were
concentrated in North Carolina and surrounding states for much of its early life. By 1996, KKD has grown to 95 units (an average of less than
two stores per year). KKD developed an aggressive growth plan in the late 1990s. In the early stages, KKD financed this growth by forming
alliances with Area Developers and retaining minority equity stakes in the developing ventures. In 2000, KKD boosted its expansion program
with an injection of capital from an initial public offering (IPO), in which approximately 3.4 million shares were sold for a total of $65.7 million.
Shares traded on NASDAQ, and the firms stock listing shifted to the NYSE in 2001. KKD increased the number of retail outlets to over 400 by
2004. In the post-IPO period, store sales posted growth of approximately 19 percent per annum, attributed partially to publicity from the IPO.
Despite this growth, KKD captured less than 10 percent of the U.S. doughnut market. The leader, Dunkin Donuts, had over 5,000 stores in 2004.
Growth in store sales began to slow in 2005.
The Doughnut Business
Reacquired Franchise Rights
KKD is a branded specialty retailer and manufacturer of premium quality doughnuts. Its principal business is to own and franchise
KKD doughnut stores in the U.S. and internationally. The main product is the Hot Original Glazed, a one-of-a-kind doughnut with an established
brand. Each outlet also sells over 20 other varieties of doughnuts and coffee products. Product quality and consistency has provided KKD with a
very loyal customer base.
Each of the retail stores is a doughnut factory with the capacity to produce between 4,000 and 10,000 dozen doughnuts daily. Each
factory store contains a full doughnut-making production line. The factory store is marketed as a unique retail experience, featuring the stores
production process, including a doughnut-making theater. The stores also support multiple sales channels to more fully use production capacity.
Stores provide KKD doughnuts to be sold in satellite locations, ballparks, and grocery stores, and under private label marketing agreements.
KKD factory stores are divided into three categories. First, KKD stores are owned by Krispy Kreme. Second, KKD has an Associate
program since the 1940s, where stores are owned by franchisees. Associates enter into 15-year licensing agreements to operate stores in a specific
territory and are expected to concentrate on operations of existing stores. The third category is an Area Developer program, launched in the mid1990s, where franchisees have responsibilities to develop new territories in addition to operating existing stores. Development targets pertaining
to territory, number of stores, and timing are specified in the Area Developer Agreement.
Associates pay royalties of 3 percent on store sales and 1 percent on all other sales. Area developers have significantly higher costs:
they pay royalties of 4.5 percent to 6 percent on all sales, and pay development and franchise fees of $20,000 to $50,000 per store. As of February
1, 2004, there were 141 KKD stores, 18 Associates operating 57 stores, and 26 Area Developers operating 159 stores. The Area Developers were
under contract to open 250 stores over the duration of their contract periods. KKD had a controlling interest in two of the Area Developers, who
operated 24 stores and a minority interest in 15 others, who operated 66 stores.
KKD generates revenue from four sources: KKD stores, franchise fees and royalties from franchise stores, a vertically integrated
supply chain, and offsite bakery production separate from the factory store doughnut production. The franchising program lowers capital
requirements and provides a royalty stream. The vertically integrated supply chain provides franchise stores with mixes, equipment, and coffee.
This arrangement permits individual stores to lower cost of goods sold and KKD to capture additional profit on these sales.
You should access Data File 14-3 in iLearn for Tables 1, 2, 3 and 4 which contain financial information extracted from KKDs 2004
annual report and other relevant information.
Between 2000 and 2004, KKD embarked on a franchise repurchase plan, stating that it would be easier to maintain consistency and
efficiency when dealing with KKDs suppliers and wholesalers. During this period, KKD purchased the operations of several Area Developers,
including development rights for specific territories. These acquisitions may have also included existing stores owned by the Area Developer. In
addition, KKD acquired operating stores from Associates. Acquisitions were accounted for as purchases. In a typical acquisition, KKD acquired
accounts receivable, inventory, prepaid expenses, property, plant and equipment, and reacquired franchise rights (hereafter, The Rights) subject to
certain accrued expenses. The Rights consist of the contractual responsibility to develop new territories and the right to continue operating
existing stores.
KKD defines The Rights in Table 3 as the excess of the net amount assigned to identifiable assets and liabilities recorded upon the
acquisition of franchise markets. You should access Data File 14-3 in iLearn for Table 3 for selected footnotes. The Rights are stated to have
an indefinite life and are reviewed at least annually for impairment or whenever events or circumstances indicate the carrying amount of the asset
may be impaired in accordance with SFAS No.142 (FASB 2001b).
Normally, the excess of the purchase price over the fair values of net assets acquired is assigned to goodwill. In this case, KKD
followed the residual value approach to provide an initial valuation of the required franchise rights (assigning excess purchase price above the fair
value of tangible acquired assets to an intangible other than goodwill). The use of the residual valuation approach was permitted during this time
period when obtaining a direct valuation of the intangible was not practical.
393
394
Required
Assume you are an audit senior assigned to the engagement and have been asked to investigate KKDs accounting for intangible assets in
preparation for a new audit. Use the following guiding questions to document your investigation:
1. Question on Industry Practice and The Rights
Search the internet or use the EDGAR website to locate at least two other companies that reported reacquired franchise rights between 2000 and
2003 and document:
(a) How do they report rights related to a reacquired franchise?
(b) What does the industry practice appear to be?
(c) What reasons do different companies offer for their treatment of these rights?
2. Question on Recording The Rights
KKD asserts that the reacquired franchise asset is an intangible asset with an indefinite life. Use the Conceptual Frameworks definition of an
asset (FASB 1985) and SFAS Nos. 141R and 142 (FASB 2001a, 2001b) to evaluate this assertion and document:
(a) What is the economic substance of The Rights? That is, what are the economic benefits KKD expects to receive that are implied by the
recognition of this asset? What characteristics of the operations give rise to these benefits?
(b) What are some of factors that suggest that KKDs Rights have an indefinite life? What factors suggest a limited life? Which set of factors is
more persuasive?
(c) Compare the nature and accounting of The Rights as asserted by KKD to goodwill. How do the two assets differ? How are the two assets the
same?
3. Question on Impairment of The Rights
Assume that The Rights are properly reported as an indefinite-life, identifiable, intangible asset, document:
(a) What changes in market conditions or KKDs business environment might cause The Rights to become impaired?
(b) If it is determined that the asset is impaired, how can KKD estimate the fair value of the asset in order to measure the impairment?
4. Question on Management Motivations Issues
An alternative approach to the residual value approach used by KKD is to assign the excess purchase price to goodwill. Document:
(a) What effect does KKDs treatment of The Rights have on the balance sheet and earnings compared to recording the amount as goodwill? Do
you consider the difference between the two accounting treatments material? Why or why not?
(b) Given KKDs history, past performance, and current performance, and other information provided in this simulation question (See Tables 1,
2, 3 and selected footnotes in iLearn), document what motivations might the management have to use the residual value approach?
Note: You must answer Questions 1-3 and all the subparts in order to earn the extra credit point.
395
396
Chapter 15
Inventory Cycle Tests of Controls and Tests of
Balances
LO15-1 Understand the accounting information system of a typical inventory cycle.
LO15-2 Describe some common TOC procedures for inventory.
LO15-3 Understand TOC procedures for cost accounting system.
LO15-4 Apply the analytical procedures in an inventory cycle.
LO15-5 Understand internal control in computerized inventory systems.
LO15-6 Describe some common TOB procedures for inventory.
LO15-7
Identify the procedures for observing physical inventory count.
LO15-8
Identify the timing and extent of inventory observation.
LO15-9
Identify some industry specific inventory count observation procedures.
LO15-10 Distinguish between compilation and pricing.
Chapter 15 Inventory Cycle Tests of Controls and Tests of Balances

An overview of the strategy for tests of controls in an inventory cycle is presented in Figure 15-1.
Figure 15-1 TOC Strategy in Inventory Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
397
398
Understand Internal Control in an Inventory Cycle

TOC strategy in an inventory cycle starts with an understanding of internal controls relating to an inventory cycle.
Table 15-1 provides a brief discussion of the various components relating to the understanding of internal controls in
an inventory cycle.
Table 15-1 Understanding Internal Controls in an Inventory Cycle
Understanding Internal Controls in an Inventory Cycle
2. Risk assessment
5. Monitoring
have a special effect on the inventory cycle.
inventory cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to
cycle. If the auditor plans to conduct both TOC and TOB on the inventory cycle, then s/he needs to
identify the control activities relating to specific audit objectives and for the purpose of assessing control
risk (CR). The auditor usually identifies these control activities from documentations of the understanding
using narrative descriptions, internal control questionnaires, or flowcharts. Figure 15-6 shows an example
of an inventory cycle flowchart.
The auditor must obtain sufficient knowledge of the accounting information system relating to the
inventory cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit
objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in
three areas as shown in Figure 15-2. A brief discussion of these three areas is provided in Table 15-2.
The auditor must understand the managements monitoring processes over the inventory cycle. This
includes understanding how the management monitors the internal controls of the inventory cycle over
time and what corrective action is initiated to improve the design and operation of controls in the inventory
cycle.
Figure 15-2 Understanding of Information and Communication in an Inventory Cycle
Key Functions
Understand 3 key functions of an inventory
cycle

Transactions
of transactions

records
Table 15-2 Understanding of Information and Communication in an Inventory Cycle

Accounts and Classes of Transactions
Key Functions
1. Receiving, storing, and
issuing raw materials
Receipt of the ordered
raw materials is part of
the
purchases
and
payments
in
the
expenditure cycle.
2. Manufacturing goods.
Accumulation of direct
and indirect labor costs in
producing goods is part of
the payroll cycle.
Accounts
(control ledger)
Raw materials
Classes of
Transactions
Inventory

Receiving report
This receiving report originated from the expenditure cycle. A
copy of the receiving report accompanies the raw materials
received to the storing facilities and updates the raw materials
perpetual inventory records.
Materials requisition
This materials requisition originated from the production
facilities. A copy of the materials requisition authorizes the
release of raw materials for production and updates the raw
materials perpetual inventory records. Figure 15-3 shows an
example of a material requisition.
Labor
Overhead
Work-inprocess
Production schedule
This schedule determines the quantity of goods needed and the
timing that they must be produced. It is prepared based on
backlog of orders, on sales forecasts, or just-in-time inventory
programs.
Cost accounting record

This record is in the form of worksheets that accumulate
material, labor, and overhead costs by job (job cost systems) or
process (process cost systems) as the costs are incurred. Figure
15-4 shows an example of a standard cost accounting record.
3. Storing and shipping of

finished goods
Shipping of finished
goods is part of the sales
and receipts in the
revenue cycle.
sold
Cost variance report

This report presents the results of the manufacturing process in
terms of actual costs versus standard or budgeted costs.
Finished goods
Cost of goods
(Finished goods) Perpetual inventory record (master

file)
Finished goods perpetual inventory records maintain detailed
unit cost of goods produced based on a copy of the cost
accounting record that accompanies the finished goods to the
storing facilities. Figure 15-5 shows an example of a perpetual
inventory record.
Inventory status report

This report summarizes the perpetual inventory records showing
the type and amount of goods on hand. It can also be used to
determine the status of the work-in-progress goods.
Shipping document
The shipping document originated from the revenue cycle. A
copy of the shipping document authorizes the release of finished
goods for shipment and updates the finished goods perpetual
inventory records.
399
400
Figure 15-3 An example of A Material Requisition

MR#3990
MATERIAL REQUISITION
MNO Company
5th Street, San Francisco
CA 94132
Department: Assembling, 2nd Floor, Room No. 200
Quantity
100 tubes
Description
17 feet, 3/8 inch thick, 1 inch square, silver finished,
aluminum tubing.
Requisition Approval Person: David
Date: August 10, 201x
Unit Cost
$0.49
Total Cost
$833.00
Date Required: August 15, 201x
Figure 15-4 An Example of a Standard Cost Accounting Record

SC#4875689
STANDARD COST ACCOUNTING RECORD
MNO Company
CA 94132
Department: Cost Accounting Department, 5th Floor, Room No. 500
Product: B20SS
Product Description: B20SS is the finished product Bicycle Frame Assembly (silver unit) with brass customization for the U.S. market.
Product Process: Frame is assembled from raw material stock in the bent frame assembly unit. Frames are shaped and cut to precision
with the two Cougar framing machines. The frames are polished and customized according to specific designs.
Finished products are sent to final assembly to be packaged with other frame components.
The cost and the basis for the standard costs are calculated as follows:
Description
Raw Material: 16 feet, 3/8 inch thick, 1 inch
square, silver finished, aluminum
tubing.
Product or Cost Used

16 feet used, plus 1 feet scrap
Rate
$0.49
Standard Cost
$8.33
Direct Labor: For bending and finishing.
Bending 1/30 hour

Finishing 1/12 hour
$5.50
$7.50
$0.91
Factory Overhead: Predetermined formula
Applied at 250% of standard

labor cost
$0.91
$2.28
Total
$11.52
=====
Note: Costs were accumulated 9/11/201x by engineering department based on time study of production and current cost of raw material. Factory
overhead formula reviewed by cost accounting manager.
Record Reviewed and Approved by:
Ken
Cost Accounting Manager
Date: September 21, 201x.
Figure 15-5 An Example of a Perpetual Inventory Record

PIR#003
PERPETUAL INVENTORY RECORD
MNO Company
CA 94132
Department: Inventory Control Department, 7th Floor, Room No. 700
Product: B20SS
Date
Document
Reference
Balance
RR#403
SI#37662
RR#482
SI#38941
10/1/200x
10/3/200x
10/5/200x
10/16/200x
10/23/200x
Unit Cost
In
Unit Cost
Out
$11.52
Number In
Number Out
100
$11.48
$11.49
10
50
$11.50
80
Balance in
Units
100
200
180
230
150
Balance in Cost
Figure 15-6 An Example of an Inventory Cycle Flowchart

Functions
Documents & Records
Issuing
Raw
Materials
Computer Process
Materials
Requisition
Raw Materials Inventory
Master File
Enter Material
Requisition
RAW MATERIALS UPDATE

ROGRAM
Update raw materials inventory
master file.
Print materials requisition report.
Materials
Requisition
Report
Manufacturing
Goods
Standard Costs Master File
Job Time Ticket

WORK IN PROCESS
UPDATE PROGRAM
Update work in process
inventory and general ledger
master file.
Print cost accounting record,
cost variance report, and
general ledger.
Enter Time &

Move Tickets
Goods Move
Ticket
Cost Accounting
Record
Cost Variance
Report
General Ledger
Work In Process Inventory

Master File
$ 1,280.00
2,432.00
2,317.20
2,891.70
1,971.70
401
402
Functions
Storing
Finished
Goods
Documents & Records

Finished Goods
Move Ticket
Computer Process
FINISHED GOODS
UPDATE PROGRAM
Update finished goods inventory
master file and general ledger
master file.
Print perpetual inventory record,
inventory status report, and
general ledger.
Enter Finished
Goods Data
Perpetual
Inventory
Record
Finished Goods Inventory

Master File
Inventory
Status Report
General Ledger
Consider Potential Misstatements in an Inventory Cycle

After the auditors have obtained an understanding of the internal controls relating to the inventory cycle and
weaknesses in internal control. Table 15-3 describes some of these potential misstatements in the inventory cycle.
Table 15-3 Potential Misstatements in an Inventory Cycle due to Weakness in Internal Control
Misstatement of inventory costs
Example of Fraud
Intentional misstatement of production

costs assigned to inventory items.
Intentional misstatement of inventory

prices.
Misstatement
quantities.
of
inventory
Inventory is stolen with no journal entry

reflecting the theft.
Example of Error
Unintentional mistake in assigning

labor costs, material costs, or factory
overhead to inventory items.
Unintentional mistake in pricing of

inventory.
Miscounting of inventory
physical inventory count.
during
Intentional overstatement of inventory

in certain locations.
Early
inventory.
Overstatement of inventory at locations

that are not observed by the auditors.
or
late
recognition
of
Intentional recording of purchases of

raw materials in the subsequent period.
Intentional recording of sales of finished

goods from the subsequent period.
Unintentional mistake in recording of

purchases of raw materials in the subsequent
period.
Unintentional mistake in recording of

finished goods from the subsequent period.

After considering potential misstatements, the auditors assess the control risk (CR) and perform the TOC procedures
as per the audit program for the inventory cycle. Table 15-4 describes some common TOC procedures that the
auditors perform on inventory of the inventory cycle.
Table 15-4 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Inventory
No fictitious inventory is recorded.
Internal Controls
Proper separation of duties between the

inventory management and inventory recording
functions.
Proper authorization for inventory transferred
from the raw materials storing facilities to the
production facilities.
Observe and evaluate proper separation of

duties.
Proper authorization for production.

Inventory recorded but not on hand
(stolen).
Examine materials requisitions for proper

approval.
Inspect a sample of materials requisitions for
numeric sequence.
Examine authorized production schedules.
Physical safeguards over inventory.
Observe physical controls over inventory such

as the existence of a locked storeroom or the
hiring of a competent custodian.
Materials requisitions and receiving reports are

prenumbered and accounted for.
Scan for numerical sequence of materials

requisitions and receiving reports.
Trace a sample of receiving reports to the
updated perpetual inventory records.

Inventory quantities recorded correctly.
Adequate cost accounting records.
Inventory costs recorded correctly.
Inventory obsolescence recorded correctly.
Compare inventory on hand with amounts

shown in perpetual inventory records.
Analyze cost accounting records and cost
variance reports for allocation of materials,
labor, and overhead.
Table 15-12 provides further discussion on
TOC for cost accounting system.
Inspect perpetual inventory records for
obsolete, slow-moving, or excess quantities.
Completeness:
Inventory transactions are recorded.
Classification:
Inventory transactions are properly
classified among raw materials, work-inprogress, and finished goods.
Understandability:
Inventory transactions are properly
recorded in perpetual inventory records.
Internal independent checks on the preparation

of production schedule, cost accounting records,
and cost variance report.

inventory into raw materials, work-inprogress, and finished goods.
Separation of duties between physical

handling/transferring
of
the
inventory
transactions and the recording of the inventory
transactions in the perpetual inventory records.

Observe the reconciliation of perpetual
inventory records to inventory control account
in the general ledger.
Internal Controls in Computerized Inventory Systems
The Perpetual Inventory System

Perpetual inventory records in a computerized perpetual inventory system constitute an important part of internal
control. These records, by showing at all times the quantity of inventory on hand, provide information essential to
efficient purchasing, sales, and production-planning policies. With such a record, it is possible to guide procurement
by establishing points of minimum and maximum quantities for each standard item stocked.
The use of a computerized perpetual inventory system allows clients to control the high costs of holding
excessive inventory, while minimizing the risk of running out of stock. The client can control inventories through
reorder points and economic order quantities, including just-in-time ordering systems in which inventory levels are
kept to a minimum. In addition, the system discourages inventory theft and waste, since storekeepers and other
employees are aware of the accountability over inventory established by the continuous record of inventory
received, issued, and on hand.
For good internal control over a computerized perpetual inventory system: 1. The subsidiary records should
be maintained in both quantities and dollars for all stock. 2. The subsidiary records should be controlled by the
403
404
general ledger. 3. Trial balances should be prepared at reasonable intervals. 4. Both the detailed records and the
general ledger control accounts should be adjusted to agree with physical counts that are taken periodically.
IT-Based Inventory System
An IT-based inventory system makes it much easier for the client to maintain control over inventories, purchasing,
and the manufacturing process. The IT system can automatically generate purchase requisitions and orders when
inventory levels reach predetermined reorder points. The clients IT-based inventory system may even be linked to
the system of its suppliers, allowing electronic data interchange (EDI) to completely coordinate production and
purchasing. The IT system also maintains records of inventories as they are routed through the production process.
Details of direct labor and materials usage are entered, and the computer allocates these direct costs to jobs or
processes, applies manufacturing overhead costs based on predetermined rates, and maintains perpetual records of
the costs of goods in process, finished, and sold. The system also generates various financial reports that indicate
actual costs, standard costs, and the related variances.
Good internal control over an IT-based inventory system requires the usual segregation of the purchasing,
receiving, storing, processing, and shipping functions. In addition, the client should establish appropriate controls
that ensure the accuracy of cost data as they are entered into the system and maintain the integrity of the cost data
after they are entered into the system.
An overview of the strategy for tests of balances in an inventory cycle is presented in Figure 15-7.
Figure 15-7 TOB strategy in Inventory Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
405
406
Apply TOB Strategy

Table 15-5 provides a brief discussion of the TOB strategy as it is applied to an inventory cycle.
Table 15-5 TOB Strategy in Inventory Cycle
TOB Strategy Inventory Cycle
2. Derive DR

transaction level of a transaction cycle. In an inventory cycle, the inventory account is typically the most
material items in the financial statements for manufacturing, wholesale, and retail companies. For these
reasons, the auditor typically allocates a small TM (i.e., less tolerance) to inventory account.
timing of the TOB procedures used by the auditor. In the inventory cycle, inherent risk is often assessed at
a relatively high level for companies with significant inventory.
client data. In the inventory cycle, analytical procedures are used especially to uncover misstatement of
inventory account. One of the most effective analytical procedures for uncovering misstatement of
inventory and cost of goods sold accounts is comparing gross margin percentage with that of previous
years. This is because expenses from year to year are typically relatively stable. Table 15-6 describes some
analytical procedures and potential misstatements that may be detected by them in the inventory cycle.
common TOB procedures in an inventory cycle. The auditor is especially concerned with the specific audit
objective of existence or occurrence that tests the managements assertion of existence and occurrence in
the inventory cycle.
necessary. The auditor should perform additional audit work or request the management to make an
Table 15-6 Analytical Procedures for the Inventory Cycle

Inventory:
Comparison of gross margin percentage [(net sales cost of goods sold)/net sales] with that of
previous years.
Comparison of inventory turnover [cost of goods sold/average inventory] with that of previous
years and industry averages.
Comparison of days outstanding in inventory with that of previous years and industry averages.
Pricing of inventory:
Comparison of unit costs of inventory with that of previous years.
Comparison of current-year standard costs with that of previous years after considering current
conditions.
Comparison of actual manufacturing overhead costs with budgeted or standard manufacturing
overhead costs.

Unrecorded or fictitious inventory.
Overstatement and understatement of cost of
goods sold.
Obsolete, slow-moving, or excess inventory.
Obsolete, slow-moving, or excess inventory.
Overstatement and understatement of unit
costs.
Overstatement and understatement of unit
costs.
Inclusion or exclusion of overhead costs.
Table 15-7 Specific Audit Objectives and Common TOB Procedures for an Inventory Cycle
Recorded inventory actually existed.
Completeness:
All inventories are recorded.
Cutoff:
All sales of finished goods and purchases
of raw materials are recorded in the proper
period.
Recorded inventory actually belongs to the
client.
Accuracy:
Inventory account balance is accurate.

Inventories are valued (priced) properly.
Classification:
Inventory is properly classified as raw
materials, work-in-progress, and finished
goods.
Understandability:
All inventory related accounts are properly
presented and disclosed in the financial
statements.

AU 501 Audit Evidence Specific Considerations for Selected Items requires the auditor to
observe the clients physical inventory count in order to establish the existence of the inventory.
Table 15-8 provides further discussion on the audit procedures for observing physical inventory
count.
Vouch inventory items listed in the inventory listing/sheet/schedule to the inventory tags, and to
the auditors test count sheet during the physical inventory observation.
Trace inventory tags noted during the auditors physical inventory observation to inventory items
listed in the inventory listing/sheet/schedule.
Trace a sample of the auditor test counts during the physical inventory observation to the
perpetual inventory records.
Confirm any inventory held on consignment by others or is stored in public warehouses.
Examine a sample of shipping documents for a few days before and after year-end for recording
inventory in the proper period (see Chapter 13 for sales cutoff procedures).
Examine a sample of receiving reports for a few days before and after the year-end for recording
of inventory purchases in the proper period (see Chapter 14 for purchases cutoff procedures).
Confirm that inventory held on consignment for others is not included in inventory.
Confirm that bill-and-hold goods are not included in the inventory. The bill-and-hold goods
are treated as a sale but the client holds the goods until the customer needs them.
Inspect agreements to determine whether any inventory is pledged as collateral or subject to any
liens.
Select and test a sample of inventory accounts by using MUS sampling approach (recall Chapter
12) and generalize from the sample results to the accuracy of the inventory account balance
(population).
If the client uses a standard cost system (job or process cost systems), the output of the standard
cost system (the cost accounting records and cost variance report) should show standard costs
approximate actual costs of inventory valuation. The auditor can test this by selecting a sample of
inventory and determining the unit cost of the sample by re-computing the material costs, labor
costs, and overhead.
Examine the pricing of inventory by performing the lower-of-cost-or-market test on large-dollar
inventory or inventory selected from different production lines.
Inquiry of the management about obsolete, slow-moving, or excess inventory.
Table 15-11 provides further discussion on the audit procedures for compilation and pricing.
Trace a sample of the auditor test counts during the physical inventory observation to the
classification in the cost accounting record and the inventory status report.
Read the minutes of the board of directors meetings for any pledged inventory that must be
adequately disclosed as a footnote in the financial statements.
Inquiry of management about (1) adequate disclosure of the three components raw materials,
work-in-progress, and finished goods in the balance sheet, (2) adequate disclosure of the cost
method, such as LIFO or FIFO, to value inventory, and (3) if LIFO is used to value inventory and
there is a material LIFO liquidation, footnote disclosure is provided.
Observing Physical Inventory Count

AU 501 requires the auditor to be present at the time of the clients inventory count (also known as inventorytaking) so as to observe and to do test counts of the clients inventory. Therefore, it is important to note the
distinction between the observation of the inventory count and the responsibility for taking the count. The clients
management has the responsibility for taking the inventory count. The auditors responsibility is to observe the
inventory count and draw conclusions about the reliability of the clients inventory count. Table 15-8 describes the
audit procedures for observing the inventory count.
407
408
Table 15-8 Procedures for Observing Physical Inventory Count
Procedures for Observing Physical Inventory Count
Prior to the physical inventory count.

(1) The auditor familiarizes with the inventory locations and the clients instruction for counting inventory. Figure 15-8 shows an example of a
clients instruction for physical inventory count.
(2) The auditor plans the timing of the observation, the extent of the test counts, and the use of specific inventory observation procedures. The
plans should be in writing and should ensure that all auditors understand their assignments concerning the physical inventory count; but the plan
should not be made available to the client. Figure 15-9 shows an example of the auditors plan for observing physical inventory count. Table 15-9
summarizes the auditors consideration concerning the timing and extent of inventory observation.
During the observation of the physical inventory count.

The auditor should do the following:
(1) Ensure that no production is scheduled to prevent double counting.
(2) Ensure that there is no movement of goods during the inventory count to prevent double counting.
(3) Ensure that the clients count teams are following the inventory count instructions.
(4) Ensure that inventory tags are issued sequentially.
(5) Perform test counts and record a sample of counts in the working papers.
(6) Perform industry specific inventory count observation procedures whenever practical and reasonable. See Table 15-10.
(7) Observe the condition of the inventory for obsolete, slow-moving, or excess quantity items.
(8) Inquire about inventories held on consignment for others or held on a bill-and hold basis and ensure that they are not included in the
clients inventory.
After the observation of the physical inventory count.

(1) Each auditor participating in the observation of the inventory count should prepare audit working papers that indicate the extent of test counts,
describe any deficiencies noted, and express a conclusion as to whether the physical inventory were properly taken in accordance with the
clients instructions.
(2) The auditor-in-charge should prepare a summary memorandum that indicates the overall extent of observation and the percentage of
inventory value covered by quantity tests. The memorandum should also include comments on the consideration given to the factors of quality
and condition of stock, the treatment of consigned goods on hand, and the control of shipments and receipts during the counting process. Figure
15-10 shows an example of the auditor-in-charges memorandum on the observation of physical inventory count.
Figure 15-8 An Example of a Clients Instruction for Physical Inventory Count

INSTRUCTION FOR PHYSICAL INVENTORY COUNT
MNO Company
CA 94132
Department: Accounting Department, 3rd Floor, Room No. 300
To All Supervisors:
A complete physical inventory count of all departments will be taken Sunday, December 7, 201x, beginning at 8:30 a.m. and continuing until
completed. Employees are to report at 8:15 a.m. to receive their final briefing on their instructions, which are appended hereto.
Within one week prior to Dec 7, supervisors should make sure that merchandise in departments is well organized. All merchandise with the same
stock number should be located together. Merchandise that is damaged should be segregated for separate listing on inventory sheets.
Each count team should be formed and started by a supervisor, and should be periodically observed by that supervisor to assure that instructions
are being complied with in the counting and listing processes.
A block of sequential prenumbered inventory sheets will be issued to each supervisor at 8:00 a.m. December 7, for later issuance to count teams.
Each supervisor is to account for all sheets used, unused, or voided. In addition, each supervisor will be furnished at that time with a listing of
count teams under his or her supervision.
When a count team reports completion of a department, that teams supervisor should accompany a representative of the independent auditors,
XYZ CPA, LLP, in performing the independent auditors test counts. When the independent auditors have cleared a department, the supervisor
responsible should take possession of the inventory count sheets and sign each inventory count sheet. All completed count sheets are to be placed
in numerical sequence and turned over to me when the entire inventory has been completed.
Before supervisors and employees leave the stores Saturday evening, December 6, 201x, they are to make certain that housekeeping is in order
in each department, and that all merchandise bears a price ticket.
If you have any questions about these instructions or any other aspect of the physical inventory, please see me.
Jehan
CFO
November, 25, 201x.
Figure 15-9 An Example of the Auditors Plan for Observing Physical Inventory Count
XYZ CPA, LLP

P.O.Box 888, San Francisco
CA 94132
W/P Ref : IO#1-1
Instructions For Audit Staff on Inventory Observation

We will observe physical inventory taking at the following departments of MNO Company, 5th Street, San Francisco, on December 7, 201x.
Department
Department Manager
Our Staff
San Francisco
San Jose
Oakland
G. Bush
B. Clinton
J. Carter
J. Huang, J. McWilliam
R. Wagner, A. Yuan
J. Kang, D.Frantz
Report to assigned department promptly at 8:00 a.m. Attached are copies of the MNO companys detailed instructions to employees who are to
take the physical inventories and to supervisors who are to be in charge. These instructions appear to be complete and adequate; we should
satisfy ourselves by observation that the instructions are being followed.
All merchandise counted will be listed on prenumbered inventory sheets. We should make test counts of approximately 5% of the inventory
items to ascertain the accuracy of the physical counts. A majority of the counts should be performed on the high-value inventory, as described on
the enclosed listing. Test counts are to be recorded in audit working papers, with the following information include:
Department number
Inventory sheet number
Inventory number
Description of item
Quantity
Selling price per price tag
We should ascertain that adequate control is maintained over the prenumbered inventory sheets issued. Also, we should prepare a listing of the
last numbers used for transfers, markdowns, and markups in the various departments. Inventory sheets are not to be removed from the
departments until we have cleared them; we should not delay this operation.
Each staff members audit working papers should include an opinion on the adequacy of the inventory taking. The working papers should also
include a summary of time incurred in the observation.
No cash or other cutoff procedures are to be performed as an adjunct to the inventory observation.
Ezen
Auditor-In-Charge
December 1, 201x
Table 15-9 Auditors Consideration of the Timing and Extent of Inventory Observation
Situation
a. Client maintains a periodic inventory system and all inventory
counts are done at or near balance sheet date.
b. Client with a perpetual inventory system and
i. all inventory counts are at or near balance sheet date.
ii. inventory is counted on a cycle inventory count basis throughout

the financial year.
Timing and Extent

Auditor must be present on the specific date of inventory counts.
Auditor must perform extensive test count.
Auditor must be present on the specific date of inventory counts.
Auditor must perform extensive test count.
Auditor must be present at some of the inventory counts.

Auditor must perform limited test count.
409
410
iii. inventory is counted on a statistical sampling basis throughout

the financial year.
Auditor must be present at some of the inventory counts.

Auditor must perform limited test count.
Auditor must understand the clients sampling plan and evaluate

its appropriateness.
c. Client performs inventory count at a time when it is impossible or
impractical for the auditor to observe the count.
d. Client requests auditor not to observe the inventory count.
e. Client stored inventory in a public warehouse.
Auditor must perform alternative procedures, such as a direct

confirmation with major vendors.
Auditor must issue either a qualified or disclaimer opinion.
Auditor confirms in writing with the manager of the public

warehouse.
If the inventory represents a significant amount of the current

assets, the auditor must perform supplemental inquiries as follows:
(1) Discussion with the owner of the warehouse about his/her control of
the warehouse personnel.
(2) Review with the owner of the warehouse about his/her control of the
performance of the warehouse personnel.
(3) Observation of physical counts of the inventory whenever practical
and reasonable.
(4) Confirm with lenders about their warehouse receipts that are pledged
as collateral.
Table 15-10 Some Industry Specific Inventory Count Observation Procedures
Inventory Type
Audit Procedure
Outdoor inventories such as lumber, steel coils, and tubes.

Pile inventories such as sugar, coal, and rice.
Inventory items weighed on scales.
Bulk inventories such as liquids, storage tanks, and

chemicals.
Precious inventories such as jewelries, works of art, and

collectibles.
Livestock such as cows, sheep, and chickens.
Check for chalk marking with the help of a specialist or experience

client personnel.
Use engineering estimates or geometric computation.
Check scales for accuracy before and during counts.
Check rebalancing procedures.
Check conversion factors.
Check tanks with dipping or measuring sticks.
Collect samples for analysis.
Check for the quality with the help of a specialist such as an appraiser.
More discussion on using the work of a specialist in Chapter 20.
Use aerial photographs for existence.
Perform test count whenever practical and reasonable.
Figure 15-10 An Example of the Auditor-In-Charges Memorandum on the Observation of Physical

Inventory Count
XYZ CPA, LLP
P.O.Box 888, San Francisco
CA 94132
W/P Ref : IO#1-2
Comments on Physical Inventory Observation
Advance Planning of Physical Inventory.

A physical inventory was taken by the client, MNO Company, on December 7, 201x. One week in advance of this date we reviewed the written
inventory instructions prepared by Jehan, CFO. These instructions were adequate and reflected the experience gained during the physical
inventory count of previous years. The instruction called for a complete closing down of all the departments on December 7, since the preceding
years count had been handicapped by movements of merchandise during the counting process. Training meetings were conducted by Jehan for
all employees assigned to participate in the inventory count; at these meetings the written instructions were explained and discussed.
Observation of Physical Inventory.

We were present throughout the taking of physical inventory on December 7, 201x. Prior to the count, all merchandise had been neatly
arranged, labeled, and separated by type. Two-employee inventory teams were used: one employee counting and calling quantities and
descriptions; the other employee filling in data on the serially numbered inventory tags. As the goods were counted, the counting team tore off
the first count portion of the inventory tag. A second count was made later by another team working independently of the first; this second
team recorded the quantity of its count on the second count portion of the tag.
We made test counts of the numerous items, covering approximately 5% of the total inventory value. These test counts were recorded on our
audit working papers. Our observation throughout the inventory counts indicated that both the first and second counts required by the inventory
instructions were being performed in a systematic and conscientious manner. The careful and alert attitude of employees indicated that the
training meetings preceding the count had been quite effective in creating an understanding of the importance of an accurate count. Before the
second count portions of the tags were removed, we visited all departments in the company with Jehan and satisfied ourselves that all
merchandises had been tagged and counted.
No goods were shipped on December 7. We ascertained that receiving reports were prepared on all goods taken into the receiving department
on December 7. We recorded the serial numbers of the last receiving report and the last shipping advice for the year 201x (see W/P Reference
RR#07). We compared the quantities per the count with perpetual inventory records and found no significant discrepancies.
Quality and Condition of Materials.

Certain obsolete items had been removed from inventory prior to the count and reduced to a scrap carrying value. On the basis of our personal
observation and questions addressed to the supervisors, we have no reason to believe that any obsolete or defective items remained in the
inventory. During the course of inventory observation, we tested the reasonableness of quantities of 40 items, representing 30% of the value of
the inventory, by comparing the quantity on hand with the quantity used in recent months; in no case did we find that the quantity in inventory
exceeded three months normal usage.
Ezen
Auditor-In-Charge
January 5, 201x
Compilation and Pricing

After observing physical inventory count, the auditor performs compilation and pricing procedures to test for the
specific audit objectives of accuracy and valuation and allocation. Table 15-11 describes the auditors procedures for
compilation and pricing.
Table 15-11 Procedures for Compilation and Pricing
Procedures for Compilation and Pricing
Auditors observation of physical inventory count procedures are designed to test for the specific audit objectives of existence and
completeness.
After the inventory count observation is completed, test count items taken by the auditor at the observation are traced to the inventory
listing and then to the perpetual inventory records to test for the specific audit objective of completeness.
The auditor then performs compilation and pricing procedures that are designed to meet the specific audit objectives of accuracy and
valuation and allocation.
The auditor performs compilation procedures to test for the specific audit objective of mathematical accuracy. First, the auditor performs
footing and cross-footing of the inventory listing for accuracy. Next, the auditor tests the following compilation for accuracy:
(1) Items in the perpetual records but not owned are excluded from the inventory compilation.
(2) Items on hand are counted and included in the inventory compilation.
(3) Items consigned-out or stored in outside warehouses (items owned but not on hand) are included in the inventory compilation.
(4) Items in transit (items purchased and recorded but not received) are added to the inventory count and included in the inventory
compilation.
(5) Items on hand already sold (but not delivered) are not counted and are excluded from the inventory compilation. For example, bill-and
hold items.
(6) Items consigned-in (items on hand but not owned) are excluded from the inventory compilation.
The auditor performs pricing procedures to test for the specific audit objective of valuation and allocation. First, the pricing for each item
(i.e., the unit-price) is tested by multiplying its quantity with price. Next, the unit-price of each item is tested for lower-of-cost-or-market
valuation. Cost of each item is tested by comparing its unit-price to the purchase price for raw materials and to standard cost for in-progress
and finished goods. The market price of each item is tested by examining the clients catalogue and actual sales price in the subsequent period.
In addition, obsolete or slow-moving items (e.g., old expiration date, dust, or rust items) noted by the auditor at the inventory count observation
or through inquiry of warehouse personnel are priced at their residual value, if any.
The auditor can perform the above tests automatically by using computer-assisted-audit-tests techniques (CAATs).
411
412
Table 15-12 Further Discussion on TOC for Cost Accounting System
Further Discussion on TOC for Cost Accounting System

Ordinarily, the auditor encounters a wide variety of a clients cost accounting system. The cost accounting records may be controlled
by general ledger accounts or operated independently of the general accounting system. Since the cost accounting systems vary
widely, even in the same industry, the auditors procedures for a cost accounting system must be designed to fit the specific
circumstances encountered.
In any cost accounting system, the three elements of manufacturing cost are direct materials costs, direct labor costs, and
manufacturing overhead. Cost accounting systems may accumulate either actual costs or standard (expected) costs according to
processes or jobs (job or process cost systems). The auditors TOC of the clients cost accounting system are designed to determine
that costs are appropriately valuated and allocated to specific jobs or processes. To achieve this specific audit objective, the auditor
tests the propriety of direct materials quantities and unit costs, direct labor-hours and hourly rates, and overheard rates and allocation
bases. Quantities of direct materials charged to jobs or processes are vouched to materials requisitions, and unit materials costs are
traced to the raw materials perpetual inventory records or purchase invoices. The auditors also examine job time tickets or time
summaries supporting direct labor-hour accumulations and trace direct labor hourly rates to union contracts or individual employee
personnel files.
The auditor should recognize that a variety of methods are generally accepted for the application of manufacturing (factory) overhead
to inventories. A predetermined rate of factory overhead applied on the basis of machine-hours, direct labor dollars, direct laborhours, or some similar basis is used by a variety of manufacturing clients. FAEB No.151, Inventory Costs An Amendment to ARB
No. 43, clarifies that variable manufacturing costs should be allocated to products on the basis of the actual level of activity. Fixed
manufacturing overhead, on the other hand, should be allocated based on the normal capacity of the production facility. In addition, a
distinction between manufacturing overhead and overhead costs pertaining to selling or general administration must be made under
the GAAP because selling expenses and general administrative expenses are written off in the period incurred. Typically, the auditor
analyses a number of the manufacturing overhead subsidiary ledger accounts and verifies the propriety of the charges thereto.
If standard (expected) costs are in use, the auditor should compare them with actual costs for representative items and to ascertain
whether the standards reflect current materials and labor usage and unit costs. The composition of factory overhead, the basis for its
distribution by department and product, and the effect of any change in basis during the year should be reviewed. The standard costs
of selected products should be verified by testing computations, extensions, and footings and by tracing charges for labor, materials,
and overhead to original sources.
The auditors should pay attention to any changes in cost methods of the clients cost accounting system during the year, and the
effect of such changes on the cost of sales. Close attention should also be given to the methods of summarizing costs of completed
products and to the procedures for recording the cost of partial shipments.
If the client has supply contracts with the U.S. government agencies, the auditors should determine whether standards issued by the
Cost Accounting Standards Board were complied with. Cost accounting standards issued to date have dealt with such matters as
consistency in estimating, accumulating, allocating, and reporting costs and depreciation of plant assets.
15-1
For control purposes, the quantities of raw materials ordered may be omitted from the copy of the purchase order that is
a. forwarded to the accounting department.
b. retain in the purchasing department file.
c. return to the requisitioners.
d. forwarded to the receiving department.
15-2
The objectives of internal control for an inventory cycle are to provide assurance that transactions are properly executed and recorded
and that
a. Independent internal verification of activity reports is established.
b. Transfers to the finished goods department are documented by a completed production report and a quality control
report.
c. Production orders are prenumbered and signed by a supervisor.
d. Custody of work in process and finished goods is properly maintained.
15-3
Which of the following would most likely be an internal control procedure designed to detect errors and fraud concerning the custody
of inventory?
a. Periodic reconciliation of work in process with job cost sheets.
b. Segregation of functions between general accounting and cost accounting.
c. Independent comparisons of finished goods records with counts of goods on hand.
d. Approval of inventory journal entries by the storekeeper.
15-4
Which of the following control procedures would be most likely to assist in reducing the control risk related to the existence or
occurrence of manufacturing transactions?
a. Perpetual inventory records are independently compared with goods on hand.
b. Forms used for direct materials requisitions are prenumbered and accounted for.
c. Finished goods are stored in locked limited-access warehouse.
d. Subsidiary ledgers are periodically reconciled with inventory control accounts.
15-5
An auditors tests of controls over the issuance of raw materials to production would most likely include?
a. Reconciliation of raw materials and work in process perpetual inventory records to general ledger balance.
b. Inquiry of the custodian about the procedures followed when defective materials are received from vendors.
c. Observation that raw materials are stored in secure areas and that storeroom security is supervised by a responsible
individual.
d. Examination of materials requisitions and reperformance of client controls designed to process and record issuances.
15-6
Which of the following internal control procedures is most likely to address the completeness assertion for inventory?
a. The work in process account is periodically reconciled with subsidiary records.
b. Employees responsible for custody of finished goods do not perform the receiving function.
c. Receiving reports are prenumbered and periodically reconciled.
d. There is a separation of duties between payroll department and inventory accounting personnel.
15-7
In tests of controls for managements assertion of valuation or allocation, an auditor would be most likely to learn of slow-moving or
obsolete inventory through
a. inquiry of sales personnel.
b. inquiry of store personnel.
c. physical observation of inventory.
d. review of perpetual inventory master file.
15-8
Which of the following control procedures would most likely be used to maintain accurate perpetual inventory records?
a. Independent storeroom count of goods received.
b. Periodic independent comparison of records with goods on hand.
c. Periodic independent reconciliation of control and subsidiary records.
d. Independent matching of purchase orders, receiving reports, and vendors invoices.
413
414
15-9
The auditor tests the quantity of materials charged to work-in-progress by tracing these quantities to (Hint: Tracing in
general sense, not for specific objective of completeness)
a. material requisitions.
b. receiving reports.
c. perpetual inventory records.
d. cost ledgers.
15-10
A useful starting point for understanding the audit clients inventory is for the auditor to
a. read the AICPAs Industry Audit Guide.
b. review accounting procedures covering special problems, such as gas and oil accounting, or lease-purchase agreements.
c. read the clients Accounting Manual on inventory.
d. tour the clients facility.
15-11
Master files, worksheets, and reports that accumulate material, labor, and overhead as the costs are incurred are
a. operation records.
b. perpetual inventory records.
c. cost accounting records.
d. financial accounting records.
15-12
In obtaining an understanding of a manufacturing clients internal control concerning inventory balances, an auditor most likely would
a. analyze the liquidity and turnover ratios of the inventory.
b. perform analytical procedures designed to identify cost variances.
c. review the clients descriptions of inventory policies and procedures.
d. perform test counts of inventory during the clients physical count.
15-13
Which of the following internal control procedures most likely would be used by a client to maintain accurate inventory
records?
a. Perpetual inventory records are periodically compared with the current cost of individual inventory items (i.e. check for
lower of cost or market)
b. A just-in-time inventory ordering system keeps inventory levels to a desired minimum.
c. Requisitions, receiving reports, and purchase orders are independently matched before payment is approved.
d. Periodic inventory counts are used to adjust the perpetual inventory records.
15-14
When auditing merchandise inventory at year-end, the auditor performs a purchase cutoff test to obtain evidence that
a. All goods purchased before year-end are received before the physical inventory count.
b. No goods held on consignment for customers are included in the inventory balance.
c. No goods observed during the physical count are pledged or sold.
d. All goods owned at year-end are included in the inventory balance.
15-15
In tests of balances, inquiries of warehouse personnel concerning obsolete or slow-moving inventory items provide assurance about
managements assertion of
a. completeness.
b. existence or occurrence.
c. presentation and disclosure.
15-16
Which of the following audit procedures would probably provide the most reliable evidence concerning the entitys assertion of rights
and obligations related to inventory?
a. Tracing of test counts noted during the entitys physical count to the entitys summarization of quantities.
b. Inspection of agreements to determine whether any inventory is pledged as collateral or subject to any liens.
c. Selection of the last few shipping advices used before the physical count and determination of whether the shipments
were recorded as sales.
d. Inspection of the open-purchase-order file for significant commitments that should be considered for disclosure.
15-17
Periodic or cycle counts of selected inventory items are made at various times during the year rather than via a single inventory count
at year-end. Which of the following is necessary if the auditor plans to observe inventory at interim dates?
a. Completer recounts are performed by independent teams.
b. Perpetual inventory records are maintained.
c. Unit cost records are integrated with production-accounting records.
d. Inventory balances are rarely at low levels.
15-18
After accounting for a sequence of inventory tags, an auditor traces a sample of tags to the physical inventory listing (or inventory
sheet) to obtain evidence that all items
a. included in the inventory listing/sheet have been counted.
b. represented by inventory tags are included in the inventory listing/sheet.
c. included in the inventory listing/sheet are represented by inventory tags.
d. represented by inventory tags are bona fide.
15-19
When an auditor tests a clients cost accounting records, the auditors tests are primarily designed to determine that
a. quantities on hand have been computed based on acceptable cost accounting techniques that reasonable approximate
actual quantities on hand.
b. physical inventories are in substantial agreement with book inventories.
c. the internal controls are in accordance with generally accepted accounting principles and are functioning as planned.
d. costs have been properly assigned to finished goods, work-in-process, and cost of goods sold.
15-20
When auditing a public warehouse, which of the following TOB procedures is the most important audit procedure with
respect to disclosing unrecorded liabilities?
a. Observation of inventory.
b. Review of outstanding receipts.
c. Inspection of receiving and issuing procedures.
d. Confirmation of negotiable receipts with holders.
15-21
Which of the following is true regarding the taking of physical inventory (physical inventory count)?
a. Client has the responsibility for setting up the procedures for taking an accurate physical inventory and actually making
and recording the counts.
b. Client has the responsibility for setting up the procedures and auditor has the responsibility for making and recording the
counts.
c. Auditor has the responsibility for setting up the procedures for taking an accurate physical inventory and actually making
and recording the counts.
d. Auditor has the responsibility for setting up the procedures and client has the responsibility for following the procedures
when actually making and recording the counts.
15-22
Which of the following inventory situations would most likely require special audit planning by the auditor?
a. Some inventory items do not bear identification numbers.
b. Depreciation methods used for some inventory items differ from those used on the books.
c. Inventory items are comprised of precious stone.
d. Inventory items costing less than $500 are expensed even though their expected life exceeds one year.
15-23
The primary objective of an auditors observation of a clients physical inventory count is to

a. discover whether a client has counted a particular inventory item or group of items.
b. obtain direct knowledge that the inventory exists and has been properly counted.
c. provide an appraisal of the quality of the merchandise on hand on the day of the physical count.
d. allow the auditor to supervise the conduct of the count so as to obtain assurance that inventory quantities are accurate.
15-24
A common inventory observation procedure is to be alert for items that are damaged, rust- or dust-covered, or located in
inappropriate places. The specific audit objective being achieved by this procedure is
a. classification.
c. valuation and allocation.
d. right.
15-25
When there are no perpetual inventory files and the inventory is material,
a. a complete physical inventory must be taken by the client near year-end.
b. the auditor will have to perform the inventory count and determine valuation instead of the client.
c. the auditor is relieved of responsibility for observing inventory counts but still must perform test count.
d. inventory count cannot be observed, so the auditor must issue a disclaimer.
15-26
A major difficulty in the verification of inventory cost records is determining the reasonableness of
a. direct labors hourly rate.
b. raw materials per unit cost.
c. cost allocations.
d. all three of the above.
415
416
15-27
Which of the following analytical procedures would be most helpful in alerting the auditor to the possibility of obsolete
inventory?
a. Compare gross margin percentage with previous years.
b. Compare unit costs of inventory with previous years.
c. Compare inventory turnover ratio with previous years.
d. Compare current year manufacturing costs with previous years.
15-28
Finished goods perpetual inventory master files include the same type of information as raw materials perpetual but are
a. considerably more complex if costs are included along with units.
b. simpler since materials, labor, and overhead have been combined into one total value.
c. considerably more complex because of the paper trail that is needed in addition to the computer records.
d. simpler because the cost accounting system is in effect and well defined.
15-29
Audit test results of which other cycle, in addition to the audit test results of inventory cycle will affect the TOB procedures
for inventory?
a. The revenue cycle.
b. The expenditure cycle.
c. The payroll cycle.
d. All three of the above.
15-30
While observing a clients annual physical inventory, an auditor recorded test counts for several items and noticed that
certain test counts were higher than the recorded quantities in the clients perpetual inventory records. This situation could
be the result of the clients failure to record
a. purchase discounts.
b. purchase returns.
c. sales.
d. sales returns.
15-31
When auditing inventories, an auditor would least likely verify that

a. the financial statement presentation of inventory is appropriate.
b. damaged goods and obsolete items have been properly accounted for.
c. all inventory owned by the client is on hand at the time of the count.
d. the client has used proper inventory pricing.
15-32
Which of the following TOB procedures most likely would provide assurance about a manufacturing clients inventory
Valuation and allocation?
a. Testing the clients computation of standard material costs, labor costs, and overhead.
b. Obtaining confirmation of inventories pledged under loan agreements.
c. Reviewing shipping and receiving cutoff procedures for inventories.
d. Tracing test counts to the clients inventory listing.
15-33
A client maintains perpetual inventory records in both quantities and dollars. If the assessed level of control risk is
extremely high, an auditor would probably
a. decrease the extent of tests of controls of the inventory cycle.
b. request the client to schedule the physical inventory count at the end of the year.
c. request the client to schedule the physical inventory counts several times during the year.
d. apply gross profit tests to ascertain the reasonableness of the physical counts.
15-34
Which of the following TOB procedures would provide the most reliable evidence concerning the managements assertion
of rights and obligations relating to inventories?
a. Inspect the open purchases order file for significant commitments that should be considered for disclosure.
b. Inspect agreements to determine whether any inventory is pledged as collateral or subject to any liens.
c. Select the last few shipping advices used before the physical count and determine whether the shipments were recorded
as sales.
d. Trace test counts noted during the clients physical count to the clients summarization of quantities.
15-35
An auditor selected items for test counts while observing a clients physical inventory. The auditor then traced the test
counts to the clients inventory listing. This procedure would most likely obtain evidence concerning management
assertion of
a. rights and obligations.
c. completeness.
15-36
An auditor would make inquiries of production and sales personnel concerning possible obsolete or slow-moving inventory
to support managements financial statement assertion of
d. presentation and disclosure.
15-37
To gain assurance that all inventory items in a clients inventory listing schedule are valid, an auditor most likely would
a. trace inventory tags noted during the auditors observation to items listed in the inventory listing schedule.
b. inventory tags noted during the auditors observation to items listed in receiving reports and vendors invoices.
c. vouch items listed in the inventory listing schedule to inventory tags and the auditors recorded count sheets.
d. trace items listed in receiving reports and vendors invoices to the inventory listing schedule.
15-38
An auditor concluded that no excessive costs for an idle plant were charged to inventory. This conclusion most likely
related to the auditors objective to obtain evidence about the financial statement assertions regarding inventory, including
presentation and disclosure and
a. valuation and allocation.
b. completeness.
d. right and obligations.
15-39
Which of the following auditing procedures most likely would provide assurance about a manufacturing clients inventory
valuation and allocation?
a. Testing the clients computation of standard overhead rates.
b. Obtaining confirmation of inventories pledged under loan agreement.
c. Reviewing shipping and receiving cutoff procedures for inventories.
d. Tracing test counts to the clients inventory listing.
15-40
An auditor performs the inventory compilation and pricing procedures to primarily test the specific audit objective of:
a. existence and completeness
b. valuation and allocation, and understandability.
c. accuracy and valuation.
d. completeness and rights and obligations.
15-41
Which of the following is not a correct statement pertaining to the auditors compilation tests on inventory?
a. Items on hand are counted and included in the inventory compilation.
b. Items in transit (items purchased and recorded but not received) are added to the inventory count and included in the
inventory compilation.
c. Items in the perpetual records but not owned are included in the inventory compilation.
d. Items consigned-out or stored in outside warehouses (items owned but not on hand) are included in the inventory
compilation.
417
418

15-1 d. 15-2 d. 15-3 c. 15-4 c. 15-5 d. 15-6 c. 15-7 d. 15-8 b. 15-9 a. 15-10 d. 15-11 c.
15-12 c. 15-13 d. 15-14 b. 15-15 d. 15-16 b. 15-17 b. 15-18 b. 15-19 d. 15-20 d. 15-21 a.
15-22 c. 15-23 b. 15-24 c. 15-25 a. 15-26 c. 15-27 c. 15-28 a. 15-29 d. 15-30 d. 15-31 c.
15-32 a. 15-33 b. 15-34 b. 15-35 c. 15-36 a. 15-37 c. 15-38 a. 15-39 a. 15-40 c. 15-41 c.

Simulation Question 15-1 is an adaptation with permission from a case by Knapp, M.C. and C.A. Knapp in the Issues in Accounting Education , a
Background
In 1957, a 27-year-old pharmacist, Jack Robinson, founded Perry Drug Stores (hereafter, PDS) in Detroit, Michigan. PDS grew
rapidly under Robinsons leadership. Robinson incorporated his business in 1980 and later took the company public, listing its stock on the New
York Stock Exchange. By 1994, PDS operated more than 200 retail outlets, had a workforce of approximately 5,000 employees, and boasted
annual revenues of $700 million.
Although the 14th largest drug retailer in the United States by the early 1990s, PDS could not compete with the much larger
nationwide drug store chains. Walgreen, Rite Aid, and other nationwide drug retailers benefited from economies of scale unavailable to PDS. For
example, PDSs competitors invested millions of dollars in state-of-the-art inventory management systems that linked these companies to their
major suppliers via electronic data interchange (EDI) networks. These systems allowed the nationwide chains to maximize sales while
minimizing inventory-related carrying costs, including losses due to inventory obsolescence.
BY comparison, PDS relied largely upon outdated inventory management and control systems. For example, PDSs retail stored did
not have point-of-scale scanning devices at sales terminals. Unlike major competitors, PDS had not installed computer-based logistics systems to
ensure timely and accurate deliveries to retail stores from the companys merchandise distribution centers. PDSs inability to monitor precisely
the daily inventory movements and balance complicated the efforts of company executives to evaluate the results of chain-wide sales promotions
and other special programs. At the store level, the absence of detailed inventory data forced the companys store managers to rely heavily upon
their own intuition in making critical decisions, such as which products to stock in their individual stores.
PDSs inventory control problems were magnified greatly in the early 1990s. To compete more effectively with the national drug store
chains, PDS rapidly expanded its product line in the front end of its stores to include a wide array of cosmetics, personal beauty treatment
products, and home office supplies. One company executive noted that by 1991, PDS retail outlets stocked approximately 200 shampoos, more
than 100 hair sprays, and two dozen mousses. In 1992, PDS inventory problems contributed to the companys loss of position as the number-one
drug store chain in the metropolitan Detroit area, which easily ranked as PDSs largest sales region. In that year, Arbor Drugs, Inc. replaced PDS
as the drug store chain with the largest total sales in Detroit.
A former PDS executive who accepted a position with one of the large nationwide drug store chains in the early 1990 commented on
the stark differences between the nationwide chain and PDS. The executive noted that PDS lacked sufficient funds to invest in technology needed
to effectively and efficiently manage a large retail business. He also observed that leaving PDS and accepting a position with the nationwide
chain was comparable to going from the Dark Ages to the 21 st Century.
In 1992, PDSs financial fortunes took a sharp turn for the worse when company executives discovered an inventory shortage of
approximately $20 million, a shortage that went unreported in the companys 1992 financial statements. The following year, PDS wrote off the
inventory shortage, which contributed to the company suffering a huge loss. Late in 1994, Rite Aid, the nations largest drug retailer with 2,500
stores and $4 billion in annual revenues, purchased PDS for $132 million.
You should access Data File 15-1 in iLearn for Table 1, which presents selected key financial data of PDS for the period 1989-
1993.
PDSs Inventory Problems
PDS used a periodic inventory system and both the LIFO and FIFO costing methods. In a typical year, PDS applied the LIFO method
to approximately 70 percent of its total inventory and the FIFO method to the remainder. Throughout the early 1990s, PDS retained an outside
firm to count the inventory of each of its stores. The firm performed these counts in regular cycles, meaning it counted the same group of PDS
stores at approximately the same point each year. Following the completion of each cycle count, PDS adjusted the given stores recorded
inventory balances to agree with the physical inventory results and recorded a collective book-to-physical inventory adjustment for the general
ledger inventory account at corporate headquarters. Between the annual physical inventory counts, PDS used the gross profit method to estimate
each stores inventory and to arrive at a collective inventory figure (estimate) for the company as a whole as follows:
PDS would add to the amount of the [recorded] beginning inventory the actual cost of its goods purchased through its accounts payable system
(cost of goods acquired for sale). PDS would then reduce the inventory by an estimate of the cost of goods sold calculated using the estimated
gross profit margin. PDS included the estimated inventory balance on its general ledger, until the actual inventory was verified through a new
physical count.
Arriving at a reasonable estimated gross profit margin is the most critical step in applying the gross profit method. If an entitys
estimated gross profit margin varies significantly from actual, the resulting estimates of cost of sales and inventory will be unreliable. The
estimates yielded by the gross profit method can be made more reliable by applying an estimated gross profit margin to each major inventory
group. However, PDS used an overall estimated gross profit margin in applying this method.
PDSs management regularly reviewed the estimated gross profit margin used in applying the gross profit method. Among other
factors, the companys management considered changes in merchandising plans and the year-to-date results of its cycle inventory counts during
these reviews. PDS typically revised its estimated gross profit margin more than once per year.
PDSs cycle counts in early fiscal 1992 revealed much larger differences than usual between the book inventories and inventory
values determined by physical inventory counts. (Recognize that the book inventories reflected estimates resulting from yearlong application of
the gross profit method.) By the end of the second quarter of of fiscal 1992, these differences totaled $7.6 million. Following the completion of
all cycle counts for fiscal 1992, the collective difference amounted to more than $20 million. This figure alarmed PDSs management since it
represented approximately 14 percent of the companys collective book inventory of $140.2 million.
Unlike in previous years, as fiscal 1992 progressed, PDS did not immediately adjust the corporate inventory account to recognize the
book-to-physical differences uncovered by the cycle inventory counts. PDSs management believed the large discrepancies between stores book
and physical inventories were not reasonable. Management therefore created a suspense account to which it transferred the differences
between given stores book and physical inventories. That is, after adjusting a stores book inventory to agree with its physical inventory results,
PDS transferred the difference to a general ledger account referred to as the Store 100 inventory account. (Store 100 was a fictitious store.)
419
420
PDSs management included Store 100s inventory balance in the total inventory figure reported for the company in its interim financial
statements for 1992. Again, by the end of fiscal 1992, the balance of the Store 100 inventory account exceeded 20 million.
Shortly after the 1992 cycle counts began revealing large inventory shortages, PDSs CFO, Jerry Stone, initiated a company-wide
investigation to uncover the source of the shortages. Stone retained Arthur Andersen & Co., PDSs independent audit firm, to perform a study to
determine whether systems problems were the cause of the discrepancy. This study was carried out by members of Arthur Andersens
computer-risk-management group, none of whom were involved in the annual audits of PDS. When that study suggested that computer
breakdowns were not responsible for the inventory shortages, Stone hired private detectives. These detectives, along with PDSs internal auditors,
searched for evidence of large-scale inventory thefts. These efforts also failed to reveal the source of the inventory shortage. Finally, Stones
subordinates performed an intensive study of a PDS store that had recently installed a point-of-sale system. The data collected by that stores
point-of-sales system allowed Stone to more accurately assess the companys actual gross profit margins on the products it sold. Although PDS
did not publicly reveal the data, they apparently failed to convince Stone that the estimated gross profit margin being applied by the company was
unreasonable.1
Input from Arthur Andersen & Co
SEC investigate PDS
Before becoming PDSs CFO, Stone served for 12 years as an audit partner with Arthur Andersen & CO (hereafter, AA). Quite
naturally, then, Stone relied heavily on his contacts at this firm in deciding how to resolve PDSs 1992 inventory crisis.
Richard Valade, an AA audit partner, supervised the annual audits of PDS from 1984 through 1987 and again from 1991 through
1993. Stone notified Valade of the inventory shortage before AA began its audit of PDSs 1992 financial statements. In September 1992, shortly
after learning of the inventory shortage, Valade and a subordinate prepared a General Risk Analysis (GRA) memorandum for the 1992 PDS
audit. AA prepared this document for audit engagements to identify the financial statement items requiring particular attention during each
engagement. A GRA memo also identified the apparent overall audit risk (AR) posed by the engagement and the planned materiality level for the
engagement.
The GRA memo for the 1992 PDS audit indicated that AA expected an overall moderate audit risk for that engagement. This
assessment reflected that auditor expected misstatements but had reason to believe they were not likely to be material in relation to the financial
statements. AA established an overall materiality level of $700,000 for the engagement. Specifically, total misstatements that reduced PDS net
income by $700,000 or more would be considered material.
During the 1992 PDS audit, AA applied a wide range of audit tests to the clients inventory, tests more extensive than those normally
performed on PDSs inventory. AA applied many of these tests expressly to determine the source of the large inventory shortage revealed by
PDSs 1992 cycle inventory counts. You should access Data File 15-1 in iLearn for Table 2, which lists the key inventory audit procedures
completed by AA during the 1992 PDS audit.
AAs 1992 inventory audit procedures failed to uncover the source of the large inventory shortage. Before AA completed the 1992
PDS audit, PDSs management decided not to write off the $20.3 million balance of the Store 100 inventory account. Instead, it chose to include
the $20.3 million in the dollar amount reported for inventory in the companys 1992 balance sheet. PDS executives presented this decision to the
companys board of directors during a meeting that Valade attended.
Before the December 1992 meeting with Perrys Board of Directors, Valade discussed the large inventory shortage with several fellow
AA partners, including the Regional Practice Director. Valade asked two of these partners to attend the meeting with PDSs Board. During the
meeting, Valade did not object to the Boards decision to ignore the apparent inventory shortage in preparing the companys financial statements.
The minutes of that meeting showed that Valade did not object to include the Store 100 inventory as an asset on PDSs balance sheet
and that he would sign an unqualified opinion. The minutes also reflect that Valade recommended that PDS conduct a simultaneous chain-wide
physical inventory count as soon as possible to discover the reasons for the discrepancy.
PDS filed its fiscal 1992 10-K with the SEC in late 1992. PDSs income statement included in the 10-K reported a net income of $8.3
million. Your should access Data File 15-1 in iLearn for Table 1, which presents selected PDS financial data from 1989 to 1993. Had PDS
written off the $20.3 million balance of the Store 100 inventory account, the company would have reported a net loss of approximately $6 million
for the fiscal year of 1992. Also included in the 10-k was AAs unqualified audit opinion on PDSs 1992 financial statements, an opinion signed
by Valade on December 15, 1992.
The management of PDS followed the recommendation of Valade and took a companywide physical inventory in the spring of 1993.
That physical inventory confirmed the large inventory shortage discovered by the company in fiscal 1992. Near the end of fiscal 1993, PDSs
management decided to write off the balance of the Store 100 inventory account. PD included this write-off in a $33.4 million fourth-quarter
adjustment. Since management deemed that the $20.3 inventory write-off resulted from a change in estimate, it did not report the write-off
separately in its fiscal 1993 income statement, nor did the company restate its 1992 financial statements for the item. Valade did not object to
PDSs financial statement treatment of the large inventory adjustment.
You should access Data File 15-1 in iLearn for Table 3, which presents a paragraph from the Managements Discussion &
Analysis (MD&A) section of PDSs 1993 annual report that disclosed the inventory adjustment.
While reviewing the MD&A section of PDSs 1993 10-K, the SEC discovered the $33.4 million adjustment recorded by the company
during the fourth quarter of fiscal 1993. In July 1994, after discussing this matter with PDSs management, the SEC insisted that the company
restate its 1992 and 1993 financial statements. The SEC required PDS to treat the $20.3 million write-off of the Store 100 inventory account as a
correction of an error. This treatment increased PDSs cost of sales for fiscal 1992 by that amount, while decreasing 1993s cost of sales by the
same amount. You should access Data File 15-1 in iLearn for Table 4, which presents the key financial data affected by PDSs restatement
of its 1992 and 1993 financial statements, and Table 5, which contains a portion of the financial statement footnote PDS included in its
1994 10-K to disclose the restatement of its 1992 and 1993 financial statements.
1
During late 1992, PDS began installing a chain-wide, electronic perpetual inventory system. Such a system allows a business to update its
inventory records instantaneously when employees enter on a computer terminal a sale, sales return, purchase, or other transaction affecting
inventory. This installation was completed in late 1993. Since PDSs major competitors had previously installed such systems, PDSs executives
realized that to compete effectively with those firms, they had to obtain the cost savings and strategic benefits yielded by an electronic inventory
system. The new inventory system included point-of-sale terminals, electronic surveillance technology to detect theft, and a computer-based
distribution network to provide for timely and accurate shipments from PDSs warehouses to its retail outlets. Most important, the new electronic
inventory system allowed PDSs store managers to monitor closely the sales volume of individual products.
Following PDSs restatement of its 1992 and 1993 financial statements, the SEC launched an investigation of the company. The
investigation centered on the circumstances surrounding PDSs decision not to write off the balance of the Store 100 inventory account in fiscal
1992. In 1998, the SEC issued two enforcement releases reporting the results of that investigation.
The SECs firsts enforcement release (SEC 1998a) focused on Stone, the former AA audit partner who served as PDSs CFO during
the early 1990s. In this release, the SEC chastised Stone for signing PDSs 1992 Form 10-K: by signing PDSs 1992 Form 10-K, Stone caused
PDS to file with the commission financial statements that did not accurately reflect the value of PDSs inventory (SEC 1998a). The SEC
publicly sanctioned Stone for failing to correct PDSs 1992 financial statements. This sanction ordered Stone to cease and desist from causing
any violation and future violation of federal securities laws.
The SECs second enforcement release (SEC 1998b) focused on Valade, PDSs audit engagement partner during the early 1990s. This
release criticized Valade for allowing PDSs management to include the balance of the Store 100 inventory account in the companys year-end
inventory for fiscal 1992.
According to the SEC, Valade overlooked a key auditing precept during the 1992 audit. Auditing standards AU 500 explicitly state
that evidence obtained by physical examination is more persuasive than evidence produced by indirect tests. During the 1992 audit, Valade
collected and reviewed significant physical evidence indicated that the companys inventory was overstated. Nevertheless, Valade eventually
chose to rely on the results of analytical tests that suggested the data produced by the physical inventory counts were unreliable. These analytical
procedures consisted principally of AAs tests of the gross profit margins actually realized by a small sample of stores, tests that suggested that
the estimated gross profit margin used by PDS in applying the gross profit method was reasonable.
Despite Valades consultations with his partners and the additional audit procedures he performed, he nevertheless failed to obtain
sufficient appropriate evidential matter to resolve the inventory discrepancy issue. Valade failed to either: (a) require PDS to reconcile the
recorded inventory and the physical inventory, and record the proper adjustment to the books and records; (b) discredit either the recorded
inventory or the physical inventory and require PDS to adjust the books and records accordingly; (c) issue a qualified opinion; or (d) refrain from
issuing an audit opinion until the matter was resolved.
The SEC publicly censured Valade for his conduct during the 1992 PDS audit. This censure simply required Valade to comply in the
future with all applicable practice requirements for auditors of SEC registrants. Both Valade and Stone consented to the SEC sanctions imposed
n the without admitting or denying the federal agencys reported findings.
Required
Assess Data File 15-1 in iLearn for Tables 1 through to 5 on financial information to answer the following questions.
1. Develop an example to illustrate how using an improper gross profit margin in applying the gross profit method can significantly distort a
companys reported inventory and cost of goods sold. Use the framework below to develop your example.
Beginning Inventory
Purchase
Goods Available for Sale
Sales
Gross Profit ($ xxx X number of %)
Cost of Goods Sold ( ? %)
Estimated Ending Inventory
$ xxx
xxx
xxx
$ xxx
xxx
xxx
$ xxx
=====
2. Identify specific misrepresentations in PDSs 1992 financial statement data and related financial ratios that resulted from the companys failure
to write off the Store 100 inventory balance. Were these misrepresentations material? Explain. Use the frameworks below to identify specific
misrepresentations.
i. PDSs five-year trend in net income:
1993
1992
1991
1990
1989
Reported Net Income

Actual Net Income
ii. The effect of the inventory error had on PDSs other key financial statement items:
1993
1992
Cost of Sales
Inventory
Current Assets
Total Assets
Stockholders Equity
iii. The effect of the misstated inventory and cost of sales on PDSs key financial ratios for the five-year period 1989-1993.
1993
Current Ratio
Reported:
Actual:
Age of Inventory
Reported:
1992
1991
1990
1989
421
422
Actual:
Gross Profit Percentage
Reported:
Actual:
Profit Margin Percentage
Reported:
Actual:
Return on Assets
Reported:
Actual:
Return on Equity
Reported:
Actual:
3. Access Table 2 of Data File 15-1 in iLearn and critically evaluate the TOB inventory audit procedures completed by AA during the 1992 PDS
audit. Would those procedures assure sufficient appropriate evidence concerning PDSs inventory balance? What additional TOB procedure
should AA perform concerning PDSs inventory balance?

Simulation Question 15-2 is an adaptation with permission from a case by Cohen, J. R., G. Krishnamoorthy, and A. M. Wright in the Issues in
Data Data, Inc
Prior and Current Years Audits
Board of Directors
Audit Committee
Data Data, Inc. (hereafter, DD) is a global high-technology, publicly traded corporation in the data networking industry. The
Company, founded in 1990, is headquartered in the Silicon Valley, San Jose and employs approximately 2,000 people, maintaining operations in
ten countries.
DD creates hardware and software solutions that link computer networks. In the last few years, the Internet has spurred the growth of
the data networking industry into a multibillion dollar global business. DDs primary customers are computer equipment manufacturers, Internet
service providers, public and private corporations, educational institutions, and long-distance companies. The segments of the computer industry
in which DD operates continue to be very competitive,. Primary competitive factors are product performance, technology, customer service,
product availability, and price.
DD is a medium-sized client in your CPA firm with significant billable hours and audit fees. David Driver, the partner-in-charge of
the audit of DD, has audited DD for the past eight years and has issued standard unqualified reports in each of those years. A review of prior
years work papers indicated that a few, but not an excessive number of, material adjusting entries were required. The client has always been
cooperative in handling these adjusting entries. A review of current standards revealed that there were no significant changes in any accounting or
auditing standards that would affect this years audit.
Management has a positive attitude about developing a reliable control environment and relies on the information generated from the
accounting system to make management decisions. As with most public companies, there is pressure for management to meet analysts earnings
forecast and this pressure is greater for companies in the technology industry due to the high growth expectation from the investing public.
Further, as is common, management bonuses are tied to earnings.
The companys board of directors has taken the view that it is managements job to set the direction for the company and to formulate
strategies. Although the board formally approves major strategic decisions of management, they do not actively participate in helping the
company cope with environment environmental uncertainties or provide strategic direction and vision to the companys business. The Board has
taken a hands-off approach with management decisions and about the strategic fits of new products and markets. For instance, the company
hired an outside consulting firm that recommended that a Balanced Scorecard approach be implemented to help improve corporate performance.
This approach emphasizes the need to look at multiple perspectives when evaluating performance. The four perspectives (Financial, Customer,
Internal Operations, and Innovation and Learning) include both a financial and nonfinancial strategic viewpoint. The Board however, viewed the
Balance Scorecard approach as an operational issue and delegated the decision to adopt and implement the approach to the senior management of
the company.
The company has a tradition of having a majority of outside (nonexecutive) Board of Directors that oversees managements activities
closely. For example, the Board has the power to conduct independent investigations of unethical behavior. There are large institutional holdings
of the companys stock including CALPERS (California Public Employees Retirement System) and TIAA-CREF (Teachers Insurance and
Annuity Association-College Retirement Equities Fund). Both of these funds have a tradition of being at the forefront of monitoring the
governance of corporations in which they have a significant investment. This has resulted in an explicit focus on ensuring that managements
decisions are aligned with protecting shareholder interests and rights. For example, the chair of the Board is an independent outsider and all
members of the Compensation Committee are independent outsiders. The Board has also invested significant power in the Audit Committee to
fulfill its charter. It is very supportive of the Audit Committees role in ensuring sound financial reporting policies and a strong control
environment for the company.
Based on changes implemented in light of the report issued by the Blue Ribbon Committee (1999) and the regulations enacted in the
Sarbanes-Oxley Act (U.S. House of Representatives 2002), audit committees must now meet a number of requirements that more clearly define
their objectives as well as the composition of the committee. In light of these changes, the Audit Committee (hereafter, AC) of the company has
adopted a formal written charter that is similar to other firms in the industry. Further in accordance with the Sarbanes-Oxley Act, the AC also
recommends the appointment/reappointment of the companys outside auditors and determines the appropriateness of their fees. The AC
currently consists of Ms. Zheng, Mr. Kumar, and Mr. Taylor. Their background is presented to demonstrated that the audit committee meets at
least the minimum requirements as far as financial literacy and expertise is concerned.
Ms. Zheng, a Certified Management Accountant (CMA), has served on the AC of the companys Board for the last 4 years. She was
recently appointed the Chair of the Board and the Chief Executive Officer of RMA Corporation, a telecommunications company that offers local,
long distance, Internet, and advanced telecommunications services directly to business customers. Prior to her current position, she was the Chief
Information Officer (CIO) of Mandeel International, a Fortune 500 company engaged n the manufacture and marketing of semiconductor capital
equipment. She worked first five years of her career as a budget analyst and as an internal auditor, but after earning her CMA 15 years ago, she
soon thereafter switched to a career in information technology and obtained an M.B.A., concentrating in Information Sciences. Ms. Zhengs
background qualifies her as the required individual on the AC with financial expertise.
Mr. Kumar was elected to the Board three years ago and has been a member of the AC ever since. He is President of EdenCal
Consulting, Inc., a firm he founded in 1987. EdenCal provides marketing consulting services to companies in the automobile industry. Mr.
Kumars personal expertise is in the area of brand management. His prior experience includes faculty positions where he taught courses in
marketing and advertising. Mr. Kumar recently audited an introductory accounting course. He holds a Ph.D. in Psychology.
Mr. Taylor has served on the AC for the last three years. He is the chief project manager at Relief for Children, a charitable
organization providing education and healthcare assistance to children in developing countries. Prior to joining Relief for Children, he was head
of the Department of Social Work for the State of New York. Mr. Taylor holds a B.A. in English Literature and an M.A. in Social Work. In
preparation for service as an audit committee member, Mr. Taylor went through a two-day company-sponsored training program, which provided
an exposure to the fundamentals of financial statements and financial reporting.
The Inventory Cycle
Inventory Valuation
Roughly 20 percent of the companys current assets are in inventory, and cost of goods sold represents 57 percent of sales. Hence, the
inventory cycle represents a critical audit area for DD. DD has implemented an information system that ensures that raw materials are tracked
from the time they are shipped by the supplier until the company receives them. Upon receipt of materials, they are stored in the warehouse until
needed for production. Materials are issued to production only upon a properly approved materials requisition that indicates the type and quantity
of materials needed. The perpetual inventory system monitors and updates the inventory and cost of goods sold records on a real time basis. The
company undertakes an extensive physical verification of inventory each year and material discrepancies between actual counts and book records
are properly authorized and reconciled on a timely basis.
Given the rapid technological changes in the data networking industry, the potential for product obsolescence is high. Constant and
fierce competition from start-up companies further exacerbates the need to ensure that the technology on which products are based keeps pace
with the developments in the industry and the demands of the customers.
Financial information relevant to the inventory cycle is presented in Table 1. You should access Data File 15-2 in iLearn for Table
1, which presents the key financial data of DD. After reviewing last years financial statements and the current years unaudited financial
statements, materiality has been set at $6 million.
The major remaining issue in the current years audit relates to whether approximately $11.4 million of inventory for two products
(discussed below) should be written down or, as proposed by Mr. Valuer, the Chief Financial Officer (CFO), continued to be carried on the
balance sheet at cost. The following facts are available about the products.
Product History
The history of the data networking industry parallels that of the Internet, with much of the commercial and consumer applications
emerging only in the last decades. A characteristic of any emerging technology is that competing standards and protocols are constantly proposed
by participants in the industry, who strive to make their proprietary technology the de facto industry standard. The router segment of the data
networking industry is one such segment where industry rivals including DD are competing and lobbying vigorously to make their technology the
de facto industry standard. Routers consist of hardware devices and software programs that help direct and route data, voice, and video traffic
through the Internet. In the router market, DD competes with other companies that are similar in size and market share. As explain later, none of
the companies currently have a technological lead in the market for the specific class of routers that address the needs of lower-to mid-level
enterprise and Internet service provider (ISP) customers.
In late 2000, the companys management identified a significant market opportunity for this market, but the major challenge in
exploring this opportunity related to the technology on which the routers will be based. DDs routers are based on a proprietary technology, codenamed XP, which uses the time-division-multiplexing-based (TDM) technology to transmit signals. Other industry participants have proposed a
competing standard, code-named Optixx (OP), which is based on the fiber optic technology. The fiber optic technology is being successfully
deployed by regional telecom carriers. However, the technology faces significant engineering and marketing challenges for adoption in the
enterprise (business) router market covering the metropolitan areas where the routers need to work with the existing infrastructure already in
place. DDs senior management and the technical team felt that the technology on which DDs routers are based is compatible with the existing
copper-based telecom infrastructure where signals are transmitted as electrical, rather than as light waves, as is the case with the optical-based
routers. If the XP protocols based on the TDM technology become the industry standard, then DD will have an enormous competitive advantage
in an industry where early movers typically gain an unsurpassable lead over competition.
In June 2002, the board approved plans for the manufacture of two models, the XP3000 and XP2000, and commercial production of
the routers began in October 2002. The products were introduced into the market later that month. Although the quantity of sales has not made
the projected forecasts, management has maintained production levels in anticipation if their perception that demand will be strong. Until now,
management has not engaged in any price cuts. See the comparison of actual to budgeted sales in Table 2. You should access Data File 15-2 in
iLearn for Table 2, which presents the comparison of sales forecast and actual sales (units).
Inventory Observation and Costing
The inventory as of June 30, 2003 totaling $287 million included $11.4 million relating to XP3000 and XP2000 (valued at cost).
Details are as follows:
XP3000: 415 units @ $15,000 = $ 6.25 million (approx.)
XP2000: 605 units @ $8,500 = $ 5.15 million (approx.)
Total
= $ 11.4 million
423
424
As part of the current year audit, inventory quantities have been verified through observation at the year-end physical inventory
counts. Further, the relevant job cost sheets have been verified against unit cost values attached to both the XP3000 and XP2000. The remaining
$276 million (approx.) inventory items have also been audited by various offices of you CPA firms with no proposed audit adjustments. The only
remaining substantive inventory issue is the carrying value of XP3000 and XP2000.
Lower of Cost or Market
Because of the short history of the newer XP3000 and XP2000 products and their special purpose nature, a negative change in demand
potentially could drastically affect product pricing. In such an event, the products will need to be severely discounted or worse yet, disposed as
scrap as any decline in value will likely extend to the raw materials component as well. Currently, management has no specific obsolescence
reserve set up. They have a policy of only writing down inventory when specific products are viewed as obsolete.
Industry Publication
Two articles from DataNet Review magazine are relevant with respect to the valuation of XP3000 and XP2000. The first article, which
appeared in January 2003, gives a glowing review of both products. The article concludes by indicating that these routers will significantly
increase the bandwidth capacity with enterprise (business) customers located in the densely populated metro areas, thus increasing the number of
simultaneous users from areas where these routers are deployed.
The second article, which appeared in June 2003, talks about a competitors product. The article states that XP3000 and XP2000 are
based on the TDM technology that uses the existing copper-line telecommunication infrastructure for data transmission. Although TDM has
supported the recent growth of the Internet traffic using existing telephone lines, the article stated that it is not capable of scaling up to meet
future traffic as well as additional service needs of the consumer (e.g., streaming video and audio). A competitors product, released in May 2003,
is based on the fiber optic Internet working technology that uses light waves to transmit data, voice, and video. The article claims that relative to
TDM, the fiber optic technology offers significantly higher bandwidth and speed for network traffic and the fiber optic technology will increase
compatibility with the newer fiber optic equipment currently being deployed by telecommunications companies. However, as discussed earlier,
the article concludes by stating that the fiber optic technology for routers that are largely deployed by enterprise and Internet service providers in
the metro areas is still in its infancy and the ability to execute the mass deployment of products based on this technology faces significant
customer acceptance and marketing challenges.
Discussion with the CFO
On inquiry, Mr. Valuer, DDs CFO explains the reasons for the slowdown in sales of XP3000 and XP2000 and justifies their valuation
on the balance sheet at cost. Mr. Valuer says that he is bullish on these products and attributes the slowdown in new orders to the general
sluggishness of the economy. Further, he states that enterprise and ISP capital expenditures are lower during the traditionally slow summer
months. He also believes that the competitors products will be less reliable than XP3000 and XP2000 since the new technology (fiber optic) is
deemed less mature and established. Finally, Mr. Valuer stated the board concurred with managements assessments of the market potential for
the XP class router products and approved the introduction of these products. The companys management is convinced of the superiority of its
products and plans to continue production as suggested by their budget. Given this discussion with the CFO, David Driver plans to raise the issue
of salability of the products in the upcoming meeting with the audit committee of DD.
Required
The efficiency of capital markets rests on the free flow of unbiased, objective information from the stewards of capital to its providers.
Research as well as corporate malfeasance scandals provides ample evidence regarding the importance of high-quality financial information to
the efficient functioning of the capital markets. Indeed, good governance is crucial not only in preventing major financial reporting disasters, but
also in ensuring that significant issues impacting the financial reporting process (e.g., inventory valuation) are appropriately accounted for by the
corporation. However, ensuring high-quality financial reports requires that all stakeholders, and not just the management, take an active role in
the governance process. The questions that follow are designed to help you carefully consider all aspects of the governance framework and to
evaluate the role of each of the major players (e.g., auditors, management, audit committee, board of directors) who must work together to ensure
that the highest quality of financial information is provided to the stakeholders who make important decisions based on that information.
Fully answer the following questions:
1. What impact will the valuation of inventory at cost versus a write-down from cost have on the following financial statements reported to the
stockholders: (ignore any income tax implications)
a. Income Statement,
b. Balance Sheet, and
c. Statement of Cash Flows
2. Discuss the factors that may be driving Mr. Valuers desire to value the inventory at cost. List each factor and explain your answers as follows:
a. Factor one .
Reasons are
b. Factor two
Reasons are
Continue
3. Assume you are the senior auditor-in-charge of DDs audit, write a memo to David Driver, the audit partner, which fully explains whether the
inventory relating to XP3000 and XP2000 should be valued at cost or be written down.
4. Irrespective of your answer in 3. above, assume you believe that the inventory should be written down while Mr. Valuer, the CFO, believes
that it should be carried at cost. Fully explain what steps you would take to resolve your disagreement with Mr. Valuer.

Simulation Question 15-3 is an adaptation with permission from a case by Long, J. H., L. Mertins, and D. L. Searcy in the Issues in Accounting
Introduction
The Company
The Management Team
Changing Circumstances
IRCSs Inventory Costing Procedures
Lisa Martin, CMA, CPA, was recently promoted to the position of controller at International Retail Computer Solutions (IRCS). Her
promotion resulted from eight years of hard work as a corporate accountant. Martin has been with IRCS since graduating from Big State
University and was thrilled to have an opportunity to move up within the organization. She has a fantastic relationship with the other members of
IRCS's management team (all of whom are also Big State alumni) and enjoys tailgating with them before Big State sporting events. Although
Martin has enjoyed the opportunity to get involved with the bigger financial picture at IRCS and is excited about the challenges presented by her
new position, she has recently been struggling with an unexpected dilemma: in her professional judgment, some of the company's accounting
practices may be inappropriate and unethical.
IRCS is a privately held company headquartered in the southeastern United States. IRCS's primary business activities involve buying
and selling used point-of-sale (POS) computer systems. When a U.S. retailer upgrades its POS computer systems, IRCS purchases the used
equipment (including handheld scanners, receipt printers, monitors, keyboards, CPUs, and servers) and resells it to retailers in developing
countries, where it is considered to be top of the line (see Figure 1). You should access Data File 15-3 in iLearn for Figure 1. In addition,
IRCS provides replacement parts to U.S. retailers that continue to use older POS computer systems.
Ernesto Rodriguez founded IRCS in 1984. He retired last year to engage in other pursuits and is no longer involved with the day-today operations of the business. However, he still retains a majority ownership interest in the company and serves as the chairman of the board.
The president and chief executive officer, Harvey Lang, has been with IRCS since the founding of the company. He worked his way up to
become Rodriguez's right-hand man and the vice president of sales. Upon Rodriguez's retirement, Lang was promoted and given a small
ownership interest in the company.
Besides Harvey Lang and Lisa Martin, IRCS's management team includes Chief Financial Officer Christina Edmonds, Chief
Information Officer Carl Miller, Vice President of Sales Ryan Scott, and Vice President of Logistics Elizabeth Conner. Edmonds and Scott are
recent additions to the management team. Lang hired Edmonds from IRCS's largest competitor, where she had previously worked as the
controller. She replaced the old CFO, Adam Stone, who left the company soon after Rodriguez retired. Scott worked in sales at IRCS for ten
years and was Lang's handpicked successor as the vice president of sales. Miller and Conner have been with IRCS in their current positions for
more than a decade. The members of the management team all have an excellent working relationship with one another and frequently spend time
together outside of work, often at Big State University sporting events.
Management's compensation consists of a base salary and a bonus. Each manager's bonus is calculated as a percentage of Earnings before
Bonuses, Interest, and Taxes (EBBIT). In total, management receives bonuses equal to 10 percent of IRCS's EBBIT, with Lang receiving the
lion's share. At the end of each year, management makes a presentation to Rodriguez that summarizes the company's financial performance and
management's plans for the future. Once the presentation is complete and he is satisfied with management's report, Rodriguez and the board
members authorize the payment of managerial bonuses.
During the current year (2012), the continued downturn in the U.S. economy prolonged the havoc being wrought on the financial
prospects of many national retail chains. Several large chains, which had expanded aggressively during the boom years preceding 2008,
succumbed to the ongoing financial hardship and were forced into bankruptcy. IRCS's management saw an opportunity to acquire a significant
number of used, but relatively up-to-date POS systems at a significant discount from traditional market prices. However, IRCS lacked sufficient
capital to complete the acquisitions on its own. Therefore, the company obtained a $10 million loan from First National Bank (FNB) to help
finance the purchase. In order to obtain the financing from FNB, IRCS agreed to several loan covenants, the most restrictive of which involves
the interest coverage ratio (Earnings before Interest and Taxes Interest Expense). Specifically, IRCS is required to maintain a minimum interest
coverage ratio of 3. Failure to do so violates the loan covenant and allows FNB to demand immediate repayment of the loan. To verify
compliance with the debt covenants, FNB requires IRCS to provide monthly and annual financial statements prepared in accordance with U.S.
Generally Accepted Accounting Principles (GAAP), and to engage a CPA firm to provide a review of the annual financial statements to be
completed no later than 90 days after the end of the fiscal year. In addition, both Rodriguez and Lang are required to personally guarantee the
loan.
One of the most difficult management accounting issues facing IRCS relates to inventory costing and valuation. Typically, IRCS pays
a lump sum to acquire used POS equipment. This payment must be allocated to the individual pieces of equipment. Although the typical costing
approach for this scenario involves assigning costs based on the relative fair market values of the acquired items, the unique nature of IRCS's
business often precludes this approach. Many of the items the company acquires do not have readily determinable market values, and might be
considered obsolete in the U.S. and by the manufacturer. However, given IRCS's sales contacts around the world, it can usually sell these
obsolete inventory items in other countries at a profit, with normal gross margins ranging from 2575 percent.
For traditional inventory acquisitions, management begins the costing process by identifying the pieces of equipment they believe to
be the most marketable. They assign the majority of the acquisition cost to these items, which usually sell quickly at prices above allocated cost.
Equipment that remains in inventory for an extended period of time typically has very little cost assigned to it.
425
426
Costing the New Inventory
Inventory Impairment Testing
In June 2012, IRCS paid more than $12 million to acquire used POS systems from a bankrupt retail chain. Although IRCS frequently
purchases and sells used POS equipment, this latest purchase is by far the largest the company has ever made, thus the need for the $10 million
loan. In addition, the equipment acquired is much more up to date than their usual inventory, and management does not have the expertise to cost
these particular inventory items in the traditional manner. However, because the latest purchase primarily consists of newer equipment, the
relative fair market value of each inventory item is more easily determinable.
Lang (CEO), Edmonds (CFO), and Scott (VP Sales) met to decide how costs should be assigned to the newly acquired inventory.
After careful consideration of the authoritative guidance in FASB ASC 330-10-30, they determined that costs would be assigned based on the
relative fair values of the inventory items. This approach is consistent with the individual circumstances surrounding this acquisition of inventory,
as well as with methods that have been adopted by the majority of the other companies in the industry that deal with this type of equipment (ASC
330-10-30-14). They asked Martin (Controller) to perform the necessary calculations and allocate the cost to the individual items, using the latest
sales price from an industry-wide database as an approximate measure of each type of equipment's relative fair market value. You should access
Data File 15-3 in iLearn for Table 1, which provides a detailed list of the purchased items, along with the last confirmed sales price from
the industry-wide database, and the date on which the item was last sold.
Martin was excited about the opportunity to lead such an important project, her first major assignment as controller. When the project
was completed, Edmonds praised her efforts, and Lang rewarded her with exclusive use of his luxury box for a Big State game.
One day in late November, over lunch with the management team, Martin listened attentively as Lang, Edmonds, and Scott discussed
the success of IRCS's latest venture. She was delighted to hear that sales of the newly acquired inventory were proceeding briskly, and that the
company's profit margins were substantially higher than normal. Scott mentioned that the sales team had been able to sell the complete
inventories of three types of monitors, two types of printers, three types of scanners, and one type of CPU. The remaining monitors, printers, and
scanners were also moving relatively well. The only items that were cause for concern were the three remaining types of CPUs. Scott noted that
there just did not seem to be much demand for these items, even when IRCS offered relatively deep discounts. However, he mentioned that his
sales team had several promising leads, and that he was confident that they would be able to find buyers for these items, even if they had to offer
even larger discounts.
Shortly after year-end, Martin was instructed to prepare the first draft of ICRS's financial statements. As part of the preparation
process, she conducted an inventory impairment test to determine whether inventories were appropriately recorded on IRCS's books at the lower
of cost or market, as required by ASC 330-10-35. This impairment test had not resulted in significant impairment losses in prior years because
prior-year ending inventory levels were generally small. Based on her research into the technical standards and consistent with the impairment
tests that had been conducted in prior periods, Martin determined that she should compare each inventory item's cost to its market value at an
individual item level (see Table 2). You should access Data File 15-3 in iLearn for Table 2. Consistent with ASC 330-10-35-4, Martin used the
current cost of replacement as the proxy for market value. This cost of replacement was obtained from the industry-wide database used to
assign costs to inventory initially.
When she had completed the impairment test, she was surprised to see that her calculation indicated that there was an impairment loss
of $538,005. Upon further examination, Martin determined that the impairment loss was attributable to the decline in market value of the three
slow-moving CPU items. Concerned, she sought out Ryan Scott to determine whether the sales force had had any luck finding buyers for the
three CPU items:
Martin: Hey, Ryan. Do you have a minute to chat about those three slow-moving CPU items from the June purchase?
Scott: Sure, Lisa. What can I do for you?
Martin: I need to know if you still think that we might be able to sell those items at any amount close to the cost we have on the books. In
other words, is it reasonable to hope that we can sell them for a normal profit?
Scott: Well, Lisa, that's a tough question. You know, we have a great sales team here at IRCS, and we are generally able to move our used
inventory pretty quickly. We did have several promising leads, but unfortunately, those customers bought CPUs from our competition at a deeply
discounted price relative to our carrying amount. Given the market, I think a more realistic expectation is that we will have to offer them at a
significant discount if we want to sell them.
Martin: I see. Okay, Ryan, thanks for taking the time to talk things over with me.
Scott: Of course! Any time.
Given her discussion with Scott, and the lack of evidence that the CPU items assigned cost could be recovered with an approximately
normal profit upon sale in the ordinary course of business (see ASC 330-10-35-5), Martin recorded the loss, which directly reduced income
before taxes and interest, and significantly reduced net income. She then sent the financial statements and impairment test documentation to
Edmonds for review and approval.
The next day, Lang called Martin into his office:
Lang: Thanks for dropping by, Lisa.
Martin: No problem, Harvey. What's up?
Lang: I wanted to talk about the draft of the financial statements that you sent to Christina yesterday. I see that you've indicated that we
should recognize an impairment loss in excess of $500,000 associated with our inventory. You do realize that amount would reduce our bonuses
by more than $50,000? I use my bonus to pay for my Big State luxury box and provide scholarships for deserving student athletes. In addition,
these financial statements are going to our bankers. The impairment loss you booked will cause us to violate the interest coverage ratio debt
covenant. In fact, any impairment adjustment above $72,000 will place us in violation of our debt covenants in the first year of our loan!
Martin: I definitely don't want us to violate our debt covenants. But do you really think the bankers would call our loan on our first
violation?
Lang: Look, the bank wasn't really excited about extending us the loan to begin with; however, Ernesto was a friend of the bank president
and that was what got us the loan. Unfortunately, that bank president retired within weeks of our loan approval and the bank has become much
more conservative under its new leadership. As a matter of fact, Dean, our new loan officer, has called me twice already this month about the
financial statements. He mentioned that it is imperative that we get the financials ready for the review so that the bank can have them as soon as
possible. He has also mentioned the importance of not violating our debt covenants. The down economy has really hurt the bank and they are in
no position to have risky loans outstanding. So, to answer your question, yes, I believe the bank will call our loan if we violate our debt covenants
this year. Doing so will probably send us to bankruptcy and put 25 people out of work, and Ernesto and I would be on the hook for the remaining
loan balance. Do you want that to happen?
Martin: Of course not, especially since I am one of those people that could be out of work! Look Harvey, I didn't make up the accounting
rules, but we have to follow them, especially since a CPA firm will review these financial statements before we send them to the bank.
Lang: The bankers are not interested in the nuts and bolts of our accounting, particularly an issue that doesn't affect our cash flows. An
impairment loss isn't a real loss anyway; it's just a paper write-down. Besides, when it comes time to sell our inventory items, we've never had
any trouble recovering our costs before. The bank just needs to get a big picture of our financial situation, and I am telling you, we are in good
shape! Now, I need you to find a way to lower that adjustment, so that we don't violate our debt covenants.
Martin: Harvey, based on my reading of the authoritative guidance, I don't think we have an option here. And I don't feel comfortable with
you pressuring me
Lang: Okay, okay. I'm sorry I got so riled up. Tell you what, why don't you walk me through the impairment calculation, and we will see
what we can figure out.
Martin: Okay. Essentially, the impairment is tied to those slow-moving CPU items. The last sales price according the industry-wide database
for each item was far below our carrying amount, and that leads to a large impairment associated with those items. If we had evidence that the
cost was recoverable with a normal profit in the ordinary course of business, we could argue that we shouldn't recognize an impairment loss for
these items. However, I talked with Ryan yesterday, and he doesn't think we will be able to sell them without offering deep discounts.
Lang: Wait a minute. You're saying that if we can provide some evidence that the cost is recoverable, we won't have to recognize the
impairment?
Martin: Essentially, we would be able to argue that impairment is unnecessary.
Lang: I tell you what. I think I can see our way out of this. Let me have a few days to get things lined up, and I will touch base with you
soon.
Two days later, Martin received a note from Lang that read, This should take care of our impairment problem! Once you've reversed
the impairment loss and updated the financial statements, just send them on to Christina for final review. Underneath was a copy of Lang's
impairment test (see Table 3), a purchase order from one of IRCS's largest Indian customers, along with IRCS's corresponding invoice (see
Figure 2) and shipping documentation. You should access Data File 15-3 in iLearn for Table 3 and Figure 2. Martin noticed that three items
included in the order were the slow-moving CPU items. Martin considered whether this documentation provided sufficient evidence that the cost
assigned to the slow-moving CPU items was recoverable with a normal profit in the ordinary course of business. She noted that the sales price for
each of the CPU items exceeded the carrying amount. However, she also noted that the sales prices for the other items were substantially below
their market values, even though she knew that these items continued to sell for prices that approximated the current replacement cost she had
used in her impairment test. Concerned that there might have been a mistake in the pricing, she decided to check with Ryan Scott:
Martin: Ryan, can I ask you about Invoice Number 2011-00295? The latest sale we made to National Computers?
Scott: Sure, Lisa. What do you need to know?
Martin: First, great job selling some of those CPU units. I know we were all worried they would be tough to sell, but it looks like we were
actually able to recover our cost. I do have a question about the other items on the invoice though. I think there might be a mistake on the prices?
Scott: That's no mistake. Just between you and me, Harvey said that for financial reasons, we needed to show that we could sell the CPU
items above our carrying cost, so I was able to convince National Computers to pay' a substantial premium for the CPU items by giving them
great prices on the other items. But Harvey said to make sure to keep that information confidential. He specifically asked that we not discuss it
with the auditors coming to review the books in a few weeks.
Martin: Whoa! That's news to me. So you don't think we could sell those CPU items, even at cost, without giving the customer special'
pricing on the other item?
Scott: No way. Those CPU items are pretty obsolete, even for our overseas customers. We'll be lucky if we can sell them for half of the
carrying value.
Martin's head was spinning as she returned to her office. She was very uncomfortable with what she had learned about the sale to
National Computers. She definitely did not think that it provided evidence that IRCS could recover the cost assigned to the computers, and
strongly believed that IRCS needed to record an impairment loss related to those items. She was also concerned about the implications of
Harvey's under-the-table dealings with National Computer, and his request that they keep information about that true economics of the deal from
the CPA firm that was reviewing the financial statements. However, she knew that there could be real consequences if IRCS recorded the
impairment loss and violated its debt covenants. Unsure how she should proceed, she decided to request a meeting with Christina Edmonds to
talk through the issue.
At the meeting the next day, Martin began by describing the issues around the impairment loss, and her concerns about Harvey's
solution to the problem. She then asked Edmonds what she should do:
Edmonds: Well, Lisa, this is a tough situation. Harvey just wants to do what is best for the company, and violating our debt covenants could
have serious consequences. However, I agree with you that Harvey's solution doesn't meet the requirements laid out in the authoritative guidance
to avoid an impairment loss. But have you considered other possible alternatives? For instance, when you conducted the impairment test, it looks
like you applied the lower-of-cost-or-market rule directly to each item. However, ASC 330-10-35-8 also allows us to apply the lower-of-cost-ormarket rule to the total inventory. I took a quick look at the calculation, and I bet that if we used this method to conduct the impairment test, we
won't have a significant impairment loss.
Martin: That's a great point, Christina. But ASC 330-10-35-8 says that the method we use should be that which most clearly reflects periodic
income. ASC 330-10-35-10 goes on to say that we should only apply the lower-of-cost-or-market rule to the entire inventory when there is only
one end-product category and when the inventory items are in balanced quantities. When we sell our inventory, it is typically on an item-by-item
basis, rather than as a complete POS computer system. Additionally, the method I used initially was consistent with prior years, and ASC 330-1035-10 says that our impairment test methodology must be applied consistently from year to year. Do you think we can justify applying the lowerof-cost-or-market rule to the entire inventory?
427
428
Edmonds: It's true that the vast majority of our sales are on an item-by-item basis, but we do sell complete POS computer systems from time
to time. For instance, our recent sale to National Computers included monitors, printers, scanners, and CPUs.
Martin: But Ryan said the only reason National Computer was willing to buy the CPUs was because we gave them deep discounts on the
other items.
Edmonds: This is definitely a gray area, and we must use our professional judgment to determine the appropriate course of action. I've been
an accounting professional for a long time, and in my professional judgment, we can apply the lower-of-cost-or-market rule to the entire
inventory. I will take full responsibility for the decision. Why don't you recalculate the impairment applying lower-of-cost-or-market to the
inventory as a whole, book any entries required to adjust the impairment loss, and then send me the updated financial statements? I will let the
accounting firm know that they will be ready to review by the end of the week.
Martin: Do you think we will have any problems with the impairment issue during the review?
Edmonds: Probably not. The auditors who conduct the review of our financial statements won't be required to examine source documents as
part of their review. But if they push on the issue and want additional support for our position, we can show them the National Computers invoice
as evidence that we do sell the component items as a system. Just make sure you don't mention Harvey's side deal to them. We both know Harvey
only wanted to protect the company, but the auditors who are reviewing our financials might misinterpret his actions. All right, Lisa, thanks for
being a team player on this one. I talked with Harvey, and just to show you how much we value your loyalty to the company, he'd like to offer
you the use of his luxury box for next week's game. It should be a good one; both teams are undefeated!
Still somewhat uncomfortable with Edmond's arguments, Martin nevertheless returned to her office to rework the inventory
impairment calculations. Using Edmonds' methodology, she determined that the inventory was not impaired (see Table 4) and that IRCS did not
need to record an impairment loss. You should access Data File 15-3 in iLearn for Table 4. After she reversed her initial impairment loss, the
updated financial statements met the covenants required by the FNB loan agreement. Lisa was amazed at the effect that changing a simple
methodological assumption could have on the financial statements!
That night, Martin struggled to fall asleep. Her thoughts kept drifting back to her discussions with Lang and Edmonds about the
inventory impairment test. She wanted to be a good team player, but she continued to be uncomfortable about upper management's accounting
choices. In her professional judgment, management's choice of accounting methodology was inconsistent, inappropriate, and motivated more by
the effect each method had on the company's loan covenants and managerial bonuses than by objective accounting and reporting. She worried
that the company's updated financial statements misrepresented IRCS's financial performance to both First National Bank and Mr. Rodriguez.
She was also concerned about Harvey's under-the-table dealings with National Computer, and the implications for management's integrity with
respect to financial reporting. As a CPA, she knew she had a duty to behave ethically, but how did that apply in this situation?
Required
Given the guidance in ASC 330 Inventory, which of the three impairment tests do you believe is allowable (Martin's in Table 2,
Lang's in Table 3, or Edmonds' in Table 4)? Why? Which of the three impairment tests do you believe is the most appropriate
(Martin's in Table 2, Lang's in Table 3, or Edmonds' in Table 4)? Why?
2. Based on the discussion in the case and the AICPA's Code of Professional Conduct, how did Martin adhere to the principle of due
care (Article V)? What concerns related to due care might she have about management's accounting methodology? (Refer to
Chapter 3).
3. What implications does the principle of integrity (Article III) from the AICPA's Code of Professional Conduct have for Martin in
this situation? Does this principle also have implications for Harvey's under-the-table dealings with National Computers? (Refer to
Chapter 3).
4. As part of the standard of the principle of objectivity and independence (Article IV), the AICPA's Code of Professional Conduct
requires Martin to be intellectually honest and free of conflicts of interest. Do you believe that Martin acts in accordance with this
principle? In addition, the AICPA's Code of Professional Conduct defines six threat categories that jeopardize compliance with the
rules of conduct, especially the principle of objectivity and independence (Rules of Compliance Guides, para. 13). Which of these
threats are applicable to Martin's situation? (Refer to Chapter 3).
5. Article II (the public interest) in AICPA's Code of Professional Conduct states that financial accountants should serve the public
interest and honor the public trust. Who are the intended users of Martin's reports? How should Martin apply this principle, given her
current situation?
6. Does Edmonds' statement taking full responsibility for the accounting decisions absolve Martin of her ethical responsibilities? Why or
why not?
7. Lang requested that Martin keep her concerns about the company's accounting methods confidential. However, Martin believes that
the application of the company's newly introduced accounting methods is unethical. What options does Martin have to resolve this
ethical dilemma?
8. How should the potential consequences of recording the more conservative impairment loss factor into Martin's decision (e.g., lost
jobs if the bank calls the loan, smaller management bonuses, and fewer scholarships for Big State athletes)?
9. Discuss the positive and negative factors associated with the beyond-work relationships that exist among the management team.
10. Which individual (Martin, Edmonds, or Lang) do you believe is ethically correct? Defend that person's position.
11. Defend the position of the two individuals (Martin, Edmonds, or Lang) that you did not select for Question 10.
12. What would you do if you were Martin?
1.
429
430
Chapter 16
Payroll Cycle Tests of Controls and Tests of
Balances
LO16-1 Understand the accounting information system of a typical payroll cycle.
LO16-2 Describe some common TOC procedures for payroll.
LO16-3 Identify internal controls in computerized payroll systems.
LO16-4 Apply the analytical procedures in a payroll cycle.
LO16-5 Understand internal control in computerized payroll system.
LO16-6 Describe some common TOB procedures for payroll.
LO16-7 Describe some common audit procedures for share-based compensation.
Chapter 16 Payroll Cycle Tests of Controls and Tests of Balances

An overview of the strategy for tests of controls in a payroll cycle is presented in Figure 16-1.
Figure 16-1 TOC Strategy in Payroll Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
431
432
Understand Internal Controls in a Payroll Cycle

TOC strategy in a payroll cycle starts with an understanding of internal controls relating to a payroll cycle. Table 161 provides a brief discussion of the various components relating to the understanding of internal controls in a payroll
cycle.
Table 16-1 Understanding Internal Controls in a Payroll Cycle
Understanding Internal Controls in a Payroll Cycle
2. Risk assessment
5. Monitoring
have a special effect on the payroll cycle.
payroll cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to
cycle. If the auditor plans to conduct both TOC and TOB on the payroll cycle, then s/he needs to identify
the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR).
payroll cycle flowchart.
The auditor must obtain sufficient knowledge of the accounting information system relating to the payroll
cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in
Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown
in Figure 16-2. A brief discussion of these three areas is provided in Table 16-2.
The auditor must understand the managements monitoring processes over the payroll cycle. This includes
understanding how the management monitors the internal controls of the payroll cycle over time and what
corrective action is initiated to improve the design and operation of controls in the payroll cycle.
Figure 16-2 Understanding of Information and Communication in a Payroll Cycle
Key Functions
Understand 4 key functions of a payroll cycle

Transactions
of transactions

records
Table 16-2 Understanding of Information and Communication in a Payroll Cycle

Key Functions
Accounts
(control ledger)
Classes of
Transactions
1. Personnel
Managing human
resources that include
hiring and terminating
employees, setting wage
rates and salaries, and
establishing and
monitoring employee
benefit programs.
Note: Personnel function
=
Human
resources
function. Ordinarily, a
payroll department refers
to a department that
combines the personnel
and
accounting/recordkeeping departments.
2. Payroll processing
Preparing and reviewing
employees time card and
coding payroll costs to
appropriate accounts.
Computing gross pay,
deductions, and net pay,
and recording and
summarizing payments.
Note:
Controllership
function
=
Accounting/recordkeeping
function.
Ordinarily, the production
department provides the
hours worked, and the
accounting/recordkeeping
department
calculates and records the
payroll.
3. Payroll disbursement
Preparing and distributing
payroll checks.
Note:
Administrative
function
=
Internal
accounting
function.
Ordinarily, the treasurer
in the administration
department has custody
of payroll checks and
distributes payroll checks.

Personnel file
This file contains each employees hiring date, wage rate or
salary, payroll deduction authorization forms, wage-rate and
salary adjustment authorizations, performance evaluations and
termination notice, if applicable.
Deduction authorization form

A form authorizing payroll deductions including withholding
of income taxes, 401(k) and other retirement savings plans,
U.S. savings bonds, and union dues.
Rate authorization form

A form authorizing the rate of pay.
W-4 form
A form authorizing the withholding of federal and state
income taxes.
Accrued
payroll
accounts
(liabilities)
(e.g.,
accrued wages and
salaries,
accrual
payroll tax expense)
Payroll
expense
accounts
(expenses)
(e.g.,
bonuses,
commissions, direct
labor, payroll tax
expense)
Payroll
withholding/deducti
on
accounts
(liabilities)
(e.g.,
income
taxes
withholding, FICA
taxes withholding,
union
due
deductions)
Payroll
Form 1120 - Corporate income tax returns

Form 1040 -Personal income tax returns
ST 140 Sales tax returns
Time card (Clock card)

This document records the time the employee started and
stopped working each day and the number of hours the
employee worked. The employee fills in the time worked or a
time clock records the time. Figure 16-3 shows an example of
a time card.
Job time ticket (Job card)

This document indicates specific jobs on which a factory
employee worked during a given time period, such as
overtime work. Figure 16-4 shows an example of a job time
ticket.
Payroll register (Payroll journal)

This document records payroll checks showing the
employees gross pay, deductions, and net pay. The details in
the journal are also included in the payroll master file.
Payroll master file

This computer file records each payroll transaction for each
employee and maintains total employee wages paid for the
year to date. The record for each employee includes social
security number, gross pay for each payroll period, deductions
from gross pay, net pay, check number, and date.
Periodic payroll reports

This report is prepared at the end of each week or month
depending on the clients organization. A manufacturing
company usually prepares a payroll expense report that shows
the allocation of direct labor to various job or unit in a
standard cost accounting system.
Payroll Cash
Cash in Bank
Payroll check
A check written to the employee for services performed. The
amount of the check is the gross pay less taxes and other
deductions withheld. The payroll check may be in the form of
a direct deposit into the employees bank account.
Imprest payroll account

An imprest payroll account is a separate payroll account in
which a small balance is maintained. A check for the exact
amount of each net payroll is transferred from the general
payroll account to the imprest payroll accounting immediately
433
434

Key Functions
Accounts
(control ledger)
Classes of
Transactions

before the distribution of the payroll. The advantages of an
imprest account are (1) it limits the clients exposure to
payroll fraud, (2) it allows the delegation of payroll checksigning duties, (3) it separates routine payroll expenditures
from irregular expenditures, and (4) it facilitates cash
management.
4. Payroll tax returns

processing
Preparing and submitting
payroll tax returns.
W-2 form
This form issued to each employee showing the earnings
record for the calendar year. The information includes gross
pay, income taxes withheld, and FICA withheld. The same
information is also submitted to the Internal Revenue Services
and state and local tax commissions when applicable. The W2 form is prepared from the information on the payroll master
file.
Form 941
These payroll tax forms are submitted to local, state, and
federal units of government for the payment of withheld taxes
and the employers tax. The due dates of the forms vary
depending on the type of taxes. For example, federal
withholding and social security payments are due weekly,
monthly, or quarterly depending on the amount of
withholding, and most state unemployment taxes are due
quarterly. These tax forms are prepared from the information
on the payroll master file.
Figure 16-3 An Example of a Time Card

TM#58359
TIME CARD
MNO Company
CA 94132
Employee Name:
Employee Number:
Barry Bond
8645
Date
10/14/201x
Day
Mon
Time In
8:00
Time Out
18:00
10/15/201x
Tues
8:10
18:10
10/16/201x
Wed
8:00
18:00
Supervisor Signature
S.F. Giants
S.F. Giants
S.F. Giants
Thurs
Fri
Sat
Sun
Figure 16-4 An Example of a Job Time Ticket

JTT#67352
JOB TIME TICKET
MNO Company
CA 94132
Employee Name:
Employee Number:
Date
11/12/200x
Jeff Garcia
4949
Start Time
6:00 a.m.
End time
10:30 a.m.
Special Production Order #68341

Specific Job Description: Assemble Bicycle Frame
Quantity Completed: 49 Bicycle Frames
Supervisor Signature:
F. Niners
Date: 11/12/201x
Hourly Rate
$25.50
Total Hours
4.5
435
436
Figure 16-5 An Example of a Payroll Cycle Flowchart

Functions
Personnel
Documents & Records
Computer Process
Rate Authorization
Form
PERSONNEL PROGRAM
Controls changes to personnel
data master file.
Enter Personnel
Data
Personnel Data Master File
Report of
Master File Changes
Payroll
Processing
Time Card
Supervisory
Approval
Personnel Data Master File
Enter Time
Card
PAYROLL PROGRAM
Calculate payroll.
Update employee earnings master file.
Update general ledger master file.
Print payroll expense report
Print paychecks
Payroll Register
General Ledger
Employee Earnings Master

.
File

File
Payroll Expense
Report
Payroll
Disbursement
Paycheck
Direct Deposit
Report
Consider Potential Misstatements in a Payroll Cycle

After the auditors have obtained an understanding of the internal controls relating to the payroll cycle and
weaknesses in internal control. Table 16-3 describes some of these potential misstatements in the payroll cycle.
Table 16-3 Potential Misstatements in a Payroll Cycle due to Weakness in Internal Control
Creation of fictitious employee.
Example of Fraud
Insertion of phantom employees on the

personnel data master file and paychecks
made out to the perpetrators.
Creation
of
phantom
part-time
employees at remote locations and paychecks
made out to the perpetrators.
Not notifying payroll department on

terminated employees and the perpetrators
collect the paychecks.
Misstatement of work hours.
Fraudulent recording of overtime work

that was never performed.
Use a buddy system to clock in time

cards for one another.
Misstatement
earned.
of
commission
Fraudulent increase of sales commission

by creating fictitious sales, falsifying the
value of sales, or overstating sales by
claiming sales from another period.
Example of error
Unintentional entering of personnel

information of individuals who are not hired
by the client.
Double recording of female employees

who changed their maiden names.
Mistake made in entering the time card

or job time ticket to the employee earning
master file.
Mistake
made
in
calculating
commission earned by employees.

the audit program for the payroll cycle. Table 16-4 describes some common TOC procedures that the auditors
perform in the payroll cycle.
Table 16-4 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Payroll
Recorded payroll payments are for work
actually performed by existing employees.
Internal Controls
Proper separation of duties among personnel,
timekeeping, and payroll disbursement.
Adequate personnel files (documentation) are
maintained.
Time clock is used to record time.
Time cards are approved by supervisor.
Only employees with valid employee number
(social security number) are paid.
Completeness:
Payroll transactions are recorded.
Cutoff:
Payroll transactions are recorded in the
correct period.

Employee compensation and payroll
deduction are properly authorized.
Accuracy:
Employee
compensation
and
payroll

Read organization chart,
employees, and observe
performed.
Inspect personnel files.
inquiry with
duties being
Observe employees use of time clock.

Inspect time cards for indication of approvals.
Examine clients procedures for entering and
removing employee numbers from the payroll
master file.
Payroll checks are prenumbered and accounted

for.
Scan for numerical sequence of payroll

checks.
Scan for numerical sequence of time cards.
Notices of additions, terminations, and changes

to salaries, wages, and deductions reported
promptly to the payroll department, and the
changes are updated promptly in the payroll
master file.
All time cards forwarded timely to the payroll
department.
Inspect the clients procedures for accepting

and updating the payroll master file in the
correct dates.
Proper authorization procedures for (1) hiring

and terminating of employees, (2) time worked,
(3) wages, salary, and commission rates, (4)
withholdings, (5) benefits, and (6) issuing
payroll checks.
Examine authorization procedures for each

point of authorization in the payroll cycle.
Internal independent checks on payroll amounts
Scan for indication of internal independent
Observe the gathering and forwarding of the

time cards to the payroll department in timely
manner.
437
438

deduction are computed correctly.
Classification:
Payroll transactions are properly classified
among the payroll accounts, such as
payroll expense is classified appropriately
into direct and indirect labor accounts.
Internal Controls
and benefit calculations.

Use of payroll budget to control payroll
expenses.
verification.
Inspect the clients budgeting procedures and
scan payroll register for unusual amounts.
Analyze chart of accounts for adequacy.

payroll expenses into the appropriate payroll
accounts.
Scan for indication of internal independent
verification.
Internal independent check on payroll accounts

classifications.
Internal Controls in Computerized Payroll Systems

Computerized payroll systems use computer software to produce checks and record transactions. Record keeping
function is paperless, and even a W-4 Form can be submitted online directly to the payroll systems. Fraud
prevention in the computerized payroll systems covers several areas:
The Payroll Department
The job duties of each payroll staff should be reviewed to determine the highest computer access needed. Not all
staff members need complete access to all computer files and programs. For example, the supervisor/manager of the
payroll department should only submit payroll to the computerized payroll systems. This duty could even be limited
to only one computer that is kept in the manager/supervisor's locked office. If the payroll staff only inputs timecards
or Forms W-4 to the payroll systems, then their total access to report writers or check writing program would not be
necessary.
Generally, hard or paper copies of payroll records should always be kept locked in the payroll department.
However, if an off-site facility is used to store old payroll data, the payroll department should make sure that this
area is secure as well. Garnishment records and court related documents should be kept in a separate locked cabinet
in the payroll department. Access to this cabinet should be given only to those payroll staff members who deal
directly with garnishments. The general employee population should not know the name of the payroll staff who
handles garnishments. Emails concerning garnishments should go to a separate email address and then forwarded to
the payroll staff who handles garnishments.
Human Resources or Benefits Department
Access to the computerized payroll systems by the human resources or benefits departments depends on how new
hires and benefit deductions are processed. If the computerized payroll systems are not integrated and these two
departments do not handle any of the input for the payroll systems then they should have a read only access to the
payroll computer screens. If the human resources or benefits departments do handle the input for these areas for the
payroll systems, then full access to the screens would be necessary.
Generally, employees have access to their personal files in the computerized payroll systems with appropriate
access codes. For example, an employee may want to check what s/he is claiming on the latest Form W-4 or what
benefits s/he may have. However, proper identification should always be required when an employee requests
information in writing or copies of information to be printed by the human resources or benefits department.
Moreover, the employee should pick up such information in person and present proper identification.
Information System or Information Technology Department
Programmers or IT personnel would need access to payroll software to handle upgrades and software adjustments.
However, their access should be limited to software upgrades and adjustments and not allow making changes to
benefits or payroll screens that affect data such as hourly wage or Form W-4 information. Programmers or IT
personnel who do not interact with the payroll software but handle other software functions should not have access
to the computerized payroll systems. For example, an IT personnel who maintains the websites or email does not
need payroll computer access.
An overview of the strategy for tests of balances in a payroll cycle is presented in Figure 16-6.
Figure 16-6 TOB Strategy in Payroll Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
439
440
Apply TOB Strategy

Table 16-5 provides a brief discussion of the TOB strategy as it is applied to a payroll cycle.
Table 16-5 TOB Strategy in Payroll Cycle
TOB Strategy Payroll Cycle
2. Derive DR

transactions level of a transaction cycle. In a payroll cycle, the payroll expense accounts are normally
significant in the income statement, whereas the accrual payroll accounts are normally insignificant in the
balance sheet. The auditor typically allocates TM to accrual payroll accounts in the balance sheet (recall
allocation to balance sheet verses income statement items in Chapter 9), and allocates a large TM (i.e.,
more tolerance) to the accrual payroll accounts.
timing of the TOB procedures used by the auditor. In the payroll cycle, inherent risk is typically assessed at
a low level because misstatement in payroll accounts is unlikely due to employees self-interests in making
sure that they are properly compensated for and the external government agencies demand for accurate
submission of payroll-related tax returns.
client data. In the payroll cycle, analytical procedures are used especially to examine the reasonableness of
payroll expense accounts and accrued payroll accounts. Table 16-6 describes some analytical procedures
and potential misstatements that may be detected by them in the payroll cycle.
procedures but perform only TOB procedures. In a payroll cycle, the CR (as well as IR) is typically set at a
low level. Therefore, the derived DR is normally high resulting in fewer TOB procedures being performed
in a payroll cycle. Table 16-7 summarizes some specific audit objectives and common TOB procedures in
a payroll cycle. The auditor is especially concerned about the specific audit objective of existence or
occurrence that tests for fictitious employee and fraudulent work hours.
Table 16-6 Analytical Procedures for the Payroll Cycle

Payroll expense accounts:
Comparison of payroll expense account balances with prior years balances after adjusting for
pay changes and number of employees.
Comparison of budgeted payroll expenses with actual payroll expenses.
Comparison of payroll costs as a percentage of sales with prior years and industry data.
Comparison of direct labor as a percentage of sales with prior years.
Comparison of commission expense as a percentage of sales with prior years.
Estimate sales commissions by applying commission formulas to recorded sales totals.
Comparison of payroll tax expense as a percentage of salaries and wages with prior years after
adjusting for changes in the tax rates.
Analyze the overall reasonableness of the payroll expense accounts.
Accrued payroll accounts:
Accrued withholding/deduction accounts:
Comparison of accrued payroll account balances with prior years balances after adjusting or
changes in payroll conditions.
Analyze the overall reasonableness of the accrued payroll accounts.

Overstatement and understatement of payroll
expense.
expense.
expense.
Misstatements of direct labor and inventory.
Misstatement of commission expense.
Misstatement of sales commission.
Misstatement of payroll tax expense.
Misstatement of payroll expense.
Overstatement and understatement of accrued

liabilities.
Misstatement of accrued payroll liabilities.
Table 16-7 Specific Audit Objectives and Common TOB Procedures for a Payroll Cycle
Recorded payroll actually existed.
Conduct tests for non-existent payroll (fictitious employee) as follows:

Compare employee names on cancelled checks (endorsed signatures) with time cards and
other records for authorized signatures.
Trace selected payroll transactions recorded in the payroll register (payroll journal) to the
personnel department to determine whether the employees (personnel files) were actually
employed.
Select personnel files for employees who were terminated to determine whether each
received his/her termination pay according to company policy.
Observe an employee collecting a paycheck on behalf of another employee who is sick on

payday.
No fraudulent work hours recorded.
Conduct a surprise payroll payoff check (spot check).
Conduct tests for fraudulent work hours as follows:

Reconcile the total hours paid according to the payroll master file with an independent
record, such as time cards for the hours worked.
Completeness:
All payroll expenses and payroll accruals
are recorded.
Cutoff:
All payroll expenses and payroll accruals
are recorded in the proper period.
Accuracy:
Accrued payroll account balances are
recorded correctly.
Classification:
Accrued payroll accounts are properly
classified in the balance sheet.
Understandability:
All payroll-related accounts are properly
presented and disclosed in the financial
statements.
Observe an employee clocking in more than one time card under a buddy approach.
Vouch data for a sample of employees in the payroll register to approved time card data.
Trace a sample of the payroll expenses and accrued payroll balances to the payroll master file.
Inspect preparation of the monthly payroll account bank reconciliation.
Examine a sample of time cards or paychecks for a few days before and after a pay period for
recording payroll expenses in the proper period.
Examine a sample of balances in the periodic payroll reports for a few days before and after the
year-end for recording of accrued payroll accounts in the proper period.
Vouch a sample of accrued payroll account balances from the payroll master file for the supporting
documents such as payroll tax returns and corporate benefit policies.
Compare pay rates with union contract or approval by board of directors.
Compare withholdings by reference to tax tables and authorization forms in personnel files.
Recompute hours worked form time cards.
Recompute gross pay.
Recompute net pay.
Recompute payroll deductions.
Compare cancelled checks with payroll register (journal) for correct amount.
Reconcile the disbursements in the payroll register (journal) with the disbursements on the payroll
bank statement.
Analyze accrued payroll accounts for proper classification between short-term and long- term
liabilities.
Read the clients financial statements and inquiry of the management to ensure that all the
necessary disclosures for the payroll cycle are made according to GAAP. These items include:
Pension disclosure required by FASB No.87.

Postretirement benefit disclosures required by FASB No.106.
Profit sharing plans disclosure in the footnotes.
Deferred compensation arrangements disclosure in the footnotes.
Stock options either as expenses or disclosure in the footnotes.
Auditing Share-Based (Stock Options) Compensation

In 1995 the FASB issued Statement No.123, which encouraged but did not mandate the use of the fair
value method to determine compensation expense on the income statement. Initially, nearly all companies continued
to use the intrinsic value method to report compensation expense, which typically resulted in zero compensation
expense. After the accounting scandals of the early 2000s, some companies (e.g., Amazon, Coca-Cola) decided
voluntarily to use the fair value method to determine share-based compensation expense as a way of signaling the
441
442
high quality of their financial reporting to the capital markets. Within a few years, over 700 companies in the United
States voluntarily applied the fair value method. The FASB revisited the issue of share-based compensation, and in
December 2004 the FASB issued Statement No.123R Share-Based Payment, requiring the expensing of the fair
value of stock options granted and other share-based payments as compensation. Statement No.123R became
effective in 2006 for most public companies.
The determination of the fair value for share-based payments will require the use of an option-pricing
model for most companies. The most common models are the Black-Scholes-Merton model and the binomial model.
These models incorporate a variety of factors, including:
1. The exercise price of the option.
2. The term of the option.
3. The current market price of the underlying stock.
4. Expected volatility.
5. Expected dividends.
6. Expected risk-free rate.
Many of these factors are complex and involve forward-looking information. As such auditing share-based
compensation often presents high inherent risk because of the complexity of the accounting rules and the degree of
judgment and estimation that must go into the fair value determination. In addition to FASB statement No. 123
there are a number of other sources of technical literature that clients and auditors should consider in this area, for
example, FIN28, FIN38, FIN44, EITF90-7, EITF00-18, EITF00-23. In addition, CPA firms develop extensive audit
programs to help audit teams ensure that a client is appropriately accounting for share-based compensation. Table
16-8 discusses some common procedures that the auditor performs on share-based compensation.
Table 16-8 Common Audit Procedures for Share-based Compensation
Common Audit Procedures for Share-based Compensation

Read all applicable share-based plans and inquire of management whether other documents, for example, employment agreements contain
relevant information.
Understand policies, processes, and controls around share-based compensation.
Test design and operating effectiveness of controls, including a determination that the transactions have been properly authorized.
Obtain and test the accuracy of schedule supporting the granting of share-based compensation awards.
Review board of directors minutes to ensure completeness of the supporting schedules and to identify modifications to the terms of
outstanding awards or existing plans, for example, exercise price or date.
Perform analytical procedures to identify unusual fluctuations in compensation expense as well as related income/expense accounts.
Determine if any awards were exercised for other than cash, for example, loan or if employees were offered the opportunity to replace an
out-of-the-money award for another award.
Test the fair value measurements of option pricing. If the client is using an approved model, for example, Black-Scholes-Merton or
binomial model, verify the mathematical accuracy of the clients calculations, tie the output of the model to the financial statements, and tie
the known inputs, for example, term, stock price to relevant source documents. For forward-looking inputs, for example, expected
volatility, dividends, interest rate, test the reasonableness of these inputs.
Consider using the work of a valuation specialist to obtain evidence regarding fair value measurements. When specialists are used the
auditor is required to evaluate the specialists qualifications and objectivity. The auditor also must determine if the valuation model used by
the specialist is appropriate and consistent with GAAP. Finally, the auditor must understand and agree with the reasonableness of the
underlying assumptions.
16-1
A factory supervisor at XYZ Company terminated an hourly worker but did not notify the payroll department. The supervisor then
forged the workers signature on time cards and, when giving out the payroll checks, diverted the payroll checks drawn from the
terminated worker to his own use. The most effective procedure for preventing this payroll fraud is to
a. require written authorization for all employees added to or removed from the payroll.
b. have a paymaster who has no other payroll responsibility distribute the payroll checks.
c. have someone other than persons who prepare or distribute the payroll obtain custody of unclaimed payroll checks.
d. from time to time, rotate persons distributing the payroll.
16-2
Which of the following is an example of a weak internal control weakness when a supervisor in the payroll department is assigned the
responsibility for
a. distributing payroll checks to subordinate employees.
b. reviewing and approving time reports for subordinates.
c. interviewing applicants for subordinate positions before hiring is done by the personnel department.
d. initiating requests for salary adjustments for subordinate employees.
16-3
For good internal control, distributing payroll checks to employees is best handled by the
a. accounting department.
b. personnel department.
c. treasurers department.
d. employees department supervisor.
16-4
The purpose of segregating the duties of hiring personnel and distributing payroll checks is to separate the
a. Human resources function from the controllership function.
b. Administrative controls from the internal accounting controls.
c. Authorization transactions from the custody-related assets.
d. Operational responsibility from the record-keeping responsibility.
16-5
Tracing selected items from the payroll register (journal) to employee time cards that have been approved by supervisory personnel
provides evidence that
a. internal control relating to payroll disbursement were operating effectively.
b. payroll checks were signed by an appropriate officer independent of the payroll preparation process.
c. only bona fide employees worked and their pay was properly computed.
d. employees worked the number of hours for which their pay was computed.
16-6
Effective control procedures over the payroll function may include

a. reconciliation of totals on job time cards with job reports by employees responsible for those specific jobs.
b. verification of agreement of job time cards with employee clock card hours by a payroll department employee.
c. preparation of payroll transaction journal entries by an employee who reports to the supervisor of the personnel
department.
d. custody of the rate authorization records by the supervisor of the payroll department.
16-7
Which of the following procedures would most likely be considered a weakness in a clients internal controls over payroll?
a. A voucher for the amount of the payroll is prepared in the general accounting department based on the payroll
departments payroll summary.
b. Payroll checks are prepared by the payroll department and signed by the treasurer.
c. The employee who distributes payroll checks returns unclaimed payroll checks to the payroll department.
d. The personnel department sends employees termination notices to the payroll department.
16-8
An auditor is most likely to perform TOB on payroll transactions and balances when
a. cutoff tests indicate a substantial amount of accrued payroll expense.
b. the assessed level of control risk, CR, relative to payroll transactions is low.
c. analytical procedures indicate unusual fluctuations in recurring payroll entries.
d. accrued payroll expense consists primarily of unpaid commissions.
443
444
16-9
The auditor may observe the distribution of paychecks (spot check) to ascertain whether
a. pay rate authorization is properly separated from the operating function.
b. deductions from gross pay are calculated correctly and are properly authorized.
c. paychecks agree with the payroll register and the time cards.
d. recorded employees actually exist and are employed by the client.
16-10
A computer operator perpetrated a theft by preparing erroneous W-2 forms. The operators FICA withheld was overstated by $10,000,
and the FICA withheld from all other employees was understated. Which of the following audit procedures would detect such a fraud?
a. Multiplication of the applicable rate by the individuals gross taxable earnings.
b. Using form W-4 and withholding charts to determine whether deductions authorized per pay period agree with amounts
deducted per pay period.
c. Footing and cross footing of the payroll register followed by tracing postings to the general ledger.
d. Vouching cancelled checks to federal tax form 941.
16-11
In the audit of which of the following types business organizations would the auditor be most likely to place special emphasis on TOC
for proper classifications of payroll transactions?
a. A manufacturing organization.
b. A retailing organization.
c. A wholesaling organization.
d. A service organization.
16-12
Which of the following conditions would not alert the auditor to the possibility of errors or frauds on the payroll tax forms
which the client must file?
a. The existence of serious liquidity problems.
b. An ongoing IRS audit of clients Form 1120.
c. The payment of penalties and interest in the prior period for improper payments.
d. New personnel in the payroll department who are responsible for preparation of the forms.
16-13
From an audit point of view, which of the following would not be an important internal control in the payroll cycle?
a. Formal methods of informing payroll personnel of new employees.
b. Authorization of changes in pay rates.
c. Notice of the termination date of employees no longer working for the company.
d. Reconciliation of total payroll expense in the general ledger with the payroll tax returns and the W-2 forms.
16-14
Weak internal control allows a foreman to clock in daily for a fictitious employee and to approve the time card at the end
of the payroll period. This fraud would be detected if other controls were in place, such as having an independent party
a. recomputed hours worked from time cards.
b. foot the payroll journal and trace postings to the general ledger and the payroll master file.
c. distribute paychecks.
d. compare the date of the recorded check in the payroll journal with the date on the canceled checks and time cards.
16-15
Which of the following best describes proper internal control over payroll?
a. The preparation of the payroll must be under the control of the personnel department.
b. The confidentiality of employee payroll data should be protected to prevent fraud.
c. The duties of hiring, payroll computation, and payment to employees should be separated.
d. The payment of cash to employees should be replaced with payment by checks.
16-16
Verification of the legitimacy of year-end unpaid bonuses to officers and employees can be accomplished by comparing
the recorded accrual to the amount
a. in the expense account.
b. used in the prior period.
c. paid in the subsequent period.
d. authorized in the minutes of the board.
16 -17
Which of the following is the best TOB procedure for an auditor to determine that every name on a companys payroll is
that of a bona fide employee presently on the job?
a. Examine personnel records for accuracy and completeness.
b. Examine employees names listed on payroll tax returns for agreement with payroll accounting records.
c. Make a surprise observation of the companys regular distribution of paychecks.
d. Visit the working areas and confirm with employees their badge or identification numbers.
16-18
Recorded payroll transactions are for the amount of time actually worked and at the proper pay rate; withholdings are
properly calculated relates to which specific audit objective?
a. Accuracy.
b. Existence.
c. Valuation and allocation.
d. Completeness.
16-19
Which of the following is a test of control (TOC) procedure in the payroll cycle?
a. Review the payroll journal, general ledger, and payroll earnings records for large or unusual amounts.
b. Examine time cards for indication of supervisor approval.
c. Compare canceled check with payroll journal for name, amount, and date.
d. Examine canceled checks for proper endorsement.
16-20
To minimize the opportunity for fraud, unclaimed salary checks should be

a. held for the employee in the personnel department.
b. left with employees supervisor.
c. kept in the payroll department.
d. deposited in a special bank account.
16-21
When control risk (CR) is assessed to be very low, tests of balances (TOB) for the payroll cycle would most likely limited to
applying analytical procedures and
a. observing the distribution of paychecks.
b. examining time cards for fraudulent work hours.
c. inspecting payroll tax returns.
d. re-computing payroll accruals.
16-22
An auditor most likely would extend TOB of payroll when

a. payroll is extensively audited by the state government.
b. payroll expense is higher than in the prior year.
c. overstatement of work hours is discovered in performing TOC procedures.
d. employees complain to management about too much overtime.
16-23
An auditor vouched data for a sample of employees in a payroll register to approved clock card data to provide assurance
that
a. payments to employees are computed at authorized rates.
b. employees work the number of hours for which they are paid.
c. segregation of duties exists between the preparation and distribution of the payroll.
d. internal controls relating to unclaimed payroll checks are operating effectively.
16-24
Which of the following circumstances most likely would cause an auditor to suspect an employee payroll fraud scheme?
a. There are significant unexplained variances between standard and actual labor cost.
b. Payroll checks are disbursed by the same employee each payday.
c. Employee time cards are approved by individual departmental supervisors.
d. A separate payroll bank account is maintained on an imprest basis.
16-25
In a computerized payroll system environment, an auditor would be least likely to use test data approach to test controls
related to
a. missing employee numbers.
b. proper approval of overtime by supervisors.
c. time tickets with invalid job numbers.
d. agreement of hours per clock cards with hours on time tickets.
445
446
16-26
In a computerized payroll system environment, an auditor would be most likely to use a test data approach that contains
conditions such as
a. deductions not authorized by employees.
b. overtime not approved by supervisors.
c. time tickets with invalid job numbers.
d. payroll checks with unauthorized signature.
16-27
In determining the effectiveness of a clients policies and procedures relating to the existence or occurrence assertion for
payroll transactions, an auditor most likely would inquire about and
a. observe the segregation of duties concerning personnel responsibilities and payroll disbursement.
b. inspect evidence of accounting for prenumbered payroll checks.
c. re-compute the payroll deductions for employee fringe benefits
d. verify the preparation of the monthly payroll account bank reconciliation.
16-28
The sampling unit in a test of controls (i.e., using attribute sampling plan) pertaining to the existence of payroll transactions
ordinarily is a(n)
a. clock card or time ticket.
b. employee Form W-2.
c. employee personnel record.
d. payroll register entry.
16-29
Which of the following internal control procedures most likely would prevent direct labor hours from being charged to
manufacturing overhead?
a. Periodic independent counts of work in process for comparison to recorded amount.
b. Comparison of daily journal entries with approved production orders.
c. Use of time tickets to record actual direct labor worked on production orders.
d. Reconciliation of work-in-process inventory with periodic cost budgets.
16-30
In meeting the specific audit objective of safeguarding of assets, which department should be responsible for
a.
b.
c.
d.
16-31
Distribution of Paychecks
Treasurer
Payroll
Treasurer
Payroll
Custody of Unclaimed Paychecks

Treasurer
Treasurer
Payroll
Payroll
An auditor most likely would assess control risk (CR) at the maximum (100%) if the payroll department supervisor is
responsible for
a. examining authorization forms for new employees.
b. comparing payroll registers with original batch transmittal data.
c. authorizing payroll rate changes for all employees.
d. hiring all subordinate payroll department employees.
16-32
Which of the following departments most likely would approve changes in pay rates and deductions from employee
salaries?
a. Personnel.
b. Treasurer.
c. Controller.
d. Payroll.
16-33
Which of the following is an internal control procedure that most likely could help prevent employee payroll fraud?
a. The personnel department promptly sends employee termination notices to the payroll supervisor.
b. Employees who distribute payroll checks forward unclaimed payroll checks to the absent employees supervisors.
c. Salary rates resulting from new hires are approved by the payroll supervisor.
d. Total hours used for determination of gross pay are calculated by the payroll supervisor.
16-34
An audit client has changed from a system of recording time worked on clock cards to a computerized payroll system in
which employees record time in and out with magnetic cards. The computer system automatically updates all payroll records. Because
of this change
a. a generalized computer audit program must be used.
b. part of the audit trail is altered.
c. the potential for payroll-related fraud is diminished.
d. transactions must be processed in batches.
16-35
An auditor most likely would introduce test data into a computerized payroll system to test internal controls related to the
a. existence of unclaimed payroll checks held by supervisors.
b. Early cashing of payroll checks by employees.
c. discovery of invalid employee I.D. number.
d. proper approval of overtime by supervisors.
16-36
An auditor is gathering evidence regarding a clients share-based compensation. If the auditors specific audit objective is
accuracy of the clients presentation- and disclosure-related information, which of the following is the most appropriate audit
procedure to use?
a.
b.
c.
d.
16-37
Use the work of a valuation specialist to obtain evidence regarding fair value measurements
Understand policies, processes, and controls around share-based compensation.
Determine if the valuation model used by the client is appropriate and consistent with GAAP.
Obtain and test the accuracy of schedule supporting the granting of share-based compensation awards.
In auditing a clients share-based compensation, which of the following risk assessments would an auditor typically make?
a. Audit risk (AR) is typically set at moderate level.
b. Inherent risk (IR) is typically assessed at high level.
c. Control risk (CR) is typically assessed at low level.
d. Detection risk (DR) is typically derived at moderate level.

16-1 b. 16-2 a. 16-3 c. 16-4 c. 16-5 d. 16-6 b. 16-7 b. 16-8 c. 16-9 d. 16-10 a. 16-11 a.
16-12 b. 16-13 d. 16-14 c. 16-15 c. 16-16 d. 16-17 c. 16-18 a. 16-19 b. 16-20 d. 16-21 d.
16-22 c. 16-23 b. 16-24 a. 16-25 b. 16-26 c. 16-27 a. 16-28 d. 16-29 c. 16-30 a. 16-31 c.
16-32 a. 16-33 a. 16-34 b. 16-35 c. 16-36 d. 16-37 b.
447
448

Simulation Question 16-1 is an adaptation with permission from a case by Keim, M.T. and C.T. Grant in the Issues in Accounting Education, a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a fictitious yet realistic set of
facts.
To Tell or Not to Tell
Digital Manufacturing, Inc. is a publicly traded company that produces consumer goods for sale, primarily to wholesalers. The
company hired your accounting firm, San CPA, more than three years ago under both auditing and consulting engagements to assist with its
initial public offering (IPO) of common stock under the 1933 Securities Act. San CPA is among the 12 largest accounting firms in the United
States. It has developed a respectable reputation regarding its ability to help growing companies go public. You are currently an audit manager for
San CPA, having been promoted to this position from senior auditor in the last year, due in large part to your successful handling of the Digital
Manufacturing accounts.
You have just returned from lunch with Jay Hoffman, the new chief financial officer (CFO) for Digital Manufacturing, Inc. The
purpose of the meeting was to congratulate Hoffman on his recent promotion. You have known Hoffman since you were assigned to this
engagement, during which time he has progressed from accounting manager to chief accountant and now to his current position. When you
expressed how pleased you were about his promotion, Hoffman explained how proud he was of the accomplishments he has achieved since
entering the country as an illegal alien. He then told you that he entered the U.S. illegally because, at the time, that was the only way he could get
into this country. He was quick to explain that he has been a U.S. citizen for almost three years and asked that you keep this in confidence.
In connection with your audit of executive payroll, you pulled Hoffmans personnel file, along with those of all senior executives of
Digital Manufacturing. After the lunch meeting with Hoffman, you reviewed the contents of his personnel file. As required by federal law, a
Form I-9, Employment Eligibility Verification, from the U.S. Immigration and Naturalization Service, was included in his personnel record.
Hoffman completed and signed the form in 1992 at the commencement of his initial employment with Digital Manufacturing. He checked the
box indicating he was a citizen of the United States and signed the form; attesting under the penalty of perjury that he had made no false
statements or used false documents in connection with the completion of the form.
You should access Data File 16-1 in iLearn for Attachment 1, which presents Hoffmans I-9 Form, along with the official instructions for
completion.
Since 1986, federal law has required all newly hired employees (citizens and non-citizens) to complete and sign Section 1 of Form I-9.
Federal law also establishes that the employer is responsible for ensuring that Section 1 is timely and properly completed. Employers must then
complete and sign Section 2 of the form. This process requires employers to examine evidence of employee identity and employment eligibility
within three business days of the date employment begins. The employee must present specific acceptable documentation to verify identity and
employment eligibility, for example, a U.S. Passport or Certificate of U.S. Citizenship. You should access Data File 16-1 in iLearn for page
three of Form I-9, which provides a complete list of acceptable documentation. To your surprise, Digital Manufacturing never completed
Section 2 of Hoffmans form.
Note: If you encounter difficulty opening the scanned documents I-9 Form in iLearn, simply proceed to answer this simulation questions
without viewing those scanned documents.
Required
1. As part of your duties as the auditor, should you contact the audit committee about the CFOs illegal act? Support your answers by researching
and discussing specific guidance provided by the following authorities:
i. The AICPA Code of Professional Conduct (CPC) 1997.
The AICPA Code of Professional Conduct (CPC) is available at http://www.aicpa.org/about/code/index.htm
ii. The AICPA Statement on Auditing standards No.54 Illegal Acts.
The AICPA Statements on Auditing Standards are available on Lexis-Nexis at http://web.lexis-nexis.com/universe. If online access to AUs is not
available, you may use AICPA printed versions of the AUs available in the university libraries. In addition, the AICPA prints AUs in the Journal
of Accountancy as they are released in the Official Releases section of the journal.
iii. The Private Securities Litigation Reform Act of 1995.
Specifically, Discovering Illegal Acts by the Client is available at http://www.nysscpa.org/prof%5Flibrary/lrm/ii%5F13c.htm
iv. The Sabanes-Oxley Act of 2002
Articles and discussions on Sabanes-Oxley Act are available at http://www.imaknowledge.org/sox/
v. Refer back to Chapter 3 about auditor and confidential information on illegal acts.
2. Based on your research and discussing in 1, write a memo to Sue Pincus, the audit partner-in-charge, informing her of your recommendation
regarding San CPAs resolution of this issue. Be sure to fully explain your reasoning and provide authoritative support for your proposed
handling of this matter, including any extended TOC and TOB procedures for Digital Manufacturings payroll cycle.

This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly
available sources. The simulation question is developed by F. Choo in Financial and Integrated Audits, a publication of the CSU AcademicPub in
San Francisco, California.
Phantom Employees
In 1890, the Brooklyn Trolley Dodgers professional baseball team joined the National League. Over the following years, the Dodgers
would have considerable difficulty competing with the other baseball teams in the New York City area. Those teams, principal among them the
New York Yankees, were much better financed and generally stocked with players of higher caliber. In 1958, after nearly seven decades of
mostly frustration on and off the baseball field, the Dodgers shocked the sport world by moving to Los Angeles. Walter OMalley, the
flamboyant owner of the Dodgers, saw an opportunity to introduce professional baseball to the rapidly growing population of the West Coast.
Furthermore, OMalley saw an opportunity to make his team more profitable. As an inducement to the Dodgers, Los Angeles County purchased a
goat farm located in Chavez Ravine, an area two miles northwest of downtown Los Angeles, and gave the property to OMalley for the site of his
new baseball stadium.
Since moving to Los Angeles, the Dodgers have been the envy of the baseball world: In everything from profit to stadium
maintenance the Dodgers are the prototype of how a franchise should be run (The Wall Street Journal, August 31, 1990). During the 1980s
and 1990s, the Dodgers reigned as the most profitable franchise in baseball with a pretax profit margin approaching 25 percent in many years. In
late 1997, Peter OMalley, Walter OMalleys son and the Dodgers principal owner, sold the franchise for $350 million to media mogul Rupert
Murdoch. A spokesman for Murdoch complimented the OMalley family for the longstanding success of the Dodgers organization. The
OMalleys have set a gold standard for franchise ownership (Los Angeles Times, September 5, 1997)
During an interview before he sold the Dodgers, Peter OMalley attributed the success of his organization to the experts he had
retained in all functional areas: I dont have to be an expert on taxes, split-fingered fastballs, or labor relations with our users., That talent is all
available (The Wall Street Journal, August 31, 1990).
Edward Campos, a longtime accountant for the Dodgers, was seemingly a perfect example of one of those accepts in the Dodgers
organization. Campos, accepted an entry-level position with the Dodgers, as young man. By 1986, after almost two decades with the club, he had
worked his way up the employment hierarchy to become the operations payroll chief.
After taking charges of the Dodgers payroll department, Campos designed and implemented a new payroll system, a system that
reportedly only he fully understood. In fact, Campos controlled the system so completely that he personally filled out the weekly payroll cards for
each of the four hundred employees of the Dodgers. Campos was known not only for his work ethic but also for his loyalty to the club and its
owners: The Dodgers trusted him, and when he was on vacation, he even came back and did the payroll ( Los Angeles Times, September 17,
1986).
Unfortunately, the Dodgers trust in Campos was misplaced. Over a period of several years, Campos embezzled several hundred
thousand dollars from his employer. According to court records, Campos padded the Dodgers payroll by adding fictitious employees to various
departments in the organization. In addition, Campos routinely inflated the number of hours worked by several employees and then split the
resulting overpayments fifty-fifty with those individuals.
The fraudulent scheme came unraveled when appendicitis struck down Campos, forcing the Dodgers controller to temporarily
assume his responsibilities. While completing the payroll one week, the controller noticed that several employees, including ushers, security
guards, and ticket salespeople, were being paid unusually large amounts. In some cases, employees earning $47 an hour received weekly
paychecks approaching $2,000. Following a criminal investigation and the filing of charges against Campos and his cohorts, all the individuals
involved in the payroll fraud confessed.
A state court sentenced Campos to eight years in prison and required him to make restitution of approximately $132,000 to the
Dodgers. Another of the conspirators also received a prison sentence. The remaining individuals involved in the payroll scheme make restitution
were placed on probation.
Required
1. Refer to Table 6-2 in Chapter 6 and identify the risk factors pertaining to Camposs payroll fraudulent scheme under three separate headings as
follows:
(a) Incentives/Pressure
Risk factor 1 . . .
Risk factor 2 . . .
(b) Opportunities
Risk factor 1 . . .
Risk factor 2 . . .
(c) Rationalization
Risk factor 1 . . .
Risk factor 2 . . .
2. Based on the risk factors identified in 1. above, plan your test of control procedures that might led to the discovery of the fraudulent scheme
masterminded by Campos using the following format:
Specific audit objective #1 . . .
Planned test of control procedure #1 . . .
449
450
3. Based on the risk factors identified in 1. above, plan your test of balance procedures that might led to the discovery of the fraudulent scheme
masterminded by Campos using the following format:
Planned test of balance procedure #1 . . .
Planned test of balance procedure #2 . . .
Planned test of balance procedures #1 . . .
Planned test of balance procedures #2 . . .
4. Assume when you were conducting the planned audit tests in 2. and 3. above, Campos and his cohorts fled from the U.S. to Mxico.
(a) Explain whether a federal prosecutor in the U.S. would likely or unlikely get a warrant to extradite them from Mxico.
You should search the Internet for information on any extradition or law-enforcement cooperation agreements between the U.S. and Mxico. Cite
all relevant cases and sources of information from the Internet, and your search of the Internet should be reasonably exhaustive.
(b) Explain whether a federal prosecutor in the U.S. would likely or unlikely get the Mxico government to cooperate in the criminal/civil
investigation of Campos and his cohorts who fled to Mxico.
You should search the Internet for information regarding the diplomatic track record between the U.S. Embassy in Mxico City and the Mxico
government. Cite all relevant cases and sources of information from the Internet, and your search of the Internet should be reasonably exhaustive.

This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly
available sources. The simulation question is developed by F. Choo in Financial and Integrated Audits, a publication of the CSU AcademicPub in
San Francisco, California.
The Executive Compensation Issues
An example of Executive Compensation Abuses
Executive compensation ballooned in the 1990s. There were notable compensation abuses. The most popular form of executive
compensation the 1990s was company stock (or options to purchase stock). Designers of these compensation plans argue that by compensating
officers with stock, the officers will take actions in the best interest of the shareholders. Critics claim executive compensation is often too high in
proportion to average salaries at companies and that the compensation levels motivate officers to take selfish actions.
Tyco International Ltd.s Dennis Kozlowski looms large as a rogue CEO for the ages. His $6,000shower curtain and vodka-spewing,
full-size ice replica of Michelangelos David will not be soon forgotten. In essence, prosecutors accused Kozlowski and former Chief Financial
Officer Mark Swartz of running a criminal enterprise within Tycos executive suite. The two were hit with 38 felony counts for pilfering $170
million directly from the company and for pocketing an additional $430 million through tainted sales of stock. Ironically, both Kozlowski and
Swartz were former auditors; Kozlowski has become the personification of the widespread irrational exuberance of the late 1990s. Kozlowski
handpicked some of the members of the compensation committee, and the changes worked to his benefit as his total compensation rose from $8.8
million in 1997 to $67 million in 1998 to $170 million in 1999. But it appears that Kozlowski believed that he deserved more money that he was
making. The more he was paid as a reward for Tycos soaring stock price, the more he spent on luxuries and the more he stole. During these
years, Kozlowski was secretly selling lots of stock - $280 million worth, according to the Manhattan DAs indictment of Kozlowski.
Kozlowski also ran up a $242 million tab at Tyco under a loan program designed to finance the purchase of company stock. Rather
than use the money to buy Tyco stock, he used it to purchase fine art and antiques, a yacht, and a Nantucket estate. The loans were forms of
compensation, but characterizing the compensation as a loan provided significant tax and accounting benefits to the executive and the
corporation. Tycos board approved some, but not all, of the forms of compensation Kozlowski had tapped into.
When Congress learned of the level of abuse in corporate loans, it was shocked. In the Sarbanes-Oxley Act of 2002, Congress forbids
public companies to make or even arrange new loans to executives or to modify or renew old ones. The penalties for a violation are up to 20 years
in jail and fines reaching $ 5 million for executives and $25 million for companies.
In June 2005, Kozlowski and Swartz were each convicted on 22 criminal charges relating to their misdeeds at Tyco. Both were
sentenced to serve up to 25 years in prison and pay fines and restitution totaling $240 million. In May of 206 Kozlowski agreed to pay $21.2
million dollars to New York State to settle tax-evasion charges that included millions in sales taxes, fines, and penalties relating to his purchases
of fine art.
Required
1. (a) Research executive compensation of at least three well-known companies. You can find executive compensation in SEC filings on EDGAR
at www.sec.gov or on a variety of Internet sites, such as eComp at www.ecomponline.com .
(b) Use your best judgment to compute the proportion of executive compensation to average salary (i.e., are executives earning 5 times, or 10
times, or 100 times the average employee).
(c) In your opinion, are the executives in (a) and (b) above worth it? Please explain.
2. In your opinion, what are the costs and benefits associated with compensating executives with stock options to purchase stock?
3. What do you believe are the most effective audit procedures to use to identify executive compensation abuse or fraud? Please explain.
451
452
Chapter 17
Capital Cycle Tests of Controls and Tests of
Balances
LO17-1 Understand the accounting information system for notes payable.
LO17-2 Describe some common TOC procedures for notes payable.
LO17-3 Apply the analytical procedures for notes payable.
LO17-4 Describe some common TOB procedures for notes payable.
LO17-5 Understand the accounting information system for stockholders equity.
LO17-6 Describe some common TOC procedures for stockholders equity.
LO17-7 Describe some common TOB procedures for stockholders equity.
Chapter 17 Capital Cycle Tests of Controls and Tests of Balances

An overview of the strategy for tests of controls for notes payable in a capital cycle is presented in Figure 17-1.
Figure 17-1 TOC Strategy for Notes Payable in Capital Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
453
454
In capital cycle, the auditor focuses on auditing of long-term liabilities and stockholders equity. Long-term debt
accounts consist of notes payable, bonds payable, and mortgages payable. Auditing of notes payable, a
representative long-term debt account is discussed here. Stockholders equity consists of capital stock - common,
capital stock - preferred, paid-in capital in excess of par, dividends, retained earnings, and treasury stock. Auditing
of common stock, dividends and retained earnings as representative stockholders equity are discussed here.
Understanding Internal Controls for Notes Payable in a Capital Cycle
TOC methodology for notes payable (a long-term liabilities in the capital cycle) starts with an understanding of
internal controls relating to notes payable. Table 17-1 provides a brief discussion of the various components relating
to the understanding of internal controls of notes payable.
Table 17-1 Understanding Internal Controls of Notes Payable
Understanding Internal Controls of Notes Payable (a Long-Term Liabilities in the Capital Cycle)
2. Risk assessment
5. Monitoring
have a special effect on notes payable. Notes that are issued longer than a year are long-term notes payable.
Long-term notes are usually audited in the capital cycle whereas short-term notes are usually audited in the
revenue cycle (issuance) and expenditure cycle (payment of principal and interests).
risk assessment. The auditor must understand how management assesses risks that are relevant to notes
payable, estimates their significance, assesses the likelihood of their occurrence, and takes action to address
those risks in order to meet the five basic management assertions.
cycle. If the auditor plans to conduct both TOC and TOB on notes payable, then s/he needs to identify the
control activities relating to specific audit objectives and for the purpose of assessing control risk (CR).
notes payable internal control questionnaires.
The auditor must obtain sufficient knowledge of the accounting information system relating to notes
payable to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed
in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as
shown in Figure 17-2. A brief discussion of these three areas is provided in Table 17-2.
The auditor must understand the managements monitoring processes over notes payable. This includes
understanding how the management monitors the internal controls of notes payable over time and what
corrective action is initiated to improve the design and operation of controls in the capital cycle.
Figure 17-2 Understanding of Information and Communication for Notes Payable
Key Functions
Understand 1 key function of notes payable

Transactions
Understand how the 1 key function is
of transactions

records
Table 17-2 Understanding of Information and Communication for Notes Payable

Key Functions
1. Financing
Financing activities are
infrequent:
Approval of common
financing instruments such
as notes, bonds, and
mortgages.
Financing activities are
frequent:
Approval of other
sophisticated financing
instruments such as
collateralized mortgage
obligations, repurchase and
reverse repurchase
agreements, interest-rate
swaps, and derivatives.
Accounts
(control ledger)
Notes payable
Interest
payable

Classes of
Transactions
Long-term
liabilities
Minutes
The board of directors is responsible for the issuance of
notes payable. The boards approval for the issuance is
recorded in the minutes of its meetings.
Interest
expense
Notes payable
This legal document states the type of notes payable
(unsecured or secured), the amount of loan (principal), and
the term of repayment (principal and interest).
Cash in bank
Schedule of notes payable and accrued interest

This schedule details each note transaction showing the
name/entity of the note holders, the principal amount
borrowed, the type of security, the term of the notes, the
amount of repayment in principal and interests, and the
accrued interest payable.
Figure 17-3 An Example of a Notes Payable Internal Control Questionnaires

W/P Ref: ICQ -7
Internal Control Questionnaire Notes Payable
Client: ABC Company
Completed by:
Reviewed by:
1. Are investment transactions (marketable securities, notes

payable, and equity) made in accordance with managements
authorization?
2. Are sources of capital funds (marketable securities, notes
payable and equity) authorized in accordance with
managements criteria?
3. Are adjustments of marketable securities (e.g., adjustment
of carrying value), notes payable (e.g., adjustment of debt
obligations after renegotiation), and equity (e.g., changes to
par or stated value of stock) authorized in accordance with
managements criteria?
4. Are marketable securities, notes payable, and equity
transactions recorded at the correct amounts, in the proper
period, and properly classified?
5. Is access to securities restricted to personnel authorized by

management?
6. Are access to marketable securities, notes payable, and
equity-related records and forms restricted to personnel
authorized by management?
Helen
Mary
Date: 8.12.201x
Date: 10.30.201x
Yes, No, N/A

Yes
Comments
The management has established policies for
selecting and approving investment transactions.
Yes

obtaining capital funds.
Yes

approving marketable securities, debt, and equity
adjustments. Adjustment forms are prenumbered.
Adjustments exceeding pre-established dollar
amounts required specific authorization.
The management reviews board minutes regularly
for directives related to dividend, long-term debt, and
treasury transactions. The management also regularly
prepares schedules of interest and loan payment due
dates.
Securities are kept in a locked safe. Files of
authorized signatures are maintained.
Forms and records are kept in a secured locker room.
All un-issued, issued, and retired securities are
accounted for by an officer who is independent of
physically controlling securities, accounting, and
cash activities.
Yes
Yes
Yes
Conclusion: Internal controls for notes payable are adequate. Specifically, the control activities of authorization, independent check, and safe
guarding of assets are present and strong.
455
456
Consider Potential Misstatements of Notes Payable in a Capital Cycle

After the auditors have obtained an understanding of the internal controls relating to notes payable and documented
such an understanding; the auditors would consider potential misstatements that could occur due to weaknesses in
internal control. Table 17-3 describes some of the potential misstatements of notes payable in a capital cycle.
Table 17-3 Potential Misstatements of Notes Payable in a Capital Cycle due to Weakness in Internal Control
Unauthorized
marketable
securities, notes payable, and equity
transactions.
Example of Fraud
Make investment in marketable

securities, notes payable, and equity by
including more debt instruments than allowed
by the board of directors.
Make unauthorized adjustments of

investments in marketable securities, notes
payable, and equity that violate established
policies for the adjustments.
Improper recording of marketable

transactions.
No physical safeguarding of
marketable securities, notes payable, and
equity related forms and records.
Example of Error
Obtain capital funds in marketable

securities, notes payable, and equity at
unfavorable terms/cost or with overly
restrictive covenants.
Incorrect adjustments of the carrying

value of marketable securities, debt
obligations of notes payable, and stated
value of equity.
Inaccurate recording of detailed

schedules and records of marketable
transactions.
Make unauthorized access to investment

to steal un-issued or issued forms and records
relating to marketable securities, notes
payable, and equity.

the audit program for notes payable in the capital cycle. Table 17-4 describes some common TOC procedures that
the auditors perform on notes payable in the capital cycle.
Table 17-4 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Notes Payable
Internal Controls
Issuance and renewal of notes payable is
properly approved.
Proper authorization for issuing and renewing of

notes payable.
If the CFO is responsible for both the

executing and accounting of notes payable,
observe independent check on the CFO by a
member (finance committee) of the board of
directors.
Examine copies of new note or bond
agreements.
Read board of directors minutes for approval
of new and existing notes.
Review the renewal of notes payable shortly
after the balance sheet date.
Completeness:
Notes payable transactions are recorded.
Blank and paid notes are accounted for.
Observe the control over blank notes by a

responsible person.
Inspect paid notes to ensure that they are
cancelled and retained by a responsible person.
Adequate accounting records for issuing and

repaying long-term liabilities.
Inquiry of the management that at the time of

issuance of notes, the borrowed sum is
properly recorded in the revenue cycle.
Inquiry of the management that at the time of
repayment of principal and interest; the checks
are properly prepared in the expenditure cycle.
Observe internal independent check on
periodic reconciliation of the detailed notes
payable schedule with the notes payable

Notes payable are recorded correctly.
Internal Controls

account.
Observe periodic comparison with the notes
payable account with note holders records by
an employee who is not responsible for
maintaining the detailed notes payable
schedule.
457
458
An overview of the strategy for tests of balances of notes payable in a capital cycle is presented in Figure 17-4.
Figure 17-4 TOB Strategy for Notes Payable in Capital Cycle
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
Apply TOB Strategy to Notes Payable in Capital Cycle

Table 17-5 provides a brief discussion of the TOB strategy as it is applied to notes payable in a capital cycle.
Table 17-5 TOB Strategy for Notes Payable
TOB Strategy Notes Payable
2. Derive DR

transactions level of a transaction cycle. In a capital cycle, the audit focuses on examining any new debt
agreement and determining the status of prior debt agreements. Thus, if the frequency of issuing new longterm notes payable is low, and adequate records are kept for prior debt agreements, the auditor typically
allocates a large TM (i.e., more tolerance) to notes payable.
timing of the TOB procedures used by the auditor. In the capital cycle, inherent risk is often assessed at a
relatively low level for companies with a few notes payable transactions.
client data. In the capital cycle, the application of analytical procedures on notes payable is especially
efficient because if the results were favorable, the auditor might eliminate the TOB procedures on notes
payable. Table 17-6 describes some analytical procedures for notes payable and potential misstatements
that may be detected by them. Figure 17-5 shows an example of the application of analytical procedures
that might eliminate the TOB procedures for notes payable.
nature and timing, if CR were assessed at a very low level and the occurrence of notes payable transactions
is rare; the auditor would focus more on TOC procedures than TOB procedures for notes payable. TOB on
notes payable usually starts with the auditor obtaining a schedule of notes payable and accrued interest
from the client. The auditor then uses this schedule as a basis for performing the TOB procedures on notes
payable. Table 17-6 summarizes some specific audit objectives and common TOB procedures for notes
payable. The auditor is especially concerned about the specific audit objectives of existence or occurrence,
completeness, accuracy, and understandability for notes payable. Figure 17-6 shows an example of the
auditors TOB procedures performed on the schedule of notes payable.
Table 17-6 Analytical Procedures for Notes Payable

Compute approximate interest expense on the basis of average interest rates and overall monthly
notes payable. Compare this approximated interest expense with the interest expense recorded in
the clients record (notes payable account). See Figure 17-5 for an example.
Compare individual notes outstanding with those of the prior year.
Compare total balance in notes payable, interest expense, and accrued interest with prior year
balances.

Misstatement of interest expense and accrued
interest, or omission of an outstanding note
payable.
Omission or misstatement of a note payable.
Misstatement of interest expense and accrued
interest or notes payable.
459
460
Figure 17-5 An Example of the Application of Analytical Procedures that Might Eliminate the TOB
Procedures for Notes Payable
W/P Ref: NP-5
Analytical Procedure on Interest Expense Notes Payable
Client: ABC Company
Prepared by:
Reviewed by:
Helen
Mary
Date: 8.18.201x
Date: 10.30.201x
$ 2,571,000
Interest expense per general ledger

1. Compute approximate interest expense for short-term notes payable:
Balance outstanding at the end of month:
January
$ 2,000,000
February
2,500,000
March
3,000,000
April
2,000,000
May
3,000,000
June
2,500,000
July
3,000,000
August
2,500,000
September
2,000,000
October
3,000,000
November
2,500,000
December
2,000,000
Total
30,000,000
Average outstanding balance at the end of month $ 30,000,000/12 = $ 2,500,000

Average interest expense for the 12 months $ 2,500,000 @ 10% = $ 250,000
2. Compute approximate interest expense for long-term notes payable:
Beginning balance
Ending balance
Total
$ 28,000,000
30,000,000
58,000,000
Average outstanding balance for the 12 months $ 58,000,000/2 = $ 29,000,000

Average interest expense for the 12 months $ 29,000,000 @ 8% = $ 2,320,000
3. Compute approximate total interest expense for short- and long-term notes payable:
Approximate short-term interest expense
Approximate long-term interest expense
Total
$ 250,000
2,320,000
2,570,000
2,570,000
Difference
1,000
========
Agrees with general ledger and working trial balance.

Obtained from general ledger.
Estimated by examining several notes throughout the year with rates ranging from 9% to 11%.
Agrees with 8% rate for the 12 months in the permanent file schedule of long-term notes payable.
Difference is 1,000/2,570,000 = 0.04% of the approximate total interest expense.
Conclusion: The difference between the computed approximate interest expense and the clients interest expense per general ledger is not
significant because the difference is less than 5% of the approximate total interest expense. Therefore, the interest expense for notes payable per
books is acceptable.
Table 17-7 Specific Audit Objectives and Common TOB Procedures for Notes Payable
Notes payable in the schedule of notes
payable and accrued interest exist.
Completeness:
Existing notes payable are included in the
schedule of notes payable and accrued
interest.
Existing notes payable are recorded.

Accuracy:
Notes payable and accrued interests on the
interests are accurate.
Classification:
Short and long term liabilities are properly
classified.
Cutoff:
Notes payable are included in the proper
accounting period.
The client has an obligation to pay the
notes payable (rights and obligations
assertions)
Understandability:
Notes payable, interest expense, and
accrued interest are properly presented and

Confirm notes payable with creditors (usually creditors are banks, insurance companies, or trustees
representing the creditors).
Obtain a standard bank confirmation that requests specific information on the existence of notes
payable from all banks with which the client does business (see Chapter 18 for more discussion on
bank confirmation).
Examine the bank reconciliation for new notes credited to the bank account by the bank (see
Chapter 18 for more discussion on bank reconciliation).
Examine notes paid after year-end to determine whether they were liabilities at the balance sheet
date.
Compare interest expense with the notes payable amount for reasonableness.
Obtain a schedule of notes payable. See Figure 17-6 for an example.
Foot and cross-foot the schedule of notes payable and accrued interest and agree totals to the
balances in notes payable account, interest payable account, and interest expense account.
Confirm balances of notes payable, interest rates, and last date for which interest has been paid
with holders of notes.
Recompute accrued interest.
Examine due dates of notes for proper classification between current and long-term liabilities.
Examine notes to determine whether there are related-party transactions or borrowings from major
shareholders.
Examine notes payable activities for a few days before and after year-end to determine if the
transactions are included in the proper accounting period.
Scan notes to determine whether the client has obligations for payment.
Examine balance sheet for proper presentation and disclosure of short and long term liabilities,
related parties, assets pledged as security for notes, and restrictions on notes payable.
Read note agreement for any restrictions that should be disclosed in the footnotes of the financial
statements.
461
462
Figure 17-6 An Example of the Auditors TOB Procedures Performed on the Schedule of Notes Payable
W/P Ref: NP-12
TOB Procedure on Schedule of Notes Payable
Client: ABC Company
Prepared by:
Acct 301 Notes Payable

Acct 302 Interest Payable
Acct 305 Interest Expense
Reviewed by:
Description
10 % Notes
Payable to Bank
of America, due
$100,000
per
year to 7/1/2013
9% Notes
Payable to Wells
Fargo Bank, due
9/1/2013
t
#
^
r
f
x
Balance
1/1/2001
Notes Payable
Additions
Payments
300,000 t
100,000 ^
250,000
Balance
12/31/2002
Balance
1/1/2001
200,000 #
15,000 t
250,000 #
300,000
250,000
100,000
450,000
Helen
Mary
Date: 8.22.2002
Date: 10.30.2002
Interest Payable
Expense
Payments
25,000 r
30,000 ^
Balance
12/31/2002
10,000
7,500
7,500 r
15,000
32,500
30,000
17,500 #
Long-term investments in stock pledged as security; agreed to confirmation received from bank.
Land and building pledged as security; agreed to confirmation received from bank.
Traced to prior year schedule of notes payable.
Traced to general ledger at 12/31/2002.
Traced to cash journal and examined cancelled notes and/or check.
Examined copy of notes included in permanent file.
Recomputed interest expense; no difference noted.
Footed.
Cross-footed.
TOC Strategy for Stockholders Equity in Capital Cycle

The rest of this chapter focuses on auditing stockholders equity in the capital cycle. The strategy for TOC for notes
payable in capital cycle in Figure 17-1 applies the same to stockholders equity. Accordingly, the understanding of
information and communication in Figure 17-2 also applies to the stockholders equity. Table 17-9 provides specific
details concerning the auditors understanding of information and communication for stockholders equity.
It should be noted that inherent risk for stockholders equity is often assessed at a relatively low lever
because transactions in stockholders equity are normally few in number. However, control risk for stockholders
equity is often assessed at a low or moderate level depending on the responsibilities of the high level management
who handle the transactions. Table 17-8 provides a brief description of the responsibilities of high level management
for transactions in stockholders equity.
Table 17-8 Responsibilities of High Level Management for Transactions in Stockholders Equity
Responsibilities
Financial planning
Brief Description
Financial planning starts with the CFOs cash flow forecast. This forecast informs the board of directors and
management of the business plans, the prospects for cash flows, and the needs for cash flows. The cash flow
forecast usually is integrated with the capital budget, which contains the plans for asset purchases and business
acquisitions. A capital budget approved by the board of directors constitutes the authorization for major capital
Responsibilities
Raising capital
Record keeping
Brief Description
asset acquisitions and investments.
The board of directors usually authorizes sales of capital stock and debt financing transactions. All the directors
must sign registration documents for public securities offerings. Authority for recurring transactions, such as
periodic renewals of notes payable, is normally delegated to the CFO or Treasurer to complete such transactions
without specific board approval of each transaction.
Company bonds and stocks are normally handled by an external intermediary called a transfer agent, generally
a bank or trust company. The transfer agent keeps track of securities owners for payment of interest or dividends.
The certificate records are kept by a registrar who updates the records based on information from the transfer
agent. Often the registrar and transfer agent are the same company.
It should be noted that for off balance sheet financing, clients may enter into obligations and commitments that
are not required to be recorded in the accounts. Examples of such transactions include: operating leases,
endorsements on discounted notes, letters of credit, guarantees, repurchase or remarketing agreements,
commitments to purchase at fixed prices, commitments to sell at fixed prices, and certain type of stock options.
Records of notes and bonds payable are maintained by the Accounting Department and the CFO or controller.
The record keeping procedures are the same as for accounts payable, that is, interest payments are set up in
vouchers for payment, and accruals for unpaid interest are made on financial reporting dates. Clients that have a
few bonds and notes outstanding usually do not keep subsidiary accounts. All information is recorded in the
general ledger accounts (control ledger). At year end, the CFO or controller is responsible for properly
classifying them into short or long term liabilities.
For small private companies, CFOs periodically inspect the stock certificate book to verify the bona fide
existence of stockholders. The CFOs may also confirm the ownership of shares with the stockholders. For large
public companies, The CFOs periodically obtain reports from the registrars and transfer agents to verify the
company records of outstanding shares.
For some large public companies, trustees handle the ownership of bonds. The trustees have the same duties and
responsibilities as that of registrars and transfer agents. In this case, the CFOs confirm with the bond trustees to
verify the company records of bonds payable.
Table 17-9 Understanding of Information and Communication for Stockholders Equity

Key Functions

Accounts
(control ledger)
1. Financing
Non-publicly held
company:
Approval of a few, if any,
changes in the
stockholders equity
(owners equity and
dividend)
Publicly held company:
Approval of frequent and
complex changes in the
stockholders equity
(common stock, preferred
stock, paid-in capital in
excess of par, retained
earnings and dividends)
Capital stock common
Capital stock prefer
Paid-in capital
in excess of par
Dividends
payable
Retained
earnings
Cash in bank
Classes of
Transactions
Stockholders
equity including: (1)
Issuance of capital
stock.
(2) Repurchasing of
treasury stock.
(3) Payment of
dividend.

Minutes
The board of directors is responsible for the issuance of
capital stock, repurchasing of treasury stock, and declaration
of dividends (cash or stock). The boards decisions are
recorded in the minutes of its meetings.
The SEC requires all publicly held company to engage an
independent stock registrar who is responsible for (1)
ensuring that all stock is issued in accordance with the
authorized capital stock provision in the corporate charter
and the authorization of the board of directors and (2)
signing all newly issued stock certificates and making sure
that old certificates are received and cancelled before a
replacement certificate is issued.
Capital stock certificate book

This book records the issuance and repurchase of capital
stock for the life of the company. It records such information
as the certificate number, the number of shares issued, the
name of the person to whom it was issued, and the issue
date. When shares are repurchased and later retired or
reissued, it records the cancelled certificates and replacement
certificates and the date of their cancellation and
replacement.
Shareholders capital stock master file

This file records the total outstanding stock at any given
time. It is used as a check on the accuracy of the capital
stock certificate book and the balance of the Capital Stock
Common account in the general ledger. It is also used as a
basis for the payment of dividends.
Most publicly held company also engage a stock transfer
agent who is responsible for (1) preparing stock certificates,
(2) maintaining the capital stock certificate book and
shareholders capital stock master file, and (3) preparation
and disbursement of dividends.
463
464

After understanding and documenting internal controls relating to the stockholders equity, the auditors assess
control risk (CR) and perform TOC procedures as per the audit program for the stockholders equity. Table 17-10
summarizes some specific audit objectives for TOC, internal controls, and common TOC procedures for
stockholders equity.
Table 17-10 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Stockholders
Equity
Internal Controls
Issuance of capital stock (and stock
options), repurchase of capital stock, and
payment of dividends are properly
approved.
Proper
authorization
for
issuing and
repurchasing of stock, and payment of
dividends.
Read board of directors minutes for

authorization on (1) the type and number of
stock to issue, par value of stock, and the date
of the issue, (2) the type and number of stock
to repurchase, the amount to pay for
repurchasing, and the timing of the buy back,
and (3) the form of dividend (cash or stock),
the amount of the dividend per share, the
declaration, recording, and payment dates.
Vouch corporate stock (and stock options)
issuances and treasury stock transactions to the
minutes of the board of directors.
If the client does not engage a transfer agent,
observe proper segregation of duties is
maintained as follows:
The person responsible for issuing,

transferring, and canceling certificates
should
not
have
any
accounting
responsibilities.
The person responsible for maintaining

the detailed stockholders records should be
independent of the maintenance of the
capital stock related accounts in the general
ledger.
The person responsible for maintaining

the detailed stockholders records should not
also process cash receipts (issued shares) or
disbursement (dividends).
Appropriate separation of duties

among the preparation, recording, signing,
and mailing of dividend checks.
Completeness:
Existing capital stock transactions are
recorded.
Adequate stockholders equity records are

maintained.
Confirm with the stock transfer agent that all

capital stock transactions are recorded.
If the client does not engage a transfer agent:
Read the minutes of the board of

directors meeting to identify approved
capital stock transactions.
Examine the client-held capital stock

records to ensure all approved capital stock
transactions in the minutes are recorded.
Trace capital stock transactions to cash

receipts (for issuance of stock) in the
revenue cycle and cash payment (repurchase
of capital stock or cash dividend) in the
expenditure cycle.
Apply TOB Strategy to Stockholders Equity

The strategy for TOB of Notes payable in Figure 17-4 applies the same to stockholders equity. It should be noted
that since there are usually a few transactions occurring in the stockholders equity within a particular accounting
period (but each transaction is usually very significant if it occurs), the auditor does not use analytical procedures in
the TOB of the stockholders equity. Instead, the auditor focuses on the TOB procedures and conducts 100% testing
of the few but material transactions taking place in the stockholders equity. Table 17-11 summarizes some specific
audit objectives and common TOB procedures for stockholders equity. The auditor is especially concerned about
the specific audit objectives of existence or occurrence, completeness, accuracy, and understandability.
Table 17-11 Specific Audit Objectives and Common TOB Procedures for Stockholders Equity
The existence of recorded capital stock
transactions, such as issuance of new
capital stock, the merger with another
company through an exchange of stock,
donated shares, and the purchase of
treasury stock.

Confirm with the independent stock registrar and the stock transfer agent for the existence of the
capital stock transactions.
If the client does not engage a stock transfer agent:
Inquiry of the board of directors that capital stocks are issued in conformity with the
company charter.
Confirm the existence of the capital stock transaction in the minutes of the board of
directors meetings.
Trace a sample of the cancelled dividend payment checks to the authenticity of the payees
(stockholders) in the stock certificate book.
Completeness:
All capital stock transactions are recorded
in the capital stock related accounts.
Confirm with the stock transfer agent that all capital stock transactions are recorded in the capital
stock certificate book and the stockholders capital stock master file. .
If the client does not engage a transfer agent:
Foot the shares outstanding in the client-held capital stock records and agree them to total
shares outstanding in the client-held capital stock related accounts in the general ledger.
Inspect that cancelled stock certificates are defaced to prevent re-issuance.
Inspect and account for any un-issued stock certificates in the capital stock certificate
book.
Accuracy:
All capital stock related accounts are
recorded correctly.
Confirm with the stock transfer agent the ending balances of the capital-stock related accounts.
If the client does not engage a stock transfer agent:
(1) Capital stock accounts
Obtain a schedule of stockholders equity. See Figure 17-7 for an example.
Recompute the amount of the paid-in capital for all the outstanding shares and verify to the
ending balances in the capital stock accounts.
Recompute the amount of the paid-in capital in excess of par or stated value and verify to
the ending balance in the paid-in-capital in excess of par accounts.
(2) Dividends
Recompute amount of dividends (number of shares outstanding x amount of per share

dividend approved) and verify to the ending-balance of the dividend payable account.
Read the minutes for dividends declared but not recorded, and for any restrictions on the
payment of dividends in bond indenture agreements or preferred stock provisions.
(3) Retained earnings
Trace the net income/loss entry to the retained earnings account to the earnings/loss in the
income statement.
Recompute and verify any transactions entered to the retained earnings account, such as
cash dividends declared, market value of stock dividends or splits declared (debit to retained
earnings), prior-period adjustments, foreign currency translation, and appropriation of retained
earnings.
Trace the ending balance of the retained earnings account to the stockholders equity in the
balance sheet.
Understandability:
Stockholders equity is properly presented
and disclosed in the financial statements.
Examine balance sheet for proper presentation and disclosure in the stockholders equity:
Number of shares authorized, issued, and outstanding for each class of stock.
465
466

Call privileges, prices, and dates for preferred stock.
Preferred stock sinking funds.
Stock option or purchase plans.
Stock option re-pricing program.
Restrictions on retained earnings and dividends.
Market value of stock dividends or splits is capitalized (credit to capital stock) in

stockholders equity.
Figure 17-7 An Example of the Auditors TOB Procedures Performed on the Schedule of Stockholders
Equity
W/P Ref: SEA-1
TOB Procedure on Schedule of Stockholders Equity
Helen
Reviewed by: Mary
Client: ABC Company
Prepared by:
Acct 501 Stockholders Equity Accounts
Date: 8.31.20x2
Date: 10.30.20x2
Additional Paid-In Capital
Authorized
Balance, 12/31/20x1, $5 par.
Issued 6/1/20x2 at par.
15,000 Shares
____________
Balance, 12/31/20x2
t
f
15,000 Shares
===========
Issued & Outstanding
Amount At Par
12,000 Shares t
2,000 Shares
______________
$ 60,000 t
10,000
______________
____________
14,000 Shares
===========
$ 70,000
============
$ 5,000
===========
Agreed with the clients corporate charter.

Agreed with authorization in the minutes of the board of directors.
Agreed with cash receipts records.
Traced to general ledger and prior-years audit working papers.
Footed.
Conclusion: Stockholders equity accounts in the balance sheet are recorded correctly.
$ 5,000 t
17-1
The audit program for long-term liabilities should include which one of the following additional procedures?
a. Verification of the existence of the bondholders.
b. Examination of any bond trust indenture (an additional agreement to a bond issue that defines the risk of bondholders).
c. Inspection of the notes payable master file.
d. Investigation of credits to the bond interest income account.
17-2
An audit client has completed a private placement of a substantial amount of bonds. Which of the following is the most
important TOB procedures for the audit of bonds payable?
a. Confirming the amount issued with the bond trustee.
b. Tracing the cash received from the issue to the accounting records.
c. Examining the bond records maintained by the bond transfer agent.
d. Re-computing the annual interest cost and the effective yield.
17-3
An audit client has a conventional real estate mortgage loan. Which of the following audit procedures is least likely to be
performed in auditing the mortgage balance?
a. Examine the current years cancelled checks.
b. Analyze the mortgage amortization schedule.
c. Inspect public records of lien (the legal right to keep or sell someone elses property as security for a debt) balance.
d. Recompute interest expense.
17-4
When auditing a publicly held company, the auditor should obtain written confirmation regarding debenture (unsecured
bond) transactions from the
a. debenture holders.
b. clients attorney.
c. internal auditors.
d. debenture trustee.
17-5
Which of the followings is a TOC procedure for the audit of the retained earnings?
a. Examining market value used to charge retained earnings to account for a 2-for-1 stock split.
b. Examining prior period adjustment entry to retained earnings.
c. Authorization for both cash and stock dividends.
d. Gain or loss entry to retained earnings resulting from disposition of treasury shares.
17-6
When an audit client does not engage an independent stock transfer agent, and the client issues its own stocks and
maintains stock records, cancelled stock certificates should
a. be defaced to prevent re-issuance and attached to their corresponding stubs.
b. not be defaced, but segregated from other stock certificates and retained in a cancelled certificate file.
c. be destroyed to prevent fraudulent re-issuance.
d. be defaced and sent to the secretary of state.
17-7
Which of the following questions would an auditor most likely include on an internal control questionnaire for notes
payable?
a. Are assets that collateralize notes payable critically needed for the entitys continued existence?
b. Are two or more authorized signatures required on checks that repay notes payable?
c. Are the proceeds from notes payable used to purchase non-current assets?
d. Are direct borrowings on notes payable authorized by the board of directors?
17-8
An auditors purpose in reviewing the renewal of a note payable shortly after the balance sheet date is most likely to obtain
c. completeness.
d. valuation and allocation.
467
468
17-9
When a client does not maintain its own stock records, the auditor should obtain written confirmation from the transfer
agent and registrar concerning
a. restrictions on the payment of dividends.
b. the number of shares issued and outstanding.
c. guarantees of preferred stock liquidation value.
d. the number of shares subject to agreements to repurchase.
17-10
An auditor should trace corporate stock issuances and treasury stock transactions to the
a. numbered stock certificates.
b. articles of incorporation.
c. transfer agents records.
d. minutes of the board of directors.
17-11
The primary responsibility of a bank acting as a registrar of capital stock is to

a. ascertain that dividends declared do not exceed the statutory amount allowance in the state of incorporation.
b. account for stock certificates by comparing the total shares outstanding to the total in the shareholders subsidiary ledger.
c. act as an independent third party between the board of directors and outside investors concerning mergers, acquisitions,
and the sale of treasury stock.
d. verify that stock has been issued in accordance with the authorization of the board of directors and the articles of
incorporation.
17-12
It is normal practice to verify all capital stock transactions

a. only when the client is a small company.
b. that are in excess of a material amount.
c. if there arent very many such transactions during the year.
d. regardless of the controls in existence, because of their materiality and permanence in the accounting records.
17-13
Analytical procedures are essential for notes payable because

a. of the paucity of documentations in this area.
b. there are few internal controls in this area which the auditor can rely upon to reduce substantive testing.
c. tests of details for interest expense and accrued interest can frequently be eliminated when results are favorable.
d. the large quantity of transactions would make this an expensive area to audit by other test procedures.
17-14
The record of the issuance and repurchase of capital stock for the life of the corporation is maintained in the
a. capital stock certificate books.
b. shareholders capital stock master file.
c. schedule of stock owners.
d. common stock account in the general ledger.
17-15
When there are not numerous transactions involving notes during the year, the normal starting point for the audit of notes
payable is
a. a schedule of notes payable and accrued interest prepared by the audit team.
b. a schedule of notes payable and accrued interest obtained from the client.
c. a schedule of only those notes with unpaid balances at the end of the year prepared by client.
d. the notes payable account in the general ledger.
17-16
When auditing a clients retained earnings account, an auditor should determine whether there are any restrictions on
retained earnings that result from loans, agreements, or state law. This procedure is designed to attest managements
financial statement assertion of
c. presentation and disclosure.
17-17
In performing TOC concerning the granting of stock options, an auditor should

a. confirm the transaction with the Secretary of State in the state of incorporation.
b. verify the existence of option holders in the clients payroll records.
c. determine that sufficient treasury stock is available to cover any new stock issued.
d. trace the authorization for the transaction to a vote of the board of directors.
17-18
In auditing for unrecorded long-term bonds payable, an auditor most likely will
a. perform analytical procedures on the bond premium and discount accounts.
b. examine documentation of assets purchased with bond proceeds for liens.
c. compare interest expense with the bond payable amount for reasonableness.
d. confirm the existence of individual bondholders at year-end.
17-19
In auditing a typical capital cycle, an auditor would most likely

a. assess inherent risk (IR) at a high level.
b. assess control risk (CR) at a low or moderate level.
c. assess both inherent risk (IR) and control risk (CR) at a high level.
d. set detection risk (DR) at a low level.

17-1 b. 17-2 a. 17-3 c. 17-4 d. 17-5 c. 17-6. a. 17-7 d. 17-8 b. 17-9 b. 17-10 d. 17-11 d.
17-12 c. 17-13 c. 17-14 a. 17-15 b. 17-16 c. 17-17 d. 17-18 c. 17-19 b.
469
470

Simulation Question 17-1 is an adaptation with permission from a case by T.J. Vogel in the Issues in Accounting Education , a publication of the
American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
Introduction
The Formation of CC and the Subsequent Accounting Scandal
CCs Compensation Policy
Stock options are usually issued to corporate executives in an attempt to align the interests of those individuals with the interests of the
companys shareholders. The options are designed to provide a large payoff to the executives when the companys stock price increases
substantially above the exercise price of the options. However, in those periods when a company performs poorly, its stock price may decrease to
a level below the exercise price of outstanding options. When this occurs, the options are said to be underwater. Because options provide a
benefit only as the stock price increases, underwater options will often lack the motivational incentive that they were designed to create. This
creates a dilemma to the compensation committee of the company i.e., modify the compensation agreements of the individuals in charge during
the period of poor stock price performance or risk losing hose executives to other companies. One such modification that is often considered in
these circumstances is a stock-option repricing program. Here, underwater stock options are exchanged for new options containing a lower
exercise price. These programs experienced increased popularity during the 1990s despite the opposition that arose from critics who claimed that
repricing programs reward executives for poor performance.
You are the independent auditor of Cendant Corp. (hereafter, CC). In auditing its capital cycle, you are to evaluate the appropriateness
of a stock-option repricing program for the executives and other employees of CC. This audit client experienced a severe decrease in its stock
price during 1998 as a result of many factors including an accounting scandal, failed expansion efforts, and poor market conditions.
On May 27, 1997, the Boards of Directors for HFS, Inc. and CUC International Inc. approved a merger agreement that formed CC., a
conglomerate that specialized in travel and shopping-club memberships and Internet marketing. Its divisions include Avis rental cars; the Howard
Johnson, Days Inn, and Ramada Hotel chains; the Coldwell Banker and Century 21 real-estate franchises, and Sierra On-Line software. The
combination was billed as a merger of equals. Henry Silerman, CEO of HFS, Inc. was selected ad CCs president and CEO, while Walter Forbes,
CEO of CUC international Inc., was selected as the companys Chairman of the Board.
You should access Data File 17-1 in iLearn for Table 1, which contains a summary of the merger events as described in the proxy
statement filed with the SEC by HFS, Inc. on August 28, 1997.
The merger was finalized in December, and CCs stock started trading on December 17, 1997, closing that day at $32.62. Following
the merger, the company enjoyed immediate success and on April 6, 1998, its share price rose to a high of $41.69. The company was in the midst
of many acquisitions, including the recently negotiated stock-and-cash acquisition of American Bankers Insurance Group. Unfortunately, the
company was not progressing as well as the market believed. On April 9, 1998, the company announced that three former CUC executives were
leaving the company, including Cosmo Corigliano, CUCs chief financial officer, and Amy Lipton, CUCs general counsel. As reported in the
Wall Street Journal:
Rumors of changes at the top of the company had sent the stock plunging earlier in the day. The stock closed at $37, down $2.0625, or 5.3% in
composite trading on the New York Stock Exchange The company tried to reassure investors in a conference call, saying that first-quarter
earnings met or exceeded analysts expectations of 25 cents per diluted share, according to First Call In an interview, Mr. Silverman called the
impending resignations inevitable when large companies merge He added that Ms. Liptons and Mr. Coriglianos jobs went away with the
merger.
A week later, on April 15, 1998, CC released a shocking message after the markets had closed for the day. Company officials had
discovered potential accounting irregularities in its core membership-club operations that will require it to reduce reported 1997 operating
income by $100 million or more and that it will hurt this year earnings. The primary issue at hand was the method employed by the CUC unit in
recognizing revenue in its club-membership sales. It was discovered that too much of the revenue was booked up front, while the recording of
expenses associated with the memberships was deferred until future periods. The following day, CCs stock price plunged from Wednesdays
close of $36.00 to $19.06 as an astounding 108 million shares traded hands. The average trading volume for CC had been about 4 million shares
per day.
On July 14, 1998, the company sent a second shocking announcement to the market: to meet Wall Streets earnings expectations.
CUC had recorded nonexistent revenue of $300 million over a three-year period. In evaluating the situation, Mr. Silverman observed, We
merged with a company and 50% to 60% of the earnings were without substance. It should be called a terrible transaction A layman would
call it fraud. The auditor for CUC, Ernst & Young, LLP, had issued unqualified audit opinions for the period involved. In defending its position,
Ernst & Young claimed, Revenue recognition is a complex issue accounting is an art. Accounting principles are subject to interpretation.
After announcing the expanded losses involved in the investigation, CCs stock price dropped to $15.69, a 52-week low. Subsequently, on July
29, 1998, mounting pressure from irate investors forced Walter Forbes to resign as CCs Chairman, along with ten other members of CCs Board
of Directors formerly associated with CUC. Mr. Forbes received severance pay of $47.5 million, and Mr. Silverman was elected to succeed him
as the companys new Chairman.
Over the next few months, many factors forced the stock price even lower. First, the SEC had instituted its own investigation into the
companys accounting policies. The strict requirements mandated by the SEC from its investigation forced the company to downgrade its
projected earnings for 1998. Second, as the stock price continued to decline, it became apparent that the companys planned acquisitions would
be difficult to complete. Eventually, CC called off its planned acquisition of Providian Auto & Home Insurance Co. and American Bankers
Insurance Group, Inc. Third, the allegations of fraud created many lawsuits against the company. An investigation by Arthur Andersen LLP
focused the responsibility for the fraud on Walter Forbes and the other dismissed CUC employees. Finally, the overall market experienced a
decline in the third quarter of 1998. The Dow Jones Industrial Average fell from its 1998 high of 9338 on July 17 th to its low for the year of 7539
on August 31st (a 19 percent decrease in less than two months). In September 1998, CCs Stock price had impounded the aggregate effect of these
factors and was trading in the range of $10 to $14 per share.
Like most publicly traded companies, CC established a compensation committee, composed of four non-employee directors of the
company, to oversee the companys compensation policies. The compensation packages of executives and key employees contained three major
components: salary, bonus, and stock options. Primary emphasis was given to equity-based compensation (stock options). The compensation
committee believed that it was essential to align the interests of management with those of shareholders. Stock options were issued with an
exercise price of equal to the companys stock price on the date of issuance. They were designed to provide a substantial payoff to employees
when CCs stock price increased above this exercise price. In addition to stock options, employees were highly encouraged (but not mandated) to
maintain stock ownership in the company.
Unfortunately, the stock price decline experienced by CC in 1998 was so severe that the exercise price of many outstanding employee
stock options was now higher than CCs stock price (i.e., the options were underwater). Furthermore, even the options that were still in-themoney (i.e., had exercise prices below CCs stock price) had lost a tremendous amount of value. Company morale was extremely low. Employees
realized that the stock options they once hoped would provide a substantial payoff now seemed to be of little value.
In September 1998, the compensation committee held a special meeting to discuss potential modifications that could be made to the
companys compensation plans in an attempt to re-motivate and re-energize valuable company employees. The information available to
committee members at this meeting is summarized in Tables 2 through to 5. You should access Data File 17-1 in iLearn for Tables 2 through
to 5. Table 2 provides the job tiles and stockholdings in September 1998 of CCs five named executives, 1 and Table 3 provides
information on the outstanding stock options for each of the named executives. Many of the options were issued by the predecessor company
(HFS or CUC) and exchanged for CC options at the time of the merger. 2 When the merger was completed (December 1997), a significant option
grant was made to further align the interests of the employees involved. In addition, CC did not require a vesting period for option grants. All of
the options presented in Table 3 were therefore fully vested and currently exercisable.
After examining the information on the outstanding options, the magnitude of the loss of wealth to the employees became apparent.
However, the committee also noted that some employees (including Silverman, Holmes, and Buckman) held other options with extremely low
exercise prices (see Table 3). Perhaps there was really no need to modify the compensation packages currently in effect. Alternatively, committee
members acknowledged that these low exercise prices also demonstrated the value of the employees involved. They realized that it was the policy
of CC and its predecessor companies to set an options exercise price at the market price of the underlying stock on the date of issuance.
Therefore, when a low exercise price is observed on lower options, it must be the case that the companys market value has increased
significantly during the employees term of employment.
The annual compensation levels of the named executives are presented in Table 4. The compensation received in 1997, primarily from
the predecessor companies, is presented in Panel A. The importance of stock options was obvious to committee members. When CCs stock price
was rising, the compensation received from the exercise of stock options would often dwarf that received from salary and bonus. Panel B presents
similar information for 1998 (through September). The salary listed for each executive represented the scheduled annual amount. The bonus
column had zero for each executive, as this had not yet been determined as of this meeting date of the committee.
Finally, Table 5 provides the footnote disclosure from CCs 1997 financial statements summarizing the information on outstanding
employee stock options for the company as a whole. At December 31, 1997, there was a total of 172 million employee options outstanding, of
which 123.1 million had exercise prices of $10 or higher. Certainly, the stock price decline experienced by CC affected the financial fortunes of
all employees, not just the named executives.
The Repricing Decision
From the information available, the Compensation Committee concluded that CCs recent misfortunes had caused financial distress
for virtually every employee. Recognizing the value of these employees, the committee was anxious to modify the compensation packages
currently in place to reduce some of the financial hardship experienced.
It was suggested that CC adopt a stock-option repricing program whereby employees would have the opportunity to exchange
underwater options for new options with a lower exercise price. Option repricing programs had become popular with other companies
experiencing a severe stock price decline. Their purpose is to re-motivate all employees by restoring the inherent values of the options involved.
It seemed like a plausible solution, but as the meeting progressed a number of questions arose regarding the proposed repricing program: How
would the external investors who suffered significant losses with CCs stock price decline react to a repricing decision? Should an employee be
allowed to have all of his/her underwater stock options be repriced, or should only a portion of these options be eligible in the program? Should
the new exercise price in the repricing program be lowered all the way down to the current market price, or would a substantial decrease in the
exercise price to a new level that was still above the current market price (say$15) be sufficient to achieve the desired goals of the program? Also
unclear was whether all employees should be eligible to participate in the program or whether specific individuals should be excluded. These
issues and others were under consideration by the committee at its September 1998 meeting.
Required
In auditing CCs capital cycle, you are to evaluate the appropriateness of its stock-option repricing program for the executives and other
employees by answering the following questions.
1. a. When the accounting scandal was announced, CCs stock price dropped to $19.06. Afterward, the highest price obtained through September
1998 was $25.37. Panel B of Table 4 (Access Data File 17-1 in iLearn) states that Mr. Silverman and Mr. Buckman exercised options during the
first nine months of 1998. What must the stock price have been when the options were exercised? What does this tell you about the timing of the
option exercises?
b. During the period of this simulated question, CCs stock price decreased from a high of $41.69 in April 1998, to a low of $10 in September
1998. How much did the intrinsic value of the options held by Mr. Silverman and the other executives decrease during this period?
Note: The per share intrinsic value is computed by subtracting the exercise price from the market price ($41.69 on April 6, 1998 and $10
estimated on September 23, 1998), but may not be less than zero.
1
The named executives refer to those individuals for whom specific compensation information is provided in proxy statements filed with the
SEC.
2
Information on the options existing prior to the merger was obtained from individual Forms S-3 filed with the SEC at the time of the merger in
December 1997.
471
472
c. What are the major pros and cons that CCs compensation committee will need to consider when deciding whether to reprice employee
stock options, especially those of senior management and executives?
Note: Disregard any taxation issues that may result.
2. a. CC uses APB No.25 to report compensation expense (recorded at intrinsic value). How would this be different if FASBs Interpretation
No.44, Accounting for Certain Transactions Involving Stock Compensation: An Interpretation of APB Opinion No.25 (issued in March 2000),
was in effect when the repricing occurred?
For question 2.a., you should research the following documents:
i. Financial Accounting Standards Board (FASB). 2002. Accounting for Certain Transactions Involving Stock Compensation: An Interpretation
of APB Opinion No.25 is available at: http://www.fasb.org/
ii. Journal of Accountancy. 2000. FASB offers more guidance on stock options. (July): 18-19.
iii. Cocco, A.F., and G. Vent.2000. FASB Interpretation No.44: Accounting for certain transactions involving stock compensation. The CPA
Journal (July): 22-27.
iv. Hall, B.J. 2000. What you need to know about stock options. Harvard Business Review (March-April): 121-129.
b. What impact do you believe that Interpretation No.44 will have on companies considering a stock-option repricing program in the future?
Note: Compare the impact of the Interpretation No.44 of APB No.25 and FASB Statement No.123 on CCs earnings.

Simulation Question 17-2 is an adaptation with permission from a case by P. D. Kimmel and T. D. Warfield in the Issues in Accounting
Stock Buybacks Decision
It is December 15, 2006. Phillip Buyback, CFO, and Carver Smith, Controller, both employees of Oracle International, are seated in a
conference room with Hank Wiseman, an investment banker for the firm of Wiseman and Wisdom. Wiseman requested the meeting to discuss a
proposal for Oracles stock buyback program. Oracle has engaged in a number of previous large stock buybacks to make shares available for its
employee stock option plan and for use as currency in acquisitions of other companies. Oracle has a large number of employee stock options that
will most likely be exercised in the near future. Therefore, Wiseman is anticipating that Oracle will soon initiate a large stock buyback to
minimize outstanding shares and thus avoid diluting its earnings per share. Because Wiseman believes that he can structure Oracles stock
buyback in a more beneficial fashion, he scheduled a meeting with Buyback and Smith.
On the date of the meeting, Wiseman began his presentation after a brief exchange of pleasantries:
Wiseman: In your past stock repurchases you have typically announced your intentions to repurchase anywhere from 500,000 to 1,000,000 shares
over the subsequent 12-month period. You then repurchased the shares in two to four open-market repurchases scattered throughout the year.
This approach enabled you to repurchases the shares when you thought the price was advantageous. However, this approach has the disadvantage
of delaying some of the stock buybacks beneficial aspects.
Buyback: What do you mean by that?
Wiseman: One of the primary benefits of a stock buyback is that it reduces the number of outstanding shares, and thus increases reported earnings
per share. Suppose that you plan to purchase 1,000,000 shares in the coming year. Under your usual approach, your stock repurchases are
scattered throughout the year; therefore, the beneficial impact on earnings per share that results from reducing shares is much reduced. Using our
approach, you would instead record a 1,000,000-share reduction in the number of outstanding shares immediately after executing the buyback
plan, all at a pre-agree price.
Buyback: That does sound good.
Wiseman: An additional benefit of a stock buyback is that, by executing the transaction at the beginning of the buyback period, you send a more
creditable signal to the market by actually acting on your stated intentions. Otherwise, in some past instances, due to either cash shortfalls or
increases in the cost of shares, you have only partially executed your announced share repurchase plan. For example, two years ago you only
repurchased half as many shares as you had originally stated that you would . By not fulfilling your originally stated plan, you potentially left
some investors skeptical about your real intentions.
Buyback: How does your plan work?
Wiseman: Out approach, a fairly common one, is called an accelerated share repurchase. Let me explain the steps. After you announce your
share repurchase plan, you buy all of the shares at a pre-agreed price from our firm. For example, Oracles stock is currently selling for $45
dollars. If we arranged for a repurchase of 1,000,000 shares today, then you would give us $45,000,000, and we would give you 1,000,000 shares.
Buyback: I didnt realize that you are holding so many of our shares.
Wiseman: We arent, but our institutional clients are. We simply borrow the shares from them, and then sell them to you. This process enables
you to purchase more shares than are currently available in the market, and you do so without driving the price up. However, as a result of
borrowing shares from our clients, we are in a short position on your shares. So, to protect us against loss on this short position, we require that
you agree to a forward sale contract. Under this forward contract, you agree to buy our firm shares at a price equal to the price at the initiation of
the transaction, or in this case, $45. Any difference between the market price and the agreed price at the date of settlement is payable in either
cash or additional shares, at your discretion. Throughout the buyback period, we close out our short position by buying shares in the market to
replace the shares we borrowed from our clients. For example, suppose that we purchase 1,000,000 shares at an average price of $60. You would
either pay us $15,000,000 [($60 - $45) x 1,000,000] or 250,000 additional shares ($15,000,000/$60). On the other hand, if we only pay $30 for
the shares, then we would pay you $15,000,000 [$45 - $30) x 1,000,000].
Smith: What about the accounting? What is the accounting treatment for this transaction? It would seem that Oracles forward sale contract
would be treated as a derivative. If thats case, then the gains and losses on the contract that result from changes in Oracles stock price would
flow directly into net income, negating much of the earnings per share benefit.
Wiseman: Thats beauty of it. By using an accelerated share repurchase plan, you get an immediate boost to EPS because of the immediate
reduction in shares outstanding. Furthermore, under an Emerging Issues Task Force (EITF) ruling issued in the late 1990s, the forward sale
contract does not get derivative treatment because the contract is an instrument indexed to Oracles own stock. In fact, Oracle has the option of
settling in shares. As a result, gains or losses on the contract are recorded as adjustments to equity, rather than as a component of income. In other
words, if the gain or loss is paid in cash, then the amount directly increases or decreases stockholders equity. Just so you know, for diluted EPS
calculations, if your intent is to pay the difference in cash, then the numerator of EPS is adjusted for the gain or loss. On the other hand, if you
intend to settle by issuing additional shares, then the additional shares increase the shares outstanding. Thus, if your share price changes, then the
initial EPS improvement gained at the inception of the deal may change to some extent.
I have prepared the following example for a hypothetical company to illustrate the accounting treatment. Suppose that XYZ Company
engages in an accelerated share repurchase (hereafter, ASR) on January 2, 2007 for 20,000 shares at an initial price of $20 per share. XYZ makes
the following entry to record the ASR:
Treasury Stock
Cash
400,000
400,000
Assume XYZ had 2006 net income of $360,000 and that earning per share for 2006 was $1.80 ($360,000 net income / 200,000 shares
outstanding). If XYZ estimates that 2007 net income will also be $360,000, then its EPS for 2007 will increase to $2 [$360,000/ (200,000
20,000) shares outstanding]. If XYZs share price decreases to $15 during the settlement period, ending June 30, 2007, then the company will
receive a $100,000 [($20 - $15) x 20,000 shares] cash payment from Wiseman and Wisdom on settlement of the forward sale agreement. This
payment reduces the net cost of the share repurchase program to XYZ and is reported a s a direct increases to stockholders equity.
Buyback: Thank you for your presentation. We would like to do some additional analysis before we make a decision. I will call you within a
week.
Required
Smith approaches you, the external auditor, for help regarding the accounting treatment for the buybacks decision. Based on the
projected 2007 comparative financial statements, you are to prepare responses to the following questions for Smith. These responses will form the
basis of Smiths report to Buyback. You should access Data File 17-2 in iLearn for Exhibit 1, which presents the projected 2007
comparative financial statements.
1. Using the financial statement data presented in Exhibit 1 of Date File 17-2, compute the following for 2007 and 2006 (You may assume that
the December 31, 2006 balance sheet balances are representative for December 31, 2005):
a. Basic Earnings per Share
b. Debt-Equity Ratio
c. Return on Assets
2. Assume that Oracle buys back 250,000 shares on March 31, 2007, and 750,000 shares on September 30, 2007, at a price of $45 on each date,
using a traditional repurchase program.
a. What entry is made on each of the dates that treasury stock is repurchased?
b. What is the total amount paid to execute share repurchase program?
c. Repeat the analysis for Requirement 1. above and discuss the impact of a traditional share repurchase on Basic Earnings per Share, the DebtEquity Ratio, and Return on Assets.
3. Assume that Oracle enters into an ASR agreement to repurchase 1,000,000 shares on January 2, 2007 at a price of $45, and settles the forward
contract on September 30, 2007.
a. Prepare the journal entries at January 2, 2007 and September 30, 2007. Assume that Oracle share price holds steady such that the average
settlement price at September 30, 2007 is $45 per share.
b. What is the total amount paid to execute the share repurchasing program?
c. Repeat the analysis for Requirement 1. above and discuss how the results differ among the base case, the traditional repurchase, and the ASR
with respect to Basic Earnings per Share, the Debt-Equity Ratio, and Return on Assets
4. Repeat the analysis for Requirement 3. above, assuming the difference is paid in cash at an average settlement price of $50.
5. Assuming the ASR in Requirement 3. above:
a. If Oracle prepares financial statements on June 30, 2007, when its share price is $50, is the value of the ASR reflected in Oracles financial
statements on that date? Explain.
b. i. What risk does the ASR create for Oracle that it would not face under a traditional plan?
ii. Are the potential consequences of this risk adequately reported under the current standards?
6. Prepare a management letter (also known as a clients advisory comments letter) to Smith that:
a. Explains i. the accounting for the basic earnings per share treatment for the ASR, and
ii. the accounting for the forward sale contract.
b. Discusses i. the pros and cons of using the ASR to avoid the dilution of earnings per share that results from stock option exercises.
ii. the implications that the ASR transaction could be both legal and in accordance with GAAP, but not be considered ethical.
c. Explains your opinion on whether Oracle should/should not execute the share repurchase using the ASR arrangement.
473
474
Resources available on the Internet that are helpful for answering the above questions include:
a. EITF No. 99-7, Accounting for an Accelerated Share Repurchase Program (http: //www.fasb.org/pdf/abs99-7.pdf).
b. FASB (and IASB) have projects whose resolution could affect the classification of the ASR forward contract as debt (asset) or equity (see http:
//www.fasb.org/project/liabeq.shtml), as well as the EPS effects of these arrangements (see http://www.fasb.org/project/short-term intl
convergence.shtml).

Simulation question 17-3 is developed by F. Choo in Financial and Integrated Audits, a publication of the CSU AcademicPub in San Francisco,
California.
Part 1
Internal Controls of Stockholders Equity
Auditors typically use internal control questionnaires to obtain an understanding of a clients internal control of stockholders equity.
Items 1 through 6 below are common questions found in the internal control questionnaires used by the auditors. A yes to these questions
indicates the presence of an internal control, whereas a no indicates an absence of an internal control.
1. Are all entries in the stockholders equity accounts authorized at the proper level in the organization?
2. Are issues and retirements of stock authorized by the board of directors?
3. Does the company use the services of an independent registrar or transfer agent?
4. If an independent registrar and transfer agent are not used:
(a) Are unissued certificates properly controlled?
(b) Are cancelled certificates mutilated to prevent their reuse?
5. Are common stock master files and stock certificate books periodically reconciled with the general ledger by an independent
person?
6. Is an independent transfer agent used for disbursing dividend? If not, is an imprest dividend account maintained?
Required
1. For each of the common internal control questions 1 through 6 above, state the purpose of the control.
2. For each of the common internal control questions 1 through 6 above, identify the type of potential financial statements if the control is
absence.
3. For each of the potential misstatements in 2. list an audit TOC procedure that the auditor would use to determine whether a material
misstatement exists.
Part 2
Tests of Controls and Tests of Balances of Stockholders Equity
Auditors typically perform TOC and TOB procedures to verify a clients stockholders equity. Items 1 through 7 below are common
TOC and TOB procedures used by the auditors.
1. Review the articles of incorporation and bylaws for provisions about stockholders equity.
2. Analyze all stockholders equity accounts for the year and document the nature of any recorded change in each account.
3. Account for all certificate numbers in the capital stock book for all shares outstanding.
4. Examine the sock certificate book for any stock that was cancelled.
5. Review the minutes of the board of directors meeting for the year for approvals related to stockholders equity.
6. Recompute earnings per share.
7. Review debt provisions and senior securities with respect to liquidation preferences, dividends in arrears, and restrictions on the
payment of dividends or the issue of stock.
Required
1. For each of the testing procedures 1 through 7 above, identify whether it is a TOC or a TOB procedures of stockholders equity.
2. For each of the testing procedures 1 through 7 above, state the specific audit objective for each of the testing procedures.
3. For each of the testing procedures 1 through 7 above, list the type of misstatements the auditor would uncover by the use of each of the testing
procedures.
Part 3
Testing a Special Case of Stockholders Equity
You, the continuing auditor of Yesman, Inc., are beginning to test the common stock and treasury stock accounts. You have decided to
design TOB (tests of balances) procedures without relying on the companys internal controls (i.e., the companys CR (control risk) is assessed at
the maximum of 100%).
Yesman, Inc. has no par and no stated-value common stock, and it acts as its own registrar and transfer agent. During the past year
Yesman, Inc. both issued and reacquired shares of its own common stock, some of which the company still owned at year-end. Additional
common stock transactions occurred among the shareholders during the year.
Common stock transactions can be traced to individual shareholders accounts in a subsidiary ledger and to a stock certificate book.
The company has not paid any cash or stock dividends. There are no other classes of stock, stock rights, warrants, or option plans.
Required
1. List the TOB procedures you would use to test Yesman, Inc.s common stock and treasury stock accounts.
2. How should Yesman, Inc. stockholders equity be properly presented and disclosed in the financial statements?
475
476
Chapter 18
General Cash and Investments Tests of Controls and
Tests of Balances
LO18-1 Differential among accounts and documents in general cash.
LO18-2 Apply the analytical procedures for general cash.
LO18-3 Describe some common TOB procedures for general cash.
LO18-4 Understand the auditors procedures for tests of bank reconciliation (existence
or occurrence).
LO18-5 Understand the auditors procedures on bank cutoff statements (completeness).
LO18-6 Understand the auditors procedures for extended tests of bank reconciliation
(accuracy).
LO18-7 Understand the auditors procedures for proof of cash (accuracy).
LO18-8 Understand the auditors procedures for tests for kiting/tests of inter-bank
transfers (accuracy).
LO18-9 Understand the auditors procedures for tests of lapping (accuracy).
LO18-10 Describe some common TOC procedures for investments.
LO18-11 Apply the analytical procedures for investments.
LO18-12 Describe some common TOB procedures for investments.
Chapter 18 General Cash and Investments Tests of Controls and Tests

of Balances
Auditing General Cash
The audit of general cash is divided into two categories:
1. Verifying whether recorded cash in the general ledger correctly reflects all cash transactions that took place
during the year.
2. Verifying the audit clients reconciliation of the balance on the bank statement to the cash account balance in the
general ledger.
The first category of verification is primarily a TOC procedure, which is typically performed as part of the
TOC procedures in other cycles. This is because general cash is part of every cycle except the inventory cycle; and a
majority of transactions in the general cash account is closely related to accounts receivable in the revenue cycle and
accounts payable in the expenditure cycles. For example, recall Table 13-6 for the revenue cycle in Chapter 13.
Thus, the TOC strategy and procedures for general cash will not be discussed here. Figure 18-1 shows the
relationships of general cash with other transaction cycles.
The second category of verification is essentially a TOB procedure, which the auditor performs two
distinctive types of verification:
1. Verification of the clients bank reconciliation.
2. Application of fraud-related audit procedures: extended tests of bank reconciliation, proof of cash, tests for kiting
(tests of inter-bank transfers), and cash count (tests of lapping).
Figure 18-1 The Relationships of General Cash with Other Transaction Cycles
Revenue Cycle
Sales
Expenditure Cycle
Purchases
Cash Sales
Cash Purchases
Accounts Receivable
Accounts Payable
Receipts of
Account
Capital Cycle
Capital Stock
Retire Stock
Issue Stock
Bonds Payable
Payments of
Account
General Cash
Cash
Revenue Cycle
Expenditure Cycle
Capital Cycle
Capital Cycle
Investments
Investments
Purchase
Securities
Sell
Securities
Interest & Dividend Revenue

Redeem
Bonds
Issue Bonds
Investments
Investments
Payroll Cycle
Interest & Dividends Payable

Pay Interest
& Dividends
Payroll Cycle
Accrued Wages & Salaries
Payroll Cash
Receipts of
Interest &
Dividends
477
478
General Cash Accounts and Documents

Common general cash accounts and documents are described in Table 18-1 to facilitate the discussion of the TOB
strategy for general cash.
Table 18-1 Accounts and Documents in General Cash
Accounts and Documents in General Cash
Accounts:
General cash account/balance (cash on hand)
This is the principal cash account representing cash on hand for most clients. The major source of cash receipts for this account is the revenue
cycle; and the major source of cash payments are the expenditure and payroll cycles.
Imprest cash account (petty cash)

This is a fixed amount of cash, usually very small, such as $10, set aside in a strong box for incidental expenses. Periodically, a check is drawn
from the general cash account to deposit the amount of cash required to restore the balance of the imprest cash account to $10.
General bank account/balance (cash in bank)

This is the principal bank account representing cash in bank for most clients.
Imprest payroll bank account

This is a fixed balance, such as $1,000, maintained in a separate bank account. Immediately before each pay period, one check is drawn on the
general cash account to deposit the total amount of the net payroll into the imprest payroll bank account. After all payroll checks have cleared the
imprest payroll bank account, this bank account should have a $1,000 balance.
Branch bank account

Audit clients that operate branches in multiple locations often maintain separate bank accounts at local banks.
Cash equivalents
These are short-term investments such as saving account, certificates of deposit, and money market funds that are readily convertible to known
amounts of cash within a short time.
Documents:
Bank reconciliation working paper
A copy of the bank reconciliation prepared by the client. The working paper reconciles the balance per the bank (balance on the bank statement)
with the balance per the books (cash account balance in the general ledger). The major reconciliation items are deposits in transit, outstanding
checks, and other adjustments, such as bank service charges and any none-sufficient fund (NSF) check returned.
Ordinarily, this document is used to meet the specific audit objective of accuracy.
Standard bank confirmation form

A standard form titled, Standard Form to Confirm Account Balance Information with Financial Institutions , agreed upon by the AICPA,
American Bankers Association, and Bank Administration Institute and used by the auditor to confirm cash deposit balances and loan balances
(also referred to as direct liabilities) with every bank or financial institute that maintains an account for the audit client. This form is also used to
obtain information about any loans the client may have with the bank. The form confirms a direct liabilitys account number and description,
balance, due date, interest rate, and description of collateral. But the form does not request information about principal amount already paid on a
direct liability. A bundle of 100 forms can be purchased and downloaded from the AICPA website.
This standard bank confirmation form does not require bank personnel to conduct a comprehensive, detailed search of the banks records beyond
the account information requested on the confirmation. However, it does request that bank personnel indicate any other deposits or loans that
come to their attention while completing the confirmation. As a result, this confirmation request cannot be relied upon to identify all information
about a clients bank deposits or loans. If the auditor believes that additional information is needed, a separate confirmation letter signed by the
client should be sent to the bank.
Ordinarily, this document is used to meet the specific audit objective of existence or occurrence.
Bank cutoff statement

A partial-period bank statement that the auditor requested from the clients bank and sent directly to the auditor to verify reconciling items such
as deposits in transit and outstanding checks for a 7- to 10-day period after the balance sheet date/after the date on which the bank account is
reconciled.
Ordinarily, this document is used to meet the specific audit objective of completeness.
An overview of the strategy for tests of balances of general cash is presented in Figure 18-2.
Figure 18-2 TOB Strategy in General Cash
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report

1. Revenue Cycle
CH 13
CH 14
3. Inventory Cycle
CH 15

4. Payroll Cycle
CH 16
5. Capital Cycle
CH 17

CH 18
479
480
Apply TOB Strategy to General Cash

Table 18-2 provides a brief discussion of the TOB Strategy as it is applied to general cash.
Table 18-2 TOB Strategy in General Cash
TOB Strategy General Cash
transaction level of a transaction cycle. General cash balance is immaterial in most audits, therefore, the
auditor typically allocates a large TM (i.e., more tolerance) to general cash.
timing of the TOB procedures used by the auditor. Since general cash is more susceptible to theft than
other assets, the auditor typically sets inherent risk, IR, relatively high for the specific audit objectives of
existence or occurrence, completeness, and accuracy. The auditors assessment of CR depends on the
results of the TOC in other cycles, especially the revenue and expenditure cycles.
Compare client data with expected results, using non-financial data. 6. Compare financial ratio analysis on
client data. Since general cash balance is a residual balance in nature, general cash does not have a
predictable relationship with other financial statement accounts. As a result, the auditors use of analytical
procedures for general cash is limited to comparisons with prior years general cash balance. Table 18-3
describes the very limited use of analytical procedures in general cash.
The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. In
general, TOB on general cash starts with the auditor obtaining bank reconciliation from the client for
inclusion in the auditors working papers. Note that:
(1) TOB specifically for accuracy of cash in bank starts with the auditor obtaining a bank reconciliation
working paper from the client.
(2) TOB specifically for existence or occurrence of cash in bank starts with the auditor obtaining a standard
bank confirmation form directly from the bank.
(3) TOB specifically for completeness of cash in bank starts with the auditor obtaining a bank cut-off
statement directly from the bank.
The auditor also performs specific fraud-related TOB procedures. Table 18-4 summarizes some specific
audit objectives and common TOB procedures for general cash. The auditor is especially concerned about
the specific audit objectives of existence or occurrence, completeness, and accuracy.
2. Derive DR

Table 18-3 Analytical Procedures for General Cash

Compare the ending balance of general cash account with prior year ending balances.
Misstatement in cash
Table 18-4 Specific Audit Objectives and Common TOB Procedures for General Cash
Items stated in the bank reconciliation
exist.
Completeness:
Existing cash in the bank recorded.
Accuracy:
Cash in the bank as stated on the
reconciliation is accurate.

Obtain a standard bank confirmation that requests specific information on the existence of cash
deposit balances and loan balances with every bank that maintains an account for the audit client.
Tests of bank reconciliation. Table 18-5 provides more discussions on the auditors procedures for
testing bank reconciliation.
Obtain a bank cutoff statement that covers a 7-to 10-day period after the balance sheet date.
Trace deposits in transit, outstanding checks, and other reconciling items to cutoff bank statement.
Table 18-6 provides more discussions on the auditors procedures for obtaining and using bank
cutoff statements. See Figure 18-4 for an example of the auditors procedures relating to the bank
cutoff statement.
Tests of bank reconciliation. Table 18-5 provides more discussions on the auditors procedures for
testing bank reconciliation.

If the auditor suspects that some type of fraud involving cash has occurred:
(1) Extended tests of bank reconciliation. See Table 18-7 for further discussion on this audit
procedure.
(2) Proof of cash. See Table 18-8 for further discussion on this audit procedure.
(3) Tests for Kiting (for fraud), also known as Tests of Inter-Bank Transfers (for unintentional
mistake). See Table 18-9 for further discussion on this audit procedure.
(4) Tests for Lapping. See Table 18-10 for further discussion on this audit procedure.
Cutoff:
Cash receipts and cash disbursements
transactions are recorded in the proper
accounting period.
Cash receipts:
Count the cash on hand (cash counts) on the last day of the year/accounting period and
subsequently trace to deposits in transit and the cash receipts journal. In performing cash counts,
the auditor should:
(1) Take control of all cash/cash registers held by the client until they have been counted.
(2) Insist that the custodian/cashier of the cash be present throughout the count.
(3) Obtain a signed receipt from the custodian/cashier on return of the cash to the client.
Trace deposits in transit to subsequent period cutoff bank statement.

Cash disbursements:
Record the last check number used on the last day of the year/accounting period and
subsequently trace to the outstanding checks and the cash disbursements journal.
Understandability:
Cash in bank is properly presented and
Trace outstanding checks to subsequent period cutoff bank statement.
Read board of directors minutes, line-of-credit arrangements, loan agreements, or other

documents for any restrictions on cash such as compensating balances or sinking fund
requirements.
Review financial statements to make sure:
(1) Material savings accounts and certificates of deposit are disclosed separately from cash in the
bank.
(2) Cash restricted to certain uses and compensating balances are adequately disclosed.
(3) Bank overdrafts are included as current liabilities.
Table 18-5 Auditors Procedures for Tests of Bank Reconciliation
Auditors Procedures for Tests of Bank Reconciliation
The auditors procedures for tests of bank reconciliation:
Foot the bank reconciliation working paper for mathematical accuracy.

Agree the bank balance on the bank reconciliation working paper with the balance shown on the standard bank confirmation.
Trace the deposits in transit on the bank reconciliation working paper to the cutoff bank statement. Any deposit in transit shown on the
bank reconciliation should be listed as a deposit shortly after the balance sheet date.
Compare the outstanding checks on the bank reconciliation working paper with the canceled checks contained in the cutoff bank
statement for proper payee, amount, and endorsement. Any outstanding check shown on the bank reconciliation should clear the bank shortly
Agree any charges (bank service charges, bank errors and corrections, and unrecorded note transactions debited or credited directly to the
bank account by the bank) included on the bank statement to the bank reconciliation.
Agree the adjusted book balance to the cash account lead schedule. This adjusted book balance should be part of the amount included in
the financial statement for cash.
See Figure 5-6 in Chapter 5 for an example of the auditors procedures for tests of bank reconciliation.
Table 18-6 Auditors Procedures on Bank Cutoff Statements
Auditors Procedures on Bank Cutoff Statements
The client must request a bank cutoff statement from the bank
and instruct that it be sent directly to the auditor. See Figure 18-4
for an example of auditors procedures relating to the bank cutoff
statement.
This is to prevent the client from intercepting the bank cutoff

statement and to provide appropriate corroborative evidence about the
existence or occurrence of the year-end bank reconciliation.
On receipt of the cutoff statement, trace all prior-year dated

checks to the outstanding checks listed on the bank reconciliation.
If a prior-period check not on the list of outstanding checks has

cleared the bank, there may be a kiting fraud (see Table 18-9 for
more discussion).
If a prior-period check on the list of outstanding checks has not

cleared the bank, there may be delays in (1) mailing the check by the
481
482
Auditors Procedures on Bank Cutoff Statements
client, (2) depositing the check by the payees, and (3) processing the
check by the bank.
If there are a large number of outstanding checks remaining

uncleared, there may be a window dressing fraud, which is a
deliberate attempt to overstate a companys short-term liquidity. For
example, if the clients current assets are $900,000 and current
liabilities are $500,000, the current ratio is 1.8:1. But if $100,000 of
checks are deliberately paid prematurely, the current assets are now
$800,000 and the current liabilities are $400,000, which results in a
stronger current ratio of 2.0:1.
On receipt of the cutoff statement, trace deposits in transit on

the bank reconciliation to deposits on the cutoff statement.
The first deposit on the cutoff statement should be the first

deposit in transit shown on the bank reconciliation. If this is not the
case, the auditor should investigate the reason for the time lag.
On receipt of the cutoff statement, scan the cutoff statement

for unusual items.
The auditor should be alert for such items as unrecorded bank

debits and credits, and bank errors and corrections; and seek
explanations for the unusual items.
Table 18-7 Auditors Procedures for Extended Tests of Bank Reconciliation

Auditors Procedures in Extended Tests of Bank Reconciliation
When the auditor suspects that the year-end bank reconciliation may be intentionally misstated, s/he performs extended tests of the year-end
reconciliation. The purpose of the extended procedures is to verify whether all transactions included in the journals for the last month of the year
were correctly included in or excluded from the bank reconciliation and to verify whether all items in the bank reconciliation were correctly
included. The audit procedures for extended tests of bank reconciliation include:
Assume the clients year-end is December 31. Start with the bank reconciliation for November and compare all reconciling items with
cancelled checks and other documents in the December bank statement.
Compare all remaining cancelled checks and deposit slips in the December bank statement with the December cash disbursements and
receipts journals.
Inspect that all un-cleared items in the November bank reconciliation and the December cash disbursements and receipts journals are
included in the December 31 bank reconciliation.
Inspect that all reconciling items in the December 31 bank reconciliation are items from the November bank reconciliation and
Decembers journals that have not yet cleared the bank.
Table 18-8 Auditors Procedures for Proof of Cash
Auditors Procedures for Proof of Cash
When the clients has material internal control weaknesses in cash, the auditor prepares a proof of cash to determine:
All recorded cash receipts were deposited.
All deposits in the bank were recorded in the accounting records.
All recorded cash disbursements were paid by the bank.
All amounts that were paid by the bank were recorded.

The auditor prepares a proof of cash by reconciling the cash receipts and disbursement recorded on the clients books with the cash deposited into
and disbursed from the clients bank account for a specific time period, such as a month, although it may also be prepared for the entire
accounting period under audit. Because the proof contains four columns, a proof of cash is commonly referred to as a four-column proof of cash.
The four columns include:
A bank reconciliation for the beginning of the period.

A reconciliation of the cash deposited in the bank with the cash receipts recorded in the cash receipts journal.
A reconciliation of the cash disbursed through the bank account with the cash disbursements recorded in the cash disbursements journal.
A bank reconciliation for the end of the period.

Note: A proof of cash will not detect a theft of cash when the cash was stolen before being recorded in the clients book, or the recording and
deposit of an improper amount of cash.
See Figure 18-5 for an example of a proof of cash prepared by the auditor for an interim month.
Table 18-9 Auditors Procedures for Tests for Kiting (Tests of Inter-bank Transfers)
Auditors Procedures for Tests for Kiting (Tests of Inter-bank Transfers)
A clients employee may steal cash and cover the cash shortage by a fraud scheme known as kiting. In kiting, an employee covers the cash
shortage by transferring money from one bank account to another and recording the transactions improperly on the clients books. Specifically,
the employee conceals the cash shortage by preparing a check on one bank account before year-end but not recording it as a cash disbursement in
the book account until the next period. The check is deposited in a second bank account before year-end and recorded as a cash receipt in the
current period. The deposit occurs close enough to year-end that it will not clear the first bank account before the year-end. See Figure 18-3 for
an example of kiting.
Auditors procedures for tests for kiting (tests of inter-bank transfer) include:
Prepare an inter-bank transfer schedule that is used to list all inter-bank transfers made a few days before and after the balance sheet date
and to trace each transfer to the accounting records for proper recording.
Verify the accuracy of the information on the inter-bank transfer schedule.

Verify that inter-bank transfers are recorded in both the receiving and disbursing banks.
Verify the date of the recording of the disbursements and receipts for each transfer is in the same fiscal year.
Verify that disbursements on the inter-bank transfer schedule are correctly included in or excluded from year-end reconciliations as
outstanding checks.
Verify that receipts on the inter-bank transfer schedule are correctly included in or excluded from year-end reconciliations as deposits in
transit.
When an audit client has many bank transfers, the auditor prepares an inter-bank transfer schedule even though no fraud is suspected. This
schedule helps the auditor to detect unintentional mistakes and to account for proper cutoff of cash transactions. Figure 18-4 shows an example of
an inter-bank transfers schedule prepared by the auditor and the procedures relating to the bank cutoff statement.
Figure 18-3 An Example of Kiting

Bank A records the $20 cash withdrawal that decreases the balance of ABC Co. from $100 to $80.
Bank A is not aware of the $20 check transfers to Bank B just before the end of the accounting period.
Therefore, Bank As record shows a balance of $80 instead of $60 on its bank statement to the ABC
Co. at the end of the accounting period.
Bank As Record
ABC Co. Account $100
- 20
80
2.
Bank Bs Record
ABC Co. Account $100
+ 20
120
Bank B records the $20 check deposit, but

will not clear the check with Bank A until
after the accounting period.
Therefore, Bank Bs record shows an
increase in ABC Co.s balance from $100
to $120 on its bank statement to the ABC
Co. at the end of the accounting period.
1.
ABC Co.s Record
3.
Bank A Account $ 80
Bank B Account 120
200
1. The employee first withdraws $20 cash from its Bank A account just before the end of an accounting period.
2. The employee immediately deposits a check of $20 drawn from its Bank A account to its Bank B account knowing the check
will not clear Bank A account until after the end of the accounting period.
3. The employee records receipt of the $20 check in ABC Co.s Cash Receipt book to show a balance of $120, which matches
with the $120 balance on the bank statement from Bank B at the end of the accounting period. Meanwhile, the employee
intentionally fails to record disbursement of the $20 check in ABC Co.s Cash Disbursement book so that its balance remains
at $80, which matches with the $80 balance on the bank statement from Bank A at the end of the accounting period. In sum,
the employee has covered up the $20 cash embezzlement just before the end of an accounting period by taking advantage of
the time lag in clearing the inter-bank transfer.
483
484
Figure 18-4 Auditors Preparation of an Inter-Bank Transfers Schedule and Procedures Relating to the Bank
Cutoff Statement
W/P Ref: SIT-1
Schedule of Inter-bank Transfers Schedule as at 12.31.2001 and Procedures Relating to Bank Cutoff Statement as at 01.07.2002
Client: ABC Company
Prepared by:
Document BR Bank Reconciliation

Document BS Bank Statement
Document BCS Bank Cutoff Statement
Acct 508 Cash Disbursement Account
Acct 509 Cash Receipts Account
Reviewed by:
Disbursements (Transfer TO)

3. Amount
4. Date
Recorded in
5. Date Paid
by Bank
$20,000
Acct 508 *
12.26.2001
12.28.2001
cno
<
Bank - Head
Office
$30,000
12.28.2001
01.02.2002
cio
>
#3767
Bank - Head
Office
$10,000
12.30.2001
01.04.2002
cio
>
#3798
Bank - Head
Office
$40,000
01.02.2002
01.04.2002
cno
>
1. Check No.
2. Bank
#3703
Bank - Head
Office
#3736
6. Bank
Mark
Chris
Date: 1.10.2002
Date: 2.12.2002
Receipts (Transfer From)

7. Date
8. Date Received by
Recorded in
Bank
Acct 509
Bank
Branch
12.28.2001
^ cnd
<
Bank
Branch
12.29.2001
12.29.2001
BankBranch
12.30.2001
^ cid
>
Bank Branch
01.03.2002
01.04.2002
^ cnd
>
^ cnd
12-29.2001
<
01.03.2002
t
Traced to cash disbursements journal.
^
Traced to cash receipts journal.
<
Traced to bank statement as at 12.31.2001.
>
Traced to bank cutoff statement as at 01.07.2002.
cno Comparing the dates in columns 4 and 5, check is not included as outstanding check on bank reconciliation, which is correct.
cio Comparing the dates in columns 4 and 5, check is included as outstanding check on bank reconciliation, which is correct.
cnd Comparing the dates in columns 7 and 8, receipt is not included as deposit in transit on bank reconciliation, which is correct.
cid Comparing the dates in columns 7 and 8, receipt is included as deposit in transit on bank reconciliation, which is correct.
*
Vouched cash disbursements journal for the existence or occurrence of prior-period checks that were not included as outstanding checks
on the bank reconciliation as at 12.31.2001, but were paid in subsequent-period by the bank on the bank cut-off statement as at 01.07.2002. Since
no such prior-period checks was found, the existence or occurrence of a kiting fraud is very unlikely.
Conclusion: After preparing and testing the inter-bank transfers schedule, no intentional kiting fraud is discovered, and no unintentional mistake
in recording inter-bank transfers is detected.
Figure 18-5 Auditors Preparation of a Four-Column Proof of Cash for an Interim Month
W/P Ref: POC-4
Interim Proof of Cash
Client: ABC Company
Prepared by:
Document BS Bank Statement

Record CDJ Cash Disbursements Journal
Record CRJ Cash Receipts Journal
Acct100 General Cash Account
Reviewed by:
Balance per Bank:

Deposits in Transit:
5.31.201x
6.30.201x
Outstanding Checks:
5.31.201x
6.30.201x
NSF Checks
Adjust the effect of a cash disbursement
recorded as a credit item in cash receipts
journal
Balance per Bank, Adjusted:
5.31.201x
$10,000.00
Receipts
$200.00
700.00
(700.00)
800.00
Balance per books, unadjusted:

Bank debit memos:
Payroll checks erroneously entered
General Disbursements Journal:
Balance per Books, Adjusted:
Joe
Date: 07.01.201x
Don Date: 07.12.201x
Disbursements
$100.00
(300.00)
6.30.201x
$10,100.00
800.00
(50.00)
(300.00)
600.00
(50.00)
10,400.00
=======
(6.00)
244.00
=====
(6.00)
344.00
=====
10,300.00
=======
10,400.00
244.00
374.00
80
10,270.00
(80)
10,400.00
=======
244.00
=====
(50)
344.00
=====
50.00
10,300.00
=======
(600.00)
in
Obtained as per 6.30.201x bank statement.

Compiled the details of deposits in transit in the attached list; traced to subsequent bank statement.
Compiled the details of outstanding check in the attached list; examined cancelled checks.
Compiled the details of NSF item in the attached list; all NSF items were re-deposited in June and had all cleared as of
6.30.201x.
Safety deposit rentals; traced rental fee to cash disbursement journal.
Traced to journal entry correcting the error.
Conclusion: The interim proof of cash indicates that internal control on cash is adequate.
Table 18-10 Auditors Procedures for Tests of Lapping

Auditors Procedures for Tests of Lapping
A clients employee may steal cash and cover the cash shortage by a fraud scheme known as lapping. In lapping, an employee deliberately defers
recording cash receipts from one customer and covers the cash shortage with receipts from another customer. These in turn are covered from the
receipts of a third customer a few days later. The employee must continue to cover the shortage through repeated lapping. Thus, this lapping
fraud can best be prevented by segregation of duties in handling cash receipts and postings of the collections to the accounts receivable ledger. If
segregation of duties is not practical, a mandatory vacation policy should be imposed on the employee who both handles cash and records cash
receipts. The employee will not be able to continue covering the cash shortage through repeated lapping while on vacation. See Figure 18- 6 for
an example of lapping.
Auditors procedures for tests of lapping include:
Confirm accounts receivable. Recall confirmation of accounts receivable in Chapter 13.

This procedure will be more effective if it is performed on a surprise basis at the interim audit date. Confirmation at this interim date will prevent
the employee engaged in lapping from bringing the lapped accounts up to date. Confirmation at the balance sheet date will be less effective
because the employee may anticipate the auditors confirmation procedure and adjust the lapped accounts to their correct balance at that date.
Make a surprise cash count. Recall cash count procedures for the specific audit objective of cutoff in Table 18-4 above.
The cash count will include coin, currency, and customer checks on hand. The auditor should oversee the deposit of these funds. Subsequently,
the details of the deposit shown on the duplicate copy of deposit slip should be compared with cash receipts journal entries and postings to the
customers accounts.
Compare details of cash receipts journal entries with the details of corresponding daily deposit slips.
This procedure should discover discrepancies caused by the employees lapping of customers accounts.
485
486
Figure 18-6 An Example of Lapping

Lapping in day one
Assume on day one, the cash register tapes totaled $600 and the mail receipts opened by the employee consisted of one payment on account by
check for $200 from customer A. The employee would steal $200 in cash and destroy all evidence pertaining to the mail receipt except for the
customers check. The cash receipts journal entry would agree with the register tape of $600, and the deposit slip would show cash $400 and As
check for $200. Day one of lapping is shown as follows:
Actual Receipts:
Documents:
Cash Receipts Journal Entry:
Bank Deposit Slip:
Cash
$ 600
Cash Tape
$ 600
Cash sales
$ 600
Cash
$ 400
Customer A Check
200
____
_____
Customer A check
200
800
600
600
600
====
=====
====
=====
Lapping in two or three days later
In order to conceal the cash shortage, the employee would (1) keep daily bank balance and book balance in agreement so that a bank
reconciliation would not detect the lapping, (2) correct customer As account by a journal entry within two or three days, and (3) shift lapping to
customer Bs account a few days later. The total cash stolen would now be $300, $200 in day one of lapping and $100 in day two or three of
lapping. Day two or three of lapping is shown as follows:
Actual Receipts:
Documents:
Cash Receipts Journal Entry:
Bank Deposit Slip:
Cash
$ 500
Cash Tape
$ 500
Cash sales
$ 500
Cash
$ 400
Customer B Check
300
Customer A Check
200
Customer A Check
200
Customer A check
300
800
700
700
700
====
====
=====
=====
Auditing Investments
AU 501, Audit Evidence- Specific Consideration for Selected Items , provides guidance for conducting TOC and
TOB for investments. A clients investments might include equity securities such as common and preferred stock,
debt securities such as notes and bonds, and hybrid securities such as convertible bonds and stocks. The strategy for
auditing investment is not different from auditing current assets, such as inventory (in Chapter 15), for short-term
investments; and long-term assets, such as property, plant and equipment (in Chapter 14), for long-term investments.
Thus, the TOC and TOB strategy pertaining to investments are not discussed here.
It should be noted that inherent risk for investments is often assessed at a relatively high level due to:
1. Loan covenants, for example, clients finance their investments by borrowing from the bank and the loan
agreement requires the client to maintain strict debt to equity ratio.
2. Related party transactions, for example, parent companies finance their investments by borrowing from subsidiary
companies without repayment term.
3. Complex transactions, for example, clients create complex investment transactions, such as Special Purpose
Entities (SPE), that are structured to bypass GAAP.
4. Investment impairment, for example, clients understate large losses of investments value by writing off assets and
building up reserves to reduce in future year.
After understanding and documenting internal controls relating to investments, the auditors assess control risk and
perform TOC procedures as per the audit program for the investments. Table 18-11 summarizes some specific audit
objectives for TOC, internal controls, and common TOC procedures for investments.
Table 18-11 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Investments
Investments are properly approved.
Internal Controls
Proper authorization for the purchase or sales of

any investment.
Read board of directors minutes for approval

for the purchase or sale of investments.
Inquiry of the board of directors for general
policies to guide the clients investment
activities, and specific policies to delegate
investment activities to individual finance
executive, investment committee, or outside
Internal Controls

investment advisers.
Completeness:
All securities transactions are recorded.

Investments are indeed owned by the
client and safeguard against theft.
Adequate records are maintained for all

securities transactions.
Inquiry of management that a securities ledger

that records all detailed securities transactions
is maintained.
Observe periodic independent check of the
securities ledger to ensure that all dividends
and interest have been received and recorded
in the clients records.
Observe that the internal auditor compares the
securities held in bank safe-deposit box with
the clients records.
Physical safeguarding of assets.
When securities are held by the client, they

should be stored in a safe or safe-deposit box,
and access to the safe-deposit box must require
the presence of two authorized officials.
If an independent custodian such as a broker
maintains securities, observe that the client has
established proper procedures for authorizing
the transfer of securities.
Examine brokers advice for a sample of
securities purchased during the year.
Apply TOB Strategy to Investments

The auditor primarily uses analytical procedures to determine the overall reasonableness of investments as shown in
Table 18-12. Table 18-13 summarizes some specific audit objectives and common TOB procedures for investments.
Table 18-12 Analytical Procedures for Investments
Comparison of the balances in the current years investment accounts with prior years balances
after consideration of the effects of current-year operating and financing activities on cash and
investments.
Comparison of current-year interest and dividend income with the reported income for prior
years and with the expected return on investment.
Compute the amount of dividend income that should have been received by referring to
dividend record books (contain dividend amount and payment dates) for publicly held
companies that are published by investment advisory services, such as Dun & Bradstreet.

Overall reasonableness
account balances.
of
investments
Overall reasonableness of return on

investments.
The reasonableness of dividend income from
investments.
Table 18-13 Specific Audit Objectives and Common TOB Procedures for Investments
Investments exist.
AU 501 states the auditor should gather evidence for existence or occurrence as follows:
Physical examination of investments.
(1) The client maintains custody of the investments. During the physical examination, the
auditor should note the name, class and description, serial number, maturity date, registration in
the name of the client, interest rates or dividend payment dates, and other relevant information
about the investments.
Note: If the clients investment portfolio is kept in a bank safe-deposit box, and if the auditor is
unable to count the securities at the balance sheet date, the auditor most likely will request the
clients bank to seal the safe-deposit box until the auditor can count the securities at a
subsequent date.
(2) The investments are held by an issuer or a custodian such as a broker or investment adviser.
The auditor should confirm the details of the clients investments with the issuer or custodian of
the investments.
Confirmation with the issuer of investments.

Confirmation with the custodian of investments.
Confirmation of unsettled transactions with the broker-dealer.
Confirmation with the counter-party.
487
488

Completeness:
Existing notes payable are included in the
interest.
Accuracy:
Investments are recorded accurately.
Classification:
Short and long term investments are

Read executed partnership or similar agreements.
Obtain a standard bank confirmation that requests specific information on the existence of notes
payable from all banks with which the client does business (see Table 18-4 for more discussion on
bank confirmation).
Examine the bank reconciliation for new notes credited to the bank account by the bank (see Table
18-5 for more discussion on bank reconciliation).
Examine notes paid after year-end to determine whether they were liabilities at the balance sheet
date.
Obtain schedules of investments by category (held-to-maturity, trading, and available-for-sale);
foot schedules and agree totals to securities register and general ledger. Figure 18-7 shows an
example of auditors procedures on a schedule of available-for-sale investment.
Inquire of managements intent concerning investments to determine proper classification of
investments into:
Held-to-maturity investments debt securities that the client intends to hold to maturity
should be classified as current or long-term assets based on whether management expects to be
converted to cash within 12 months (current assets) or longer than 12 months (long-term assets).
Trading investments debt and equity securities that the client bought and held primarily
for the purpose of selling them in the near term all should be classified as trading as current
assets.
Available-for-sale investments debt or equity securities not classified as either held-tomaturity or trading securities - should be classified as current or long-term assets based on
whether management expects to be converted to cash within 12 months (current assets) or longer
than 12 months (long-term assets).
Examine investment activities to determine whether they corroborate or conflict with the
managements intent concerning investments. The auditor should examine investment activities
such as written and approved records of investment strategies, records of investment activities,
instructions to portfolio managers, and minutes of meetings of the board of directors or investment
committee.
See Figure 18-8 for a summary of accounting for investments under SFAS No.115, Accounting for
Certain Investments in Debt and Equity Securities.
Cutoff:
Investments are included in the proper
accounting period.
Investments recorded in the financial
statements are properly valued.
Examine purchases and sales of securities for a few days before and after year-end to determine if
the transactions are included in the proper accounting period.
AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related
Disclosures, provides guidance for fair value measurements of investments:
When securities are initially purchased, they should be recorded at acquisition cost. The
auditor verifies the purchase price of a security by examining a brokers advice or similar
documents.
Held-to-maturity investments should be valued at their amortized cost. The auditor verifies
the purchase price and use the effective interest rate to recognize the interest income and to
computer the amortization.
Trading investment should be valued at fair value (market value/market price). The auditor
verifies the fair value with securities exchanges registered with the SEC or on the over-thecounter market. The auditor can also verify the fair value by tracing it to sources such as
brokers, The Wall Street Journal, or other reliable financial literature.
Available-for-sale investments should be valued at fair value (market value/market price).

The auditor verifies the fair value as that for the trading investments above.
The auditor should determine whether there has been any permanent decline (or other-thantemporary impairment) in the value of an investment security. In other words, an investment
security has a non-temporary decline in value below amortized cost. In such a case, the security
should be written down and a new carrying amount established.
AU 540 gave examples of factors that may indicate an other-than-temporary impairment condition
as follows:
(1) Fair value is significantly below cost.
(2) The decline in fair value is attributable to specific adverse conditions affecting a particular
investment.
(3) The decline in fair value is attributable to specific conditions, such as conditions in an industry
or in a geographic area.
(4) Management does not possess both the intent and the ability to hold the investment for a period
of time sufficient to allow for any anticipated recovery in fair value.

(5) The decline in fair value has existed for an extended period of time.
(6) A debt security has been downgraded by a rating agency.
(7) The financial condition of the issuer has deteriorated.
(8) Dividends have been reduced or eliminated, or scheduled interest payment on debt securities
has not been made.
The auditor should examine the sale of any securities to ensure that proper values were used to
record the sale and any realized gain or loss.
Table 18-14 provides more discussion on auditing fair value measurements of investments in
accordance with AU 540.
For complex investments such as derivative investments and hedging activities, the auditor should
verify them based on the guidelines in AU 501 and AU 540. Derivative investments are those that
derive their value from another asset or index. For example, an option to purchase another clients
stock is a derivative. Interest rate swaps, options, convertible bonds, futures contracts and
convertible preferred stock are all derivatives. For example, an energy company might buy futures
contracts on oil and gas to lock the price of its raw ingredients so that it can predict future cost of
goods sold. Likewise, an export company might buy currency futures contracts to lock in the
currency exchange rate for their sales.
Understandability:
Investments are properly presented and
Examine financial statements for proper presentation and disclosure investments in conformity
with SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities :
Held-to-maturity investments reported at amortized cost under current assets (within 12

months) or long-term assets (longer than 12 months) on the balance sheet.
Trading investments reported at fair (market) value under current assets on the balance
sheet. Unrealized gains and losses on short-term investment are reported under Other revenue,
gains, and losses and above Net Income on the income statement.
Available-for-sale investments reported at fair (market) value under current assets

(within 12 months) or long-term assets (longer than 12 months) on the balance sheet. Unrealized
gains and losses are reported in two places:
(1) Under Other Comprehensive Income and below Net Income on the income statement, and
(2) Under Accumulated Other Comprehensive Income and below Retained Earnings on the
balance sheet.
Examine any securities have been pledged as collateral by inquiry of management and reading
board of directors minutes, loan agreements, and other documents. This information should be
disclosed in footnotes of the financial statements.
Auditing Fair Value Measurements of Investments (AU 540)

Financial Accounting Standards Board (FASB) issued SFAS No.157 (Fair Value Measurements), which defines fair
value, establishes a framework for measuring fair value, and expands disclosures. SFAS No.157 defines fair value as
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. However, it also introduces concepts such as the fair value hierarchy of
inputs and the principal and most advantageous markets. The fair value hierarchy in SFAS No.157 prioritizes the
inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three
levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities
and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value
measurement falls is determined based on the lowest level input that is significant to the fair value measurement as
follows:
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the management
has the ability to access at the measurement date.
Level 2 inputs are inputs other than quoted prices within Level 1that are observable for the asset or liability, either
directly or indirectly. A significant adjustment to a Level 2 input could result in the Level 2 measurement becoming
a Level 3 measurement.
Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are those that reflect the
managements own assumptions about the assumptions market participants would use in pricing the asset or liability
developed based on the best information available in the circumstances.
Under SFAS No.157, a fair value measurement assumes that the transaction occurs in the principal market
for the asset or liability or, in the absence of a principal market, the most advantageous market. The principal market
is one in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of
activity. If there is a principal market, under SFAS No.157, the fair value measurement represents the price in that
market even if the price in a different market is potentially more advantageous.
489
490
Auditing Standards AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates
and Related Disclosures, provide guidance for auditing fair value measurements of investment. Table 18-14
summarizes auditing fair value measurements of investments in accordance with AU 540.
Table 18-14 Auditing Fair Value Measurements of Investments in Accordance with AU 540
Auditing Fair Value Measurements of Investments (AU 540)

Obtain an understanding of the management's process for determining fair value measurements and disclosures, including relevant controls.
Evaluate whether managements assumptions are reasonable and reflect, or are not inconsistent with, market information. For example, the
fact that transaction volume in a particular market is lower than in previous periods may not necessarily support an assumption that
transactions in that market constituted forced or distressed sales.
If management relies on historical financial information in the development of an assumption, consider the extent to which such reliance is
justified. However, historical information might not be representative of future conditions or events. For example, an auditor should evaluate
whether managements use of historical default rates, in an environment in which default rates are increasing, is justified.
Evaluate whether the managements method for determining fair value measurements is applied consistently and if so, whether the
consistency is appropriate considering possible changes in the environment or circumstances affecting the company. For example, the relative
weightings in the managements model may not be reasonable in situations where there has been a change in market conditions. In such
cases, the auditor should consider whether compliance with applicable accounting standards might require a change in the model.
Inputs based on a companys own data may be more susceptible to preparer bias because they may not be based on observable market inputs.
In such cases, the auditor should be aware of the increased risk of management bias and address the related risk of material misstatement
(Recall Chapter 9 on Risk and Materiality).
With regard to the fair value hierarchy in SFAS No.157, because there are different consequences associated with each of the three levels of
the hierarchy, the auditor should be alert for circumstances in which management may have an incentive to inappropriately classify fair value
measurements within the hierarchy. For example, an asset or liability with Level 1inputs generally must be measured using unadjusted quoted
prices in an active market, while an asset or liability with Level 2 inputs is measured using observable market inputs other than quoted prices
included in Level 1. Accordingly, a Level 2 measurement might allow for more discretion or judgment on the part of management than a
Level 1 measurement. As another example, the required disclosures associated with Level 3 measurements are more extensive than those
associated with Level 1 and Level 2 measurements.
The auditors opinion is based on, among other things, his or her judgment as to whether the financial statements and related notes are
informative of matters that may affect their use, understanding, and interpretation. In evaluating whether managements disclosures are
complete, accurate, and in conformity with SFAS No.157, the auditor should be aware that a financial statement disclosure that is not in
accordance with GAAP could be a misstatement of the financial statements.
The auditor should consider whether to engage a valuation specialist and use the work of that specialist as evidential matter in performing
audit procedures related to the fair value measurement. Factors to consider include (1) significant use of unobservable inputs, (2) complexity
of the valuation technique, and (3) materiality of the fair value measurement.
If management uses a pricing service for its fair value measurements, the auditor should determine the nature of the information provided by
the pricing service. For example, the auditor should understand whether the fair value measurement was determined using quoted prices from
an active market, observable inputs (such as prices for similar assets), or fair value measurements based on a model, and adjust his or her
audit procedures based on the nature of the information provided by the pricing service. In addition, if the price is not based on quoted prices
from an active market or observable inputs (such as prices for similar assets), the auditor should obtain an understanding of the model and
evaluate whether the assumptions are reasonable.
When management uses a pricing service, the auditor should also evaluate whether the assumptions used by the pricing service reflect the
price to sell the asset or paid to transfer the liability in the principal market (or most advantageous market if the company has no principal
market). If the pricing service valuation is based on actual trades or quotes, the auditor should evaluate whether those traded or quoted prices
would be available to the company in the companys principal market (or most advantageous market, if the company has no principal
market). For example, a pricing service might provide an amount for which a large financial institution could sell the financial instrument.
However, a company that owns that financial instrument might not be able to transact in the same market as a large financial institution. If
the price available to a large financial institution would not be available to the company, then that price may not be an appropriate measure of
fair value.
Figure 18-7 Auditors Procedures on a Schedule of Available-For-Sale Investment

W/P Ref: AFSI-9
Schedule of Available-For-Sales Investment
Client: ABC Company
Prepared by:
Document SC Stock Certificate

Record CDJ Cash Disbursements Journal
Record CRJ Cash Receipts Journal
Acct801 Market Adjustment - Available-For-Sales Investment
Acct802 - Unrealized Gain (Loss) in Available-For-Sale Investment
Acct803 Dividend Account
Reviewed by:
Investee
Certificate
No. #
Date
Acquired
No. of
Shares
Cost
per
Share
Balance
01.01.2001
FF Co.
GG Co.
HH Co.
II Co.
F569
G9982
H342
I0085
3.2.2000
8.3.2000
3.1.2001
6.2.2000
900
500
200
400
22.00
33.20
18.50
27.25
$19,800 t
16,600 t
e
t
^
f
ff
v
q
e
e
e
e
Purchases
Sales
v
16,600
Balance
12.31.2001
Pat
Kay
Market
price
at
12.31.2001
Per Share
24.50 q
$19,800^
3,700 ^
3,700 v
17.00 q
10,900 ^
10,900 t
_____
_____
29.25 q
34,400 t
47,300 t
3,700
16,600
======
=====
===== ======
ff
f
f
f
Fair value over (under) cost at 12/31.2001:
Balance in Market Adjustment Available-For-Sales Investment (Acct801) before current adjustment:
Current adjustment required Increase (Decrease):
Date: 01.10.2002
Date: 01.25.2002
Market
price
at
12.31.2001
Total
$22,050
Dividend
Income
3,400
11,700
37,150
======
f
$2,750
1,250
1,500 a
====
120
922
===
f
675
127
Examined stock certificates at Stock Trust Co.

Traced to prior years audit working papers.
Traced to general ledger balance.
Footed.
Footed and Cross-footed.
Extension checked.
Vouched to brokers advice and minutes of broad of directors authorization.
Per market quotation in 1.2.2002 Wall Street Journal.
Dividend rates checked to Standard and Poors; Dividend received traced to Cash Receipts Journal and Dividend Account (Acct803).
Adjusting entry-posted to W/P AJE-3: Dr. Market Adjustment Available-For-Sale Investment (Acct801).
Cr. Unrealized Gain (Loss) in Available-For-Sale Investment (Acct802).
Conclusion: Requested the accountant to make the adjusting entry. Follow-up to the adjusting entry request indicated that the accountant has made
the adjustment as at 1.3.2002.
491
492
Figure 18-8 A Summary of SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities
Presentation on Financial
Statements
Question
Does the investor
influence or control?
have
Change in Fair Value

Other-ThanTemporary
Temporary Loss
substantial
(1) Investor owns 20% to 50% of stock and

has significant influence but not control of
the corporation
Use Equity Method
(2) Investor owns over 50% of stock or

otherwise controls the corporation
Consolidation Required
Does a readily determinable fair value
exist?
If Not, Use Cost Method
For debt securities, does the enterprise
have the positive intent and ability to
hold to maturity?
Classify as Held-to-Maturity
Is the investment objective to generate

profits on short-term differences in
price?
Classify as Trading Securities
All other debt and equity securities are
classified as
Available-for-Sale Securities
On BS at historical cost plus share of

earnings since acquisition less dividends
received (amortization may also be
required)
NA
Realized loss on IS, new

basis on BS
Consolidated financial statements
NA
NA
On BS at historical cost
NA

basis on BS
On BS at amortized cost
IS includes amortization of premiums
and discounts
Disclose fair value in notes
NA

cost basis on BS
On BS at fair value
IS reports unrealized gain/loss for period
Recognized on IS
and included in RE
No additional entries
needed
Reported on SCI and

included in AOCI

cost basis on BS
On BS at fair value
SCI reports hold gain/loss for period
AOCI = accumulated other comprehensive income (owners. equity account);

BS = balance sheet;
IS = income statement;
RE = retained earnings;
SCI = statement of comprehensive income; and
NA = not applicable (since investments are not carried at fair value).
18-1
An auditor obtains a January 10 cutoff bank statement for his client directly from the bank. Few of the outstanding checks listed on his
clients December 31 bank reconciliation cleared during the cutoff period. A probable cause of this is that the client
a. is engage in kiting.
b. is engaged in lapping.
c. transmitted the checks to the payees after year-end.
d. has overstated its year-end bank balance.
18-2
The auditor should mail a standard bank confirmation form to all banks with which the client has conducted any business
during the year, regardless of the year-end balance, because
a. the conformation form also seeks information about indebtedness to the bank.
b. this procedure will detect kiting activities that would otherwise not be detected.
c. this procedure is required by generally accepted auditing standards.
d. this procedure relieves the auditor of any responsibility with respect to non-detection of forged checks.
18-3
The usefulness of the standard bank confirmation request may be limited because the bank employee who completes the
form may
a. not believe the bank is obligated to verify confidential information to a third party.
b. sign and return the form without inspecting the accuracy of the clients bank reconciliation.
c. not have access to the clients bank statement.
d. be unaware of all the financial relationships that the bank has with the client.
18-4
Which of the following is a better audit procedure to detect kiting?

a. Review composition of authenticated deposit slips.
b. Review subsequent bank statements and cancelled checks received directly from the bank.
c. Prepare a schedule of bank transfers from the clients books.
d. Prepare year-end bank reconciliation.
18-5
The cashier of a company covered a shortage in his cash working fund with cash obtained on December 31 from a local
bank A by cashing an unrecorded check drawn on the companys head quarter bank B. The auditor would discover this
manipulation by
a. preparing independent bank reconciliation as of December 31.
b. counting the cash working fund at the close of business on December 31.
c. investigating items returned (cancelled checks) with the bank cutoff statements.
d. confirming the December 31 bank balances
18-6
On receiving the cutoff bank statement, the auditor should trace

a. deposits in transit on the year-end bank reconciliation to deposits in the cash receipts journal.
b. checks dated before year-end to outstanding checks listed on the year-end bank reconciliation.
c. deposits in transit on the cutoff statement to deposits in the cash receipts journal.
d. checks dated after year-end to outstanding checks listed on the year-end bank reconciliation.
18-7
Which of the following controls would most effectively ensure that the proper custody of assets in investments is
maintained?
a. Direct access to securities in the safe-deposit box is limited to one corporate officer.
b. Personnel who post investment transactions to the general ledger are not permitted to update the investment subsidiary
ledger.
c. Purchase and sale of investments are executed on the specific authorization of the board of directors.
d. The recorded balances in the investment subsidiary ledger are periodically compared with the contents of the safedeposit box by independent personnel.
18-8
When an auditor is unable to inspect and count a clients investment securities until after the balance sheet date, the bank
where the securities are held in a safe-deposit box should be asked to
a. verify any differences between the contents of the box and the balances in the clients subsidiary ledger.
b. provide a list of securities added and removed from the box between the balance sheet date and the security-count date.
c. confirm that there has been no access to the box between the balance sheet date and the security-count date.
d. count the securities in the box so that the auditor will have an independent direct verification.
493
494
18-9
Which of the following is the most effective audit procedure for verifying dividends earned on investments in equity
securities?
a. Trace deposits of dividend checks to the cash receipts book.
b. Reconcile amounts received with published dividend records.
c. Compare the amounts received with prior-year dividends received.
d. Recompute selected extensions and footings of dividend schedules and compare totals to the general ledger.
18-10
The standard bank confirmation form has been agreed upon by the
a. SEC and FASB.
b. AICPA and the SEC.
c. SEC and the American Bankers Association.
d. AICPA and the American Bankers Association.
18-11
Which of the following errors would be least likely to be discovered during the tests of the bank reconciliation?
a. Payment to an employee for more hours than s/she worked.
b. Cash received by the client subsequent to the balance sheet date was recorded as cash receipts in the current year.
c. The existence of payments on notes payable that were debited directly to the bank balance by the bank but were not
entered in the clients records.
d. Deposits recorded in the cash receipts records near the end of the year, deposited in the bank, and included in the bank
reconciliation as a deposit in transit.
18-12
The audit procedure which requires the auditor to record the last check number used on the last day of the year and
subsequently trace to the outstanding checks and the cash disbursements records is performed to satisfy the specific audit
objective of
a. occurrence.
b. existence.
c. completeness.
d. cut-off.
18-13
The starting point for the verification of the balance in the general bank account is to obtain
a. a bank reconciliation from the client.
b. clients cash account from the general ledger.
c. a cutoff bank statement directly from the bank.
d. the clients year-end bank statement and reconcile it.
18-14
In establishing the existence or occurrence of a long-term investment in the form of publicly traded stock, an auditor should
a. correspond with the investee company to verify the number of shares owned.
b. inspect the audited financial statement of the investee company.
c. confirm number and details of stocks owned that are held by an independent custodian.
d. determine that the investment is carried at the fair market value.
18-15
The primary purpose of sending a standard bank confirmation request to banks with which the client has done business
during the year is to
a. detect kiting activities that may otherwise not be discovered.
b. corroborate information regarding deposit and loan balances.
c. provide the data necessary to prepare a proof of cash.
d. request information about contingent liabilities.
18-16
An auditor usually tests the reasonableness of dividend income from investments by computing the amounts that should
have been received by referring to
a. dividend record books published by investment advisory services.
b. stock indentures published by stock transfer agents.
c. stock ledgers maintained by independent registrars.
d. annual audited financial statements issued by the investee company.
18-17
An unrecorded check issued during the last week of the year would most likely be discovered by the auditor when
a. the check register for the last month of the year is reviewed.
b. the cutoff bank statement is reviewed as part of the year-end bank reconciliation.
c. the bank confirmation is reviewed.
d. the search for unrecorded liabilities is performed.
18-18
Internal control over cash receipts is weakened when an employee who receives customer mail receipts also
a. prepares initial cash receipt records.
b. prepares bank deposit slips for all mail receipts.
c. maintains a petty cash fund.
d. records credits to individual accounts receivable.
18-19
An auditor should trace bank transfers for the last part of the audit period and first part of the subsequent period to detect
whether
a. the cash receipts journal was held open for a few days after the year-end.
b. the last checks recorded before the year-end were actually mailed by the year-end.
c. cash balances were overstated because of kiting.
d. any unusual payments to or receipts from related parties occurred.
18-20
Which of the following frauds is least likely to be detected by a schedule of four-column proofs of cash prepared by the
auditor?
a. A theft of cash when the cash was stolen before being recorded in the clients book.
b. A theft of cash which is concealed by lapping customers accounts.
c. A theft of cash by inter-bank transfers just before the end of an accounting period.
d. A theft of cash by preparing erroneous bank reconciliation.
18-21
Which of the following pairs of accounts would an auditor most likely analyze on the same audit working paper?
a. Notes receivable and interest income.
b. Accrued interest receivable and accrued interest payable.
c. Notes payable and notes receivable.
d. Interest income and interest expense.
18-22
An auditor would most likely verify the interest earned on bond investments by
a. vouching the receipt and deposit of interest checks.
b. confirming the bond interest rate with the issuer of the bonds.
c. recomputing the interest earned on the basis of face amount, interest rate, and period held.
d. testing internal controls relevant to cash receipts.
18-23
A client has a large and active investment portfolio that is kept in a bank safe-deposit box. If the auditor is unable to count
the securities at the balance sheet date, the auditor most likely will
a. request the bank to confirm to the auditor the contents of the safe-deposit box at the balance sheet date.
b. examine supporting evidence for transactions occurring during the year.
c. count the securities at a subsequent date and confirm with the bank whether securities were added or removed since the
balance sheet date.
d. request the client to have the bank seal the safe-deposit box until the auditor can count the securities at a subsequent
date.
18-24
An auditor performing TOB on long-term investments would ordinarily use analytical procedures to ascertain the
reasonableness of
a. existence of unrealized gains or losses.
b. completeness of recorded investment income.
c. classification as available-for-sale or trading securities.
d. valuation of trading securities.
18-25
In confirming with an outside agent, such as a financial institution, that the agent is holding investment securities in the
clients name, an auditor most likely gathers evidence in support of managements assertions of existence or occurrence and (Hint:
Think about in the clients name)
c. completeness.
d. presentation and disclosure.
495
496
18-26
To satisfy the valuation assertion concerning undistributed income when auditing an investor clients investment accounted for by the
equity method, an auditor most likely would
a. inspect the stock certificates evidencing the investment.
b. examine the audited financial statements of the investee company.
c. review the brokers advice or canceled check for the investments acquisition.
d. obtain market quotations from financial newspapers or periodicals.
18-27
An auditor suspects that a clients cashier is misappropriating cash receipts for personal use by lapping customer checks
received in the mail. In attempting to uncover this embezzlement scheme, the auditor most likely would compare the
a. dates checks are deposited per bank statements with the dates remittance credits are recorded.
b. daily cash summaries with the sums of the cash receipts journal entries.
c. individual bank deposit slips with the details of the monthly bank statements.
d. dates uncollectible accounts are authorizes to be written off with the dates the write-offs are actually recorded.
18-28
The best evidence regarding an audit clients year-end bank balances is documented in the
a. cutoff bank statement.
b. bank reconciliations.
c. interbank transfer.
d. bank deposit lead schedule.
18-29
Which of the following sets of information does an auditor usually confirm on one form (i.e., a same piece of document)?
a. Accounts payable and purchase commitments.
b. Cash in bank and collateral for loans.
c. Inventory on consignment and contingent liabilities.
d. Accounts receivable and accrued interest receivable.
18-30
The standard AICPA form directed to financial institutions requests all of the following except
a. due date of a direct liability.
b. the principal amount paid on a direct liability.
c. description of collateral for a direct liability.
d. the interest rate of a direct liability.
18-31
Which of the following cash transfers results in a misstatement of cash at December 31, 2000? (Hint: Think of kiting)
Transfer
a.
b.
c.
d.
18-32
Bank Transfer Schedule

Disbursement
Receipt
Recorded in Books Paid by Bank
Recorded in Books Received by Bank
12.31.2000
01.04.2001
12.31.2000
12.31.2000
01.04.2001
01.05.2001
12.31.2000
01.04.2001
12.31.2000
01.05.2001
12.31.2000
01.04.2001
01.04.2001
01.11.2001
01.04.2001
01.04.2001
Which of the following internal control procedures would a client most likely use in safeguarding against the loss (theft) of
trading securities?
a. An independent trust company that has no direct contact with the employees who have record-keeping responsibilities
has possession of the securities.
b. The internal auditor verifies the trading activities in the clients safe each year on the balance sheet date.
c. The external auditor traces all purchases and sales of trading securities through the subsidiary ledgers to the general
ledger.
d. One designated member of the board of directors controls the securities in a bank safe-deposit box.
18-33
Which of the following internal control procedures would a client most likely use to safeguard marketable securities when
an independent trust agent is not employed?
a. The investment committee of the board of directors periodically reviews the investment decisions delegated to the
treasurer.
b. Two company officials have joint control of marketable securities, which are kept in a bank safe-deposit box.
c. The internal auditor and the controller independently trace all purchases and sales of marketable securities from the
subsidiary ledgers to the general ledger.
d. The chairman of the board verifies the marketable securities, which are kept in a bank safe-deposit box, each year on the
balance sheet date.
18-34
Which of the following internal control procedures would a client most likely use to assist in satisfying the completeness
assertion related to long-term investments?
a. Senior management verifies that securities in the bank safe-deposit box are registered in the clients name.
b. The internal auditor compares the securities in the bank safe-deposit box with recorded investments.
c. The treasurer vouches the acquisition of securities by comparing brokers advices with canceled checks.
d. The controller compares the current market prices of recorded investments with the brokers advices on file.
18-35
Auditing investment is no different from auditing current assets (e.g., inventory), for short-term investments and long-term
assets (e.g., property, plant and equipment) for long-term investments. However, auditor should note a distinctive feature
when auditing investment, which is:
a. The level of preliminary judgment about material (PJAM) is relatively high.
b. The level of control risk (CR) is relatively low.
c. The level of materiality threshold (MT) is relatively low.
d. The level of inherent risk (IR) is relatively high.
18-36
For the specific audit objective of valuation about presentation and disclosure, which of the following is not an example of
factors that may indicate an other-than-temporary impairment condition of a clients investments?
a. The decline in fair value is attributable to specific conditions, such as conditions in an industry or in a geographic area.
b. Management does not possess both the intent and the ability to hold the investment for a period of time sufficient to
allow for any anticipated recovery in fair value.
c. A debt security has been upgraded by a rating agency.
d. The decline in fair value has existed for an extended period of time.
18-37
Which of the following available-for-sale investments (within 12 months) meets the specific audit objective of
understandability?
a. Reported at fair value under current assets on the balance sheet. Unrealized gains and losses are reported under Other
revenue, gains, and losses and above Net Income on the income statement.
b. Reported at amortized cost under current assets on the balance sheet.
c. Reported at fair value under long-term assets on the balance sheet. Unrealized gains and losses are reported in Other
Comprehensive Income and below Net Income on the income statement.
d. Reported at fair value under current assets on the balance sheet. Unrealized gains and losses are reported in Other
Comprehensive Income and below Net Income on the income statement, and in Accumulated Other Comprehensive
Income and below Retained Earnings on the balance sheet.
18-38
According to the concept of the fair value hierarchy of inputs, a fair value measurement is not determined by which of the
following level of inputs?
a. Level 1 inputs, which are quoted prices (unadjusted) in active markets for identical assets or liabilities that the
management has the ability to access at the measurement date.
b. Level 2 inputs, which are inputs other than quoted prices within Level 1 that are observable for the asset or liability,
either directly or indirectly.
c. A significant adjustment to a Level 2 input could result in the Level 2 measurement becoming a Level 1 measurement.
d. Level 3 inputs, which are unobservable inputs for the asset or liability.
18-39
Which of the following is not a guidance to the auditor in Auditing Standards AU 540, Auditing Accounting Estimates, Including Fair
Value Accounting Estimates and Related Disclosures ?
a. The auditor should consider whether to engage a specialist and use the work of that specialist as evidential matter in
performing audit procedures related to the fair value measurement.
b. The auditor should determine the nature of the information provided by a pricing service used by management for its fair
value measurements.
c. The auditor should be alert for circumstances in which management may have an incentive to inappropriately classify
fair value measurements within the three levels of the fair value hierarchy of inputs.
d. The auditor should be aware of the decreased risk of management bias when it uses unobservable market inputs in a fair
value measurement.
497
498

18-1 c. 18-2 a. 18-3 d. 18-4 c. 18-5 c. 18-6 b. 18-7 d. 18-8 c. 18-9 b. 18-10 d. 18-11 a.
18-12 d. 18-13 a. 18-14 c. 18-15 b. 18-16 a. 18-17 b. 18-18 d. 18-19 c. 18-20 a. 18-21 a.
18-22 c. 18-23 d. 18-24 b. 18-25 b. 18-26 b. 18-27 a. 18-28 b. 18-29 b. 18-30 b. 18-31 b.
18-32 a. 18-33 b. 18-34 b. 18-35 d. 18-36 c. 18-37 d. 18-38 c. 18-39 d.

Simulation Question 18-1 is an adaptation with permission from a case by Hogan, T.J., J.L. Bierstaker, and E.S. William in the Issues in
Audit Planning Meeting
Background Memorandum
Barbara Jeffrey, a partner with Cote & Company, CPAs, is responsible for the audit of Local 829. Barbara assigned to the audit
several members of her staff; each of whom had varying levels of experience related to audits of health and welfare plans. She called a meeting to
introduce the members of the audit team.
I would like to start by introducing our newest member of the firm, Emily ODonnell. She worked one year for one of the Big 5 firms
and focused on manufacturing companies. Id like to take a moment to introduce ourselves to her. Bill, would you start the introductions?
Hi. Im Bill West. I started with Cote & Company last year after leaving a CPA firm in upstate New York to relocate to Boston. Ive
worked many nonprofits in the past, in audits of pension plans as well as health and welfare.
Hi, Emily, Im Tom Myers. I started here in 95 and was promoted to senior accountant in 98. If you have any questions, Emily, feel
free to ask.
Thanks, I will, Emily replied, Im looking forward to working with all of you.
Emily, said Barbara, we may do things a little differently compared to your experience. Tom will be the in-charge staff
accountant, but there will be times when he will defer in particular areas to others with more experience. I will be both partner and manager on
this job. As a company, we dont have much experience on health and welfare plans, but we want to build our business in this market. Well all
be learning together. Do your homework. A copy of Audits of Employee Benefit Plans,1 the AICPAs industry audit guide, is in the firms library
(hereafter, Audit Guide). Well be using PPC audit programs,2 so scan ahead on the areas youll be assigned, Tom
Tom readied his pad and pencil to take notes.
Im most concerned with the asset areas of Investments and Receivables. This is yours to review, Tom. Youll be putting the
financial statements together and drafting the auditors report.
Emily, youll be helpful in testing asset balances and performing transaction tests.
I can do that, said Emily.
Here is a general Background Memorandum of the company for all of you to look over, OK? Ive given you plenty to chew on. Ill
see you at the clients office in a few days.
Local 829 Laborers Union Health Benefit Fund and Employee Activity Fund are multi-employer plans financed by employer
contributions. The two funds provide skilled union construction laborers and their dependents and beneficiaries the following benefits:
Health Benefit Fund:
Medical
Dental
Pharmaceutical
Employee Activity Fund:
Sick-leave benefit
Ms. Catherine Joshua has been Plan Administrator of the Funds for the last 15 years. Her overall management duties include
responsibility for the Plans financial statements. As the Union Plan Administrator, she has the responsibility to manage the plans and provide
plan participants with the Funds financial information. She supervises people who maintain the accounting records, process benefit claims, bill
contractors, and process cash payments and receipts.
The various contractor-employers make Health Benefit Fund contributions to the central union office. For the Health Benefit Fund,
employer contributions are based on a negotiated hourly charge times the number of hours a union member works on a construction job per week.
The contractor-employers pay salaries directly to employees; the union office pays for medical, dental, and pharmaceutical costs of union
members from the Health Benefit Fund.
Last year, employers paid $6 per hour into the Health Benefit Fund. Payroll records indicate that there were approximately 400,000
hours worked.
Previously, funding of the Employee Activity Fund came from contractors-employers, who withheld a small part of member salaries,
and paid it to the Fund. The Fund used the money to give to members when they were sick and not receiving salaries. Funding of the Activity
Fund has been dropped in favor of a new contract increasing salaries. As long as resources permit, the Employee Activity Fund will continue to
make payments to ill members for sick time. Once the Activity Fund for ill members is depleted, individuals will no longer receive pay for sick
time and the Activity Fund will be eliminated. Then, only the Health Benefit Fund will remain.
The audit for 1998 was performed by BSH, a local CPA firm. This years audit, for 1999, was appointed to Cote & Company. Upon
acceptance, Cote & Company requested and received permission from fund management to communicate with BSH for work papers relating to
the previous years audit. You should access Data File 18-1 in iLearn for Tables 1 and 2, which present BSHs work on Health Benefit Plan
in 1997.
Local 829s Plan management changed auditors because they felt that the previous years audit had been poorly planned and
supervised. In addition, audit personnel testing investments seemed inexperienced.
Discussing Financial Statements
At the Local 829, Emily leaned over Toms desk with the 1998 Financial Report in hand and asked, Why wasnt a balance sheet
presented in last years financial statements? Im also missing an income statement.
1
2
American Institute of Certified Public Accountants (AICPA) 2000, Audits of Employee Benefit Plans. New York, NY: AICPA.
Practitioners Publishing Company (PPC), Guides to Audits of Employee Benefit Plans available at http://PPCnet.com/
499
500
You wont see the same reports as in a manufacturing company, or in any publicly held company, for that matter. Theres a
difference in the format and account types utilized. Instead of a balance sheet theres a Statement of Net Assets Available for Benefits. [Note: Not
provided in this simulation question.]
What do those data reveal?
All assets available for benefits, less normal liabilities for accounts payable and accruals. Theres a separate Schedule of the Plans
Benefit Obligations. [Note: Not provided in this simulation question.]
So it is more a focus on net assets and current benefit obligations?
Exactly.
And the income statement is
Essentially the Schedule of Changes in Net Assets Available for Benefits. [Note: Not provided in this simulation question.]
Testing Investments
Testing Receivables
Receivables in the Employee Sick-Leave Activity Fund
Thats interesting, Emily said, but I really need to talk to you about investments. I looked at the clients investment schedule of
common stock for last year [1998] and this year [1999] [Tables 3 and 5] and compared it to the schedule for 1997 [Table 1]. You should access
Data File 18-1 in iLearn for Tables 1, 3 and 5, which present the investment schedules for 1997, 1998 and 1999.
I think more tests could have been performed in 1998 than were completed. For example, there is no indication that extensions of the
number of shares and price per share were tested [see Table 6 for stock-price data]. Purchase and sale transactions should have been agreed to the
schedules. Tom, take a look at the list of 1998 and 1999 stock investment transaction [Table 4] 3 Ive got here.
Emily continued, CVS had a two-for-one stock split in 1998, but the number of shares for CVS on last years 1998 schedule wasnt
changed from the 1997 amount. I checked, and they didnt sell any of the CVS stock. Im concerned that a number of possible errors might be
imbedded in the 1998 and 1999 working papers, including the number of shares, price per share, and the extensions and footings determining
total market values of the stocks.
After completing work on the investment schedules, Emily presented her work to Tom for review and then began her next task.
Tom? Emily asked. Receivables are due from contractors who employ union members on construction projects. For each hour of
employment $6 is paid to the Health Benefit Fund per Union laborer. Who determines that amount?
It was a collective bargaining agreement between the Union and a consortium of regional contractors, Tom said. Weekly payroll
information is sent to the Union office by each contractor. Expect a few weeks delay in transmission.
What if the services of the Union member are no longer required?
The member has to contact the Union Hall and get on-the-job referral listing within one week.
And if the person isnt working after two weeks, who pays? asked Emily.
The Union member has to make self-payments to the Health Benefit Fund, or health benefits would be terminated.
While reviewing the Employee Sick-Leave Activity Fund used to pay union members for sick time, Tom noted a large balance
($3,597,000) in the Contributions Receivable from Contractors account. Extracts of the partial balances of the two funds are shown below:
Extract from the Laborers Local 829 Trial Balance
Employee Health Benefit Fund
Account Description
Cash Checking Account
Cash Lowell Savings Bank
Petty Cash
Contributions Receivable
from Contractors
Members Self-Payments
Accrued Interest and Dividends
U.S. Gvt Security @ fair value (FV)
Corp. bonds and debentures @ FV
Common Stocks @ FV
Certificate of Deposit
Equipment
Total
Assume the information was agreed to source documents.
1997
$ 205,941
89,900
500
1998
$ 279,702
97,829
500
1999 Unadjusted
$ 265,000
77,650
500
2,400,600
92,829
630,500
420,000
36,000,000
29,434,308
1,000,000
750,000
2,387,560
85,230
650,300
450,000
38,000,000
42,877,638
1,000,000
720,000
2,233,829
92,800
646,500
350,000
41,000,000
38,048,650
1,000,000
$71,024,578
========
$86,548,759
========
720,000
$84,434,929
=========
Extract from the Laborers Local 829 Trial Balance

Employee Sick-Leave Activity Fund
Account Description
Cash Checking Account
Contributions Receivable
from Contractors
Certificate of Deposit
Total
1997
$ 295,000
1998
$ 455,000
1999 Unadjusted
$ 165,000
3,650,000
1,700,000
$5,645,000
=======
3,600,000
800,000
$4,855,000
=======
3,597,000
50,000
$3,812,000
========
Tom spoke with the Plan Administrator, Ms. Joshua.

Im concerned about the large balance in the Contribution Receivable from Contractors account in the Employee Activity Fund. The
balance hasnt changed much in two years.
As you know, began Ms. Joshua, the sick-leave benefit was removed in the collective bargaining agreement. When the Employee
Activity Fund is exhausted, members will not receive any monies when theyre sick. Only a few contractors are making payments to this fund.
Ms. Joshua continued, Theres no way, Tom, that contractors could owe that amount. We might collect a few thousand dollars, but
nothing more. I do recall, though, a Union meeting about ten years ago when some contractors were requested to reimburse the Sick-Leave
Fund.
Any follow-up on that? asked Tom.
Not that Im aware of.
It would seem that more than three and a half million dollars would be considered significant, thought Tom.
Required
1. a. Assume you are Emily, answer the following questions relating to the analysis of Local 829s Investment Schedules:
i.
ii.
iii.
What management assertions regarding investments should be tested?

What specific audit objectives should be met?
What type of audit evidence, external or internal, should be gathered?
b. Based on your answers to 1.a.i, ii, and iii, apply appropriate audit tests to the 1998 and 1999 Local 829s Investment Schedules. From
iLearn, download Tables 3 and 5 from Data File 18-1 and perform audit tests directly on the schedules. Use standard audit symbols to mark
the audit tests performed, for example, ff for footed and cross-footed. Your working papers should be in proper form. Include a heading, the
purpose of the analysis, preparer initials and date, and a discussion of the work performed as well as the results of such work. Assume that the
schedule for 1997 (Table 1) and the list of transactions and events for 1998 and 1999 presented in Table 4 are correct.
c. Include in your audit working papers a schedule, for both 1998 and 1999, of any stocks with errors relating to the market value of the stock.
Provide a set of columns of the original information (i.e., number of shares, market price per share, and total market value) and another set of
columns for the proper amounts. For Health and Welfare Plans, all investments are reported in the financial statements at fair value (Audit Guide,
para.4.85). Your audit working paper schedule would be used to support suggested adjusting entry to the accounts. It is not necessary to propose
adjusting entries for this simulation question.
Note: Table 6 in Data File 18-1 provides you the stock price information. However, you can also obtain the stock price information from the
Internet, such as from the Wall Street Journal online version of Market Browser http://www.marketbrowser.com/mbwsjin.html, a free software
application available for download.
2. Tom would like your assistance regarding the issue of Employee Sick-Leave Activity Fund. He would like you to prepare a memo to Barbara
Jeffrey presenting her with options for addressing the apparent overstatement of $3,597,000 in Contributions Receivable from Contractors in
the Employee Sick-Leave Activity Fund. In the memo, you should comment on whether this amount would be considered material, and the basis
for your judgment.
Note: Table 1 in Statement of Financial Accounting Concepts No.2 (para.166) provides examples of quantitative materiality guidelines (FASB
1986). It refers to SEC Accounting Series Release No.41, which requires separate disclosure of balance sheet items if 10 percent or more of
their immediate category or more than 5 percent of total assets.

Simulation Question 18-2 is an adaptation with permission from a case by Gordon T. P., and M.S. Niles in the Issues in Accounting Education , a
Auditing Marketable Securities
On a chilly Monday morning in late February, Fred Braddock sipped coffee from a paper cup and stared at his laptop computer screen.
Fred was in the coffee room of his audit client, Selden Systems (hereafter, SS), which was being used by his audit team from Sand and Rock,
CPA LLP. Because SS was a publicly traded company that had a December 31, 2000 year-end, its financial statements needed to be filed with the
501
502
SEC by March 15, just 17 days after todays date of February 26. Grey was in his third year with the CPA firm and had just been promoted to
senior. This morning he was reviewing the work of his staff auditor, Mary Jensen.
Mary had prepared a schedule supporting the presentation of SSs marketable securities. Her audit working papers, labeled as A-2 and
A2a, are displayed in Exhibit 1. Additional relevant information from SSs preliminary financial statements is included in Exhibit 2. You should
access Data File 18-2 in iLearn for Exhibit 1, which presents Marys audit working papers A-2 and A-2a, and Exhibit 2, which presents
selected financial statement information for SS.
Freds attention was particularly draw to the nearly 80 percent decline in accumulated other comprehensive income (AOCI) in
stockholders equity. The account had gone from nearly $1 million on January 1 to just $212,110.63 at December 31. Since SS had no foreign
subsidiaries and no defined benefit pension plan, Fred knew AOCI must be related to available-for sale securities; this was confirmed by a quick
look at working paper A-2 (Exhibit 1). Clearly, the market value of the investment portfolio had dropped significantly with the biggest declines
attributable to Lucent Technologies and Microsoft. As he was reflecting on the numbers, Mary walk in, dropped her computer case and headed
for the coffee machine.
Hi, Mary! I was looking at your analysis of the securities portfolio. I knew that the market was down and that the market downturn
had hit the technology sector pretty hard, but, wow! I had no idea that Lucent had gone down so much during the last year. Microsoft really took
a hit as well.
Yeah, Selden [SS] is lucky. If its year-end were later, it would be even sores, responded Mary.
What do you mean? asked Fred.
Well, on January 1, 2000, Lucents stock price was $75. On December 31, 2000, the price was $13.50. Last Friday [February 23], it
closed at $12.40, said Mary. Of course, the loss would have been partially offset by Microsoft, which seems to be recovering. Its stock is up 30
percent from around $43 to over $56 since the beginning of the year.
Is some of this million-dollar decline in the portfolio caused by the sale of Caterpillar and Coca-Cola? asked Fred.
Um, said Mary. I dont think so. They essentially took the proceeds and reinvested the money from Coca-Cola into Pepsico and
from Caterpillar into Pfizer. So the decline in value is market-related.
Fred returned to his work, but the size of the marketable securities adjustment continued to nag him. He visited a financial information
web page and verified Marys statement about the Lucent and Microsoft stocks. He also logged onto LexisNexis, read several articles, and made
some notes as to ongoing problems at Lucent and Microsoft (see Exhibits 3 and 4). You should access Data File 18-2 in iLearn for Exhibits 3
and 4, which presents Freds Research on Lucent and Microsoft). The news wasnt encouraging: the price of the Lucent stock had declined in
value by 82 percent in 2000 alone. Microsoft was hardly better with a 63 percent decline. He inserted the CD-ROM containing FASB
pronouncements and reviewed SFAS No.115 (FASB 1993). What he learned there increased his distress.
He telephoned the audit manager on the SS engagement, Kathy Caldwell. She share his concerns and said shed set up a meeting with
the senior manager and the partner.
What I need you to do, Fred, is document your understanding of the situation and work up a preliminary position statement. Dont
talk to the client personnel yet. We want to make sure that our ducks are all in a row before they get alarmed- you know how excitable their CFO
is. We need to get moving on this since were only two weeks away from our printing deadline.
Fred gathered the information he had located, and tried to outline the memo he needed to write. Different ideas about how the Lucent
and Microsoft stocks should be valued and presented in the financial statements swirled in his head.
Required
Kathy, the audit manager, would like your assistance regarding the issue of SSs marketable securities. She would like you to prepare her a memo
that addresses the following issues:
1. Although Lucent and Microsoft have, in the past, been included in SS portfolio of available-for-sale securities, at least five accounting
alternatives are available now that the market values of these shares have declined significantly. Discuss the appropriateness of each of the
following five accounting alternatives with reference to/citation of authoritative accounting and auditing literature:
i. Leave Lucent and/or Microsoft in the available-for-sale portfolio on the basis that the decline in value was temporary.
ii. Recognize in net income a realized loss on the basis that the decline in value was other than temporary.
iii. Transfer Lucent and/or Microsoft to the trading portfolio.
iv. Transfer Lucent and/or Microsoft to the held-to-maturity portfolio.
v. Reclassify Lucent and/or Microsoft as an equity method investment.
You should refer to/cite the following authoritative accounting and auditing literature:
(a) AICPA. 2000. Audit Evidence Specific Considerations for Selected Items. Statement on Auditing Standards AU 501.
(b) FASB. 1997. Reporting Comprehensive Income. Statement of Financial Accounting Standards (SFAS) No. 130 (FARS abbreviation:
FAS130).
(c) FASB. 1993. Accounting for Certain Investments in Debt and Equity Securities. Statement of Financial Accounting Standards (SFAS) No.
115 (FARS abbreviation: FAS115).
(d) FASB. 1995c. A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities (FARS
abbreviation: Q&A115).
FASB. 1995b. Emerging Issues Task Force (EITF) Appendix D-44: Recognition of Other-Than-Temporary Impairment upon the Planned Sale of
a Security Whose Cost Exceeds Fair Value (FARS abbreviation: EITF D-44).
SEC. 2004. Accounting for Noncurrent Marketable Equity Securities. Staff Accounting Bulletin (SAB) No. 59.
2. It is anticipated that SSs CFO would strongly disagree with your recommendation of the five accounting alternatives to Kathy.
i. Discuss from your (the auditors) perspective, which of the five accounting alternatives you would most likely recommend to Kathy? Support
your argument with reference to/citation of authoritative accounting and auditing literature.
ii. Discuss from CFOs (the managements) perspective, which of the five accounting alternatives the CFO would most likely ask you to
recommend to Kathy? Support your argument with reference to/citation of authoritative accounting and auditing literature.

Simulation Question 18-3 is an adaptation with permission from a case by Phillips, F. C., and B. Mackintosh in the Issues in Accounting
However, the years during which the reported activities took place have been changed. Also, some of the names and places have been changed.
The Setting
Background Information
Wiki Art Gallery, Inc. (WAG) is a privately owned business started in 2006 by two students. Rob Wilco combined his entrepreneurial
business interests with Stephen Conley's knowledge of artwork to create an online art gallery, which they named WAG. WAG's start-up years
were challenging. The owners contributed their savings to the company, but initially earned little return on their significant investments of money
and time. Propelled by a belief that their work would pay off, they persevered. Now, it appears their luck is changing. WAG became profitable in
late 2009 and has reported a sizable net income for the year ended September 30, 2011. Both owners are excited by this turn of events. In the
summer of 2010, Stephen had indicated he would like to buy-out Rob, which coincided with Rob's interest in leaving WAG and embarking on a
new career. Realizing that he has limited accounting knowledge, Stephen has approached you, a close friend and an experienced auditor, for
advice. As a private company, WAG's shares do not have a readily available price. Consequently, Stephen and Rob have agreed to calculate the
buy-out price using an earnings multiplier equal to five times WAG's GAAP-based net income for the year ended September 30, 2011.
Although Rob has been a reliable friend and business partner in the past, Stephen is concerned that WAG's fiscal 2011 results could be misstated
or biased because WAG does not obtain an annual audit. Stephen would like you to advise him whether WAG's fiscal 2011 net income fairly
reports the company's financial success, given that the purchase price he will pay Rob is to be based on WAG's 2011 net income.
Stephen explained that WAG obtains revenues from two sources. First, WAG purchases art from promising artists and sells it to
individuals and traditional art galleries. Second, WAG charges annual artist fees in exchange for displaying their work in its online galleries.
WAG's expenses relate to salaries, the cost WAG incurs to buy the artwork it sells, depreciation on WAG's computer equipment, website
maintenance, and other administrative costs (e.g., bad debts, interest, income taxes). WAG has many transactions with artists and customers
throughout the year. Stephen described some of the particularly significant events that happened during the year ended September 30, 2011,
which you summarized in Exhibit 1. You should access Data File 18-3 in iLearn for Exhibit 1. He also provided you comparative income
statements for the years ended September 30, 2011 and 2010 (see Exhibit 2), and excerpts from WAG's notes to the financial statements (see
Exhibit 3). You should access Data File 18-3 in iLearn for Exhibits 2 and 3.
Required
Stephen has asked you, a close friend and an experienced auditor, to prepare a memo that identifies and evaluates financial reporting choices that
Rob has made that may have resulted in a biased measure of WAG's 2011 financial success. Specifically, for each accounting judgment or
method that Rob has applied that might not fairly measure WAG's 2011 net income, you should:
(1) Describe the choice,
(2) Evaluate whether it is allowed under U.S. GAAP,
(3) Use WAG's specific information to explain how it leads to an unfair measure of WAG's 2011 net income, and
(4) Propose an alternative choice that is in accordance with U.S. GAAP and would yield a fairer measure of net income.
Stephen would like you to focus on accounting choices rather than investment decisions (i.e., buy-out Rob), given his primary focus on the
fairness of WAG's 2011 net income. He indicated that he would consult with you about investment decisions later, but for now he wants you to
focus on providing the accounting advice he currently needs.
503
504
Chapter 19
LO19-1 Describe the audit procedures for identifying contingent liabilities;
including inquiry of a clients lawyer concerning contingent liabilities.
LO19-2 Discuss the auditors responsibilities for reviewing subsequent events;
including audit procedures for testing subsequent events.
LO19-3 Discuss the auditors responsibilities for evaluating accounting estimates;
including audit procedures for testing specific accrued liabilities.
LO19-4 Discuss the auditors responsibilities for reviewing related-party transactions;
including audit procedures for identifying and examining related-party
transactions.
LO19-5 Discuss the auditors responsibilities for reviewing the work of a specialist;
including audit procedures on using the work of a specialist.
LO19-6 Understand the auditors considerations for subsequently discovered facts.
Chapter 19 Completing the Audit

Figure 19-1 provides an overview of the audit work performed by the auditor at the completing the audit of the audit
process.
Figure 19-1 Completing the Audit
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Financial Audit
Audit Report
Integrated Audit
Review of Contingent Liabilities

(LCAs)
Review of Subsequent Events

(SEs)
Final Evidence Evaluation

Processes
Communications with the Audit Committee and

Management
Consider Subsequently Discovered Facts

(SDFs)
505
506
Review of Contingent Liabilities (LCAs)

The auditors objectives in verifying contingent liabilities are to evaluate the accounting treatment of known
contingent liabilities and to identify any contingencies not already identified by management. Examples of
contingent liabilities and their accounting treatment are described in Table 19-1. Auditors procedures for
identifying contingent liabilities are divided into two categories: 1. Audit procedures related to tests done in other
accounting cycles, and 2. Audit procedures conducted specifically in completing the audit phase of the audit process.
Examples of these two categories of procedures are described in Table 19-2.
Table 19-1 Contingent Liabilities and Accounting Treatments
Contingent Liabilities
Examples:
Pending or threatened litigation.
Actual or possible claims and

assessments.
Income tax disputes.

Product warranties or defects.
Guarantees of obligations to
others.
Agreement
to
repurchase
receivables that have been sold.
Accounting Treatment (FASB No.5 Accounting for Contingencies)
Probability
Quantifiability
Reporting
Remote
The chance of the contingent
event occurring is slight.
Not estimated
Amount of the contingent
event is not a factor.
Reasonably possible
event occurring is more than
remote but less than probable.
Not estimated
Amount of the contingent
event is not a factor.
Disclose as footnotes in
Probable
event occurring is likely to
occur.
Amount
of
the
contingent event can be
reasonably estimated.
Accrued as contingent
liabilities in the income
statement.
Amount
of
the
contingent event cannot be
reasonably estimated.
Disclose as footnotes in
Not reported
Table 19-2 Audit Procedures for Identifying Contingent Liabilities
Procedures Related to Tests

in other Accounting Cycles
Read the minutes of meetings of the board of directors,

committees of the board, and stockholders.
Review contracts, loan agreements, leases, and correspondence

from government agencies.
Review income tax liability, tax returns, and IRS agents

reports.
Confirm guarantees and letters of credit of obtained from

financial institutions or other lending agencies.
Inspect other documents for possible guarantees.
Procedures Conducted Specifically

in Completing the Audit
Inquiry of and discussion with management about its policies

and procedures for identifying, evaluating, and accounting for
contingent liabilities.
Examine documents in the clients records such as

correspondence and invoices from lawyers for pending or threatened
lawsuits. Recall analysis of legal expenses in Chapter 14 on TOB in
expenditure cycle. The results of that analysis may result in further
examination for the existence of contingent liabilities relating to
lawsuits.
Obtain a lawyers representation letter (also known as legal

letter) that describes and evaluates any litigation, claims, or
assessments (LCAs). Figure 19-2, Table 19-3, and Figure 19-4
provide further discussion and examples on obtaining the lawyers
representation letter according to AU 501 Audit Evidence Specific
Considerations for Selected Items.
Obtain a management representation letter indicating that all

litigation, asserted and unasserted claims, and assessments (LCAs)
have been disclosed in accordance with FASB No.5. Figure 19-3
and Table 19-3 provide further discussion and examples on the
management representation furnished by the client according to AU
580 Written Representation.
Figure 19-2 Inquiry of a Clients Lawyer Concerning LCAs according to AU 501
Lawyer
7. Lawyers prepare and sign a

lawyer representation letter
1. Inform client
about LCAs
6. Send clients inquiry letter

to the lawyer.
Client
2. Inform auditor
about LCAs
5. Send both letters to client

Auditor
3. Prepare Management Representation letter

Specifically:
a. Auditor prepares a management representation letter
b. Use the clients letterhead
c. Signed by TWO client officials (CEO & another officer)
If refuses to sign, auditor issues qualified audit report
based on limitation on audit scope.
d. Dated to coincide with the audit report date.
See Figure 20-3 for an example.
4. Prepare Cover letter + Clients Inquiry of Lawyer letter

to obtain corroborative LCAs information given by the
management. Specifically:
a. Auditor prepares an auditors cover letter
b. Auditor prepares a clients inquiry of lawyer letter
on the clients letterhead
c. Sign by ONE client official.
d. Dated to coincide with the audit report date.
8. Send lawyers representation letter to auditor

Note in Step No.7 above:
1. If a clients lawyer were unable to form a conclusion about the likelihood of an unfavorable outcome of litigation, claims, or assessments
because of inherent uncertainties, and the effect on the financial statements could be material, the auditor would ordinarily conclude that an
explanatory paragraph should be added to an unqualified audit report in order to emphasize the lawyers inconclusive assessment.
2. If a clients lawyer refuses to respond, auditor would ordinarily issue a qualified audit report based on limitation in audit scope. However, there
is no limitation in scope if the lawyer simply limits the response to matters that the lawyer has given substantive attention in the form of legal
representation.
507
508
Table 19-3 Contents of Management Representation Letter and Lawyer Representation Letter
Management Representation Letter (AU 580 )
AU 580 Written Representations limits management representations to
material matter that are directly related to amounts included in the
financial statements, such as the disclosure of compensating balance
arrangements involving related parties. Accordingly, this limitation
does not apply to those management representations that are not
directly related to amounts included in the financial statements, such as
the availability of minutes of stockholders and directors meetings.
The contents of a management representation letter include:
Financial statements
Managements acknowledgement of its responsibility for the fair
presentation in the financial statements of financial positions, and cash
flows in conformity with GAAP.
Managements belief that the financial statements are fairly presented
in conformity with GAAP.
Lawyer Representation Letter (AU 501)
The contents of a lawyer representation letter include:

A list and evaluation of any pending or threatened litigation to
which the attorney has devoted substantial attention. The clients
management may prepare and provide the list to the auditor. Types
of litigation include:
(1) Breach of contract
(2) Patent infringement
(3) Product liability
(4) Violations of government legislation, such as (a) securities laws,
(b) anti-discrimination status based on race, sex, or age, (c) antitrust
laws, (d) income tax regulations, (e) environmental protection laws, (f)
Foreign Corrupt Practices Act, and (g) RICO.
A list of unasserted claims and assessments considered by

management to be probable of assertion and reasonably possible of
unfavorable outcome.
A request that the attorney describes and evaluates the

outcome of each pending or threatened litigation. This should
include the progress of the case, the action of the entity plan to take,
the likelihood of unfavorable outcome, and the amount or range of
potential loss.
Completeness of information
Availability of all financial records and related data.
Absence of unrecorded transactions.
Recognition, measurement, and disclosure
Information concerning fraud involving (a) management, (b)
employees who have significant roles in internal control, or (c) others
where the fraud could have a material effect on the financial
statements.
Information concerning related party transactions and amounts
receivable from or payable to related parties.
Significant risks and uncertainties

Unasserted claims or assessments that the clients attorney has advised
are probable of assertion and must be disclosed in accordance with
FASB No. 5, Accounting for Contingencies.
Satisfactory title to assets, liens or encumbrances on assets, and assets
pledged as collateral.
Compliance with aspects of contractual agreements that may affect the
Subsequent events
Subsequent events that have a direct effect on the financial statements
and require adjustment.
Subsequent events that have no direct effect on the financial statements
but for which disclosure is advisable.
A request for additions to the list provided by the management

or a statement that the list is complete.
A request that the attorney comment on unasserted claims

where his/her views differ from managements evaluation.
A statement by management acknowledging an understanding

of the attorneys professional responsibility involving unasserted
claims and assessments.
A request that the attorney indicates if his/her response is

limited and the reasons for such limitation.
A description of any materiality levels agreed upon for the

purposes of the inquiry and response.
Figure 19-3 An Example of a Management Representation Letter

ABC Company
February 8, 201x
XYZ CPA, LLP
Gentlemen:
We are providing this letter in connection with your audit of the consolidated balance sheet of ABC Company as of December 31, 201x, and the
related consolidated statements of operations, stockholders equity, and cash flows for the years then ended for the purpose of expressing an
opinion as to whether the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and
cash flows in conformity with generally accepted accounting principles.
Certain representations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if
they involve an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would be changed or influenced by the omission of misstatement.
We confirm, to the best of our knowledge and belief, as of February 8, 201x, the following representations made to you during your audit.
1. The financial statements referred to above are fairly presented in conformity with generally accepted accounting principles.
2. We have made available to you all
a. Financial records and related data.
b. Minutes of the meetings of stockholders, directors, and committees of directors, or summaries of actions of recent meetings for which minutes
have yet been prepared.
3. There have been no communications from regulatory agencies concerning noncompliance with or deficiencies in financial reporting practices.
4. There are no material transactions that have not been properly recorded in the accounting records underlying the financial statements.
5. There has been no
a. Fraud involving management or employees who have significant roles in internal control.
b. Fraud involving others that could have a material effect on the financial statements.
6. The company has no plans or intentions that may materially affect the carrying value of classification of assets and liabilities.
7. The following have been properly recorded or disclosed in the financial statements.
a. Related-party transactions, including sales, purchases, loans, transfers, leasing arrangements, and guarantees, and amounts receivable from or
payable to related parties.
b. Guarantees, whether written or oral, under which the company is contingently liable.
c. Significant estimates and material concentrations known to management that are required to be disclosed in accordance with the AICPAs
Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties.
8. There are no
a. Violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a
basis for recording a loss contingency.
b. Unasserted claims or assessments that out lawyer have advised us are probable of assertion and must be disclosed in accordance with Financial
Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies.
c. Other liabilities or gain or loss contingencies that are required to be accrued or disclosed by FASB Statement No.5
9. The company has satisfactory title to all owned assets, and there are no liens or encumbrances on such assets, nor has any asset been pledged
as collateral.
10. The company has complied with all aspects of contractual agreements that would have a material effect on the financial statements in the
event of noncompliance.
11. Receivables recorded in the financial statements represent valid claims against debtors for sales or other charges arising on or before the
balance sheet date and have been appropriately reduced to their estimated net realizable value.
12. Provision has been made to reduce excess or obsolete inventories to their estimated net realizable value.
13. Arrangements with financial institutions involving compensating balances or other arrangements involving restrictions on cash balances, line
of credit, or similar arrangements have been properly disclosed.
14. We have fully disclosed to you all sales terms, including all rights of return or price adjustments and all warranty provisions.
To the best of our knowledge and belief, no events have occurred subsequent to the balance sheet date and through the date of this letter that
would require adjustment to or disclosure in the aforementioned financial statements.
____________________________________________
Mr. A, Chief Executive Officer
____________________________________________
Mr. B, Chief Financial Officer
509
510
Figure 19-4 An Example of a Clients Inquiry of Lawyer Letter

ABC Company
December 15, 201x
L & L, Attorneys
Gentlemen:
Our auditors, XYZ CPA, LLP (P. O. Box 888, San Francisco), are conducting an audit of our financial statements for the fiscal year ended
December 31, 201x. In connection with their audit, we have prepared and furnished to them a description and evaluation of certain contingencies,
including those attached, involving matters with respect to which you have been engaged and to which your devoted substantive attention on
behalf of the company in the form of legal consultation or representation. For the purpose of you response to this letter, we believe that as to each
contingency an amount in excess of $30,000 would be material, and in total, $90,000. However, determination of materiality with respect to the
overall financial statements cannot be made until our auditors complete their audit. Your response should include matters that existed at
December 31, 201x, and during the period from that date to the date of the completion of their audit, which is anticipated to be on or about
February 8, 201x.
Please provide to our auditors the following information:
1. Such explanation, if any, that you consider necessary to supplement the listed judgments rendered or settlements made involving the company
from the beginning of this fiscal year through the date of our reply.
2. Such explanation, if any, that you consider necessary to supplement the listing of pending or threatened litigation, including an explanation of
those matters as to which your views may differ from those stated and an identification of the omission of any pending or threatened litigation,
claim, and assessment or a statement that the list of such matters is complete.
3. Such explanation, if any, that you consider necessary to supplement the attached information concerning unasserted claims and assessments,
including an explanation of those matters as to which your views may differ from those stated.
We understand that whenever, in the course of performing legal services for us with respect to a matter recognized to involve an unasserted
possible claim or assessment that may call for financial statement disclosure, you have formed a professional conclusion that we should disclose
or consider disclosure concerning such possible claim or assessment, as a matter of professional responsibility to us, you will so advise us and
will consult with us concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards
No.5. Please specifically confirm to our auditors that out understanding is correct.
Please specifically identify the nature of and reason for any limitations in your response.
Sincerely
_____________________________
Mr. P, Chief Executive Office
ABC Company
Review of Subsequent Events

The auditor reviews transactions and events occurring after the balance sheet date to determine whether they might
affect the fair presentation or disclosure of the clients financial statements. Figure 19-5 shows the period covered by
the auditors review of subsequent events. Table 19-4 discusses the timing of the subsequent events and the auditors
responsibilities for reviewing such subsequent events in compliance with AU 560 Subsequent Events and
Subsequently Discovered Facts.
Figure 19-5 Period Covered by the Auditors Review of Subsequent Events
Balance sheet date
1. Completion of fieldwork date

2. Clients director report date
3. Audit report date
Dec 12/31
Feb 2/28
Subsequent Events (SEs),

also known as formal SEs.
No effect on audit report date,
i.e., dated at the usual completion
of fieldwork date.
1. Audit report issue date

2. End of audit responsibility date
March 3/31
Subsequent Events (SEs), also known as new SEs.

Audit report date options:
1. One date at the audit report date and one date at the new
SEs date, refer to as dual dating.
2. Only one date at the new SEs date.
Note: Both options are not permitted if the SEs are reviewed
and tested but NOT disclosed in the financial statements. The
audit report should then be dated at the usual completion of
fieldwork date.
Subsequently Discovered Facts (SDFs)

If SDFs is factual, has material impact on the financial statements,
and condition existed at the audit report date, then request revision
to the financial statements, withdraw the audit report, and reissue a
new audit report.
Registration Statement under Securities Act 1933.

Review SEs to the effective date of the Registration Statement.
511
512
Table 19-4 Timing and Auditors Responsibilities for Reviewing Subsequent Events
Timing of Subsequent Events (SEs)
Between balance sheet date (12/31) and audit report date (2/28).
This period begins with the clients year-end balance sheet date and the
auditors audit report signing date.
Subsequent events occur within this period is also known as formal
subsequent events.
Between audit report date (2/28) and audit report and financial
statement issue date (3/31).
This period is between the audit report date and the date the signed
audit report, together with the clients financial statements, are printed
and issued to the stockholders.
Subsequent events occur within this period is also known as new
subsequent events.
After the audit report and financial statement issue date (3/31).
Auditors official responsibilities end at the date the audit report and
financial statements are issued.
Two categories of subsequent events occurring after the audit report
and financial statements issue date:
(1) Subsequently discovered facts (SDFs), or
(2) Registration statement events.
Auditors Responsibility
The auditor is responsible for reviewing and testing formal

subsequent events occur within this period.
Subsequent events occur within this period have no impact on the date
of audit report.
Officially, the auditor should date the audit report on the date of the
completion of the fieldwork. However, the auditor usually dates the
audit report on the date of the clients director report.
The auditor is responsible for reviewing and testing new subsequent
events occur within this period. Two options:
(1) The auditor expands the review and tests of all SEs to the new
SEs date.
In this option, the audit report consists of only one date, which is the
date of the new SEs.
(2) The auditor does not expand the review and tests of all SEs to the
new SEs date. Instead, the auditor restricts the review and tests to
specific SEs occurring within this period.
In this option, the audit report consists of two dates, known as dual
dating. The first date is the completion of the fieldwork as usual and
the second date is the date of the new SEs.
For example, an audit report is dual dated as follows:
February 28, 2010, except for note 8, as to which the date is March 31,
2010.
Note 8 deals with the specific subsequent events in the clients
Since the auditors official responsibilities end at the date the audit
report and financial statements are issued, s/he has no obligation to
review or test SE occurring after this date.
SEs occurring after this date that are SDFs is discussed in Table 19-8.
SE occurring after this date that involve registration statement under
the Securities Act of 1933; the auditor is responsible for reviewing and
testing the SE beyond the audit report date to the date the registration
statement becomes effective.
Types of Subsequent Events and Auditors Testing Procedures

The auditor is responsible for reviewing and testing two types of subsequent events. Table 19-5 describes the two
types of subsequent events reviewed by the auditor. The auditors tests of the subsequent events are divided into two
categories. Table 19-6 describes the two categories of auditors testing procedures for subsequent events.
Table 19-5 Auditors Review of Two Types of Subsequent Events
Type I Events
Type II Events
These are events occurring after the balance sheet date that
provide additional evidence about conditions that existed on or
before the balance sheet date.
These are events occurring after the balance sheet date that
provide evidence about conditions that did not exist on or before the
balance sheet date.
These events have a direct effect on the financial statements

and require adjustment of the financial statements. Note that
whenever there is an adjustment made to the financial statements, an
accompanying footnote is also made to the financial statements.
These events have no direct effect on the financial statements

but for which disclosure in the form of footnotes to the financial
statements is recommended.
Examples of Type I events include:

(1) An uncollectible account receivable resulting from continued
deterioration of a customers financial condition leading to bankruptcy
(2) The settlement of a lawsuit after the balance sheet date for an
amount different from the amount recorded in the year-end financial
statements.
(3) Disposal of equipment not being used in operation after the balance
sheet date at a price below the recorded year-end book value.
(4) Sale of available-for-sale investments after the balance sheet date at
a price above or below the recorded purchase price (cost).
Examples of Type II events include:

(1) An uncollectible account receivable resulting from unexpected
conditions arising subsequent to the balance sheet date.
(2) Purchase or disposal of a business by the client after the balance
sheet date.
(3) Sale of a capital stock or bond issue by the client after the balance
sheet date.
(3) Loss of manufacturing facility or assets resulting from fire or
flood.
(5) Decline in the market value of available-for-sale investments after
the balance sheet date.
Table 19-6 Auditors Two Categories of Testing Procedures for Subsequent Events
Procedures perform as part of year-end TOB of
Accounting Cycles
Procedures perform after balance sheet date specifically

to discover subsequent events
Cut off procedures performed in the various accounting cycles

that relate to transactions occurring after the balance sheet date. For
example, cut off procedures on purchases one week after the balance
sheet date.
Read any interim financial statements that are available for the
period after year-end; they should be compared to the prior-period
statements, and any unusual fluctuations should be investigated
Valuation test procedures performed in the various accounting

cycles that relate to transactions occurring after the balance sheet
date. For example, valuation test procedures on collectability of
accounts receivable after the balance sheet.
Examine the books of original entry (such as sales journals,

purchases journal, cash receipts and cash disbursements journals)
for the subsequent events period and investigating any unusual
transactions.
Inquire of management about:

(1) Whether there were or are any substantial contingent liabilities or
commitments existing at the balance sheet date or at the date of
inquiry.
(2) Whether there have been any significant changes in capital stock,
long-term debt, or working capital.
(3) The current status of any items in the financial statements that were
accounted for based on preliminary or inconclusive data.
(4) Whether any unusual adjustments have been made during the
subsequent event period.
Read the available minutes of meetings of stockholders,

directors, or other committees for the subsequent event period.
Inquire of clients lawyer about any litigation, claims, or

assessments against the company (see Table 19-3).
Obtain a representation letter from the management (see Table

19-3).
Final Evidence Evaluation Processes

In addition to review of contingent liabilities and subsequent events, the auditor performs a number of audit
procedures before deciding on the appropriate audit report to issue to the client. Table 19-7 describes some of these
procedures.
Table 19-7 Audit Procedures in the Final Evaluation Processes
Audit Procedures in the Final Evaluation Processes
Performance of Final Analytical Procedures

AU 520 Analytical Procedures requires the auditor to perform analytical procedures (Recall Table 7-10 in Chapter 7 concerning analytical
procedures) at completing the audit phase of the audit process to identify any unusual or unexpected balances not previously considered.
Evaluation of Accounting Estimates

AU 540 Auditing Accounting Estimates, including Fair Value Accounting Estimates and Related Disclosures requires the auditor to evaluate
accounting estimates to (1) Provide reasonable assurance that management developed all material estimates, and (2) Assure that the estimates are
reasonable (free from bias) and are presented in the financial statements in accordance with GAAP. Examples of accounting estimates include:
Airline passenger revenue, warranty claims, uncollectible accounts receivables, obsolete inventory, depreciation and amortization, income tax
and accrued property taxes, pension costs, subscription income, percentage of completion income on construction contracts, and loss
contingencies.
In evaluating the reasonableness of accounting estimates:
(1) The auditor normally concentrates on key factors and assumptions that are (a) significant to the accounting estimates, (b) sensitive to
variations, (c) deviations from historical patterns, and (d) subjective and susceptible to misstatement and bias.
(2) The auditor should first obtain an understanding of how management developed the estimate and then, based on his/her understanding,
consider (a) reviewing and testing the estimation process used by the management, (b) developing an independent estimate for comparison, and
(c) reviewing transactions or events that occurred subsequent to the balance sheet date that may affect the estimates.
(3) The auditor must evaluate the reasonableness of accounting estimates in the context of the financial statements taken as a whole, and (a) the
difference between the estimates best supported by the audit evidence and the estimate in the financial statements must be reasonable, (b) if the
estimate in the financial statements is not reasonable, it should be treated as a likely error or fraud and aggregated with other likely
misstatements, and (c) if the differences are individually reasonable but collectively indicate possible bias, the auditor must reconsider the
estimates as a whole.
Most accrued liabilities (expense) represent obligations payable sometime during the succeeding period for services or privileges received before
the balance sheet date. Examples include interest payable, accrued property taxes, accrued payrolls and payroll taxes, income taxes payable, and
513
514

amounts accrued under service guarantees. In other words, accrued liabilities represent accounting estimates made by the client amounts that will
subsequently become payable. For most accrued liabilities the audit approach will emphasize a review and test of managements process of
developing the estimates. Subjective (as well as objective) factors may make it difficult to establish control over accrued liabilities. As a result,
these estimates may be particularly susceptible to misstatement, especially in circumstances in which management is under pressure to show
increased earnings (i.e., earnings management).
The basic auditing procedures for testing accrual liabilities are:
(1) Examine any contracts or other documents on hand that provide the basis for the accrual.
(2) Appraise the accuracy of the detailed accounting records maintained for this category of liability.
(3) Identify and evaluate the reasonableness of the assumptions made that underlie the computation of the liability.
(4) Test the computations made by the client in setting up the accrual.
(5) Determine that accrued liabilities have been treated consistently at the beginning and end of the period.
(6) Consider the need for accrual of other accrued liabilities not presently considered (that is, test completeness).
(7) For significant estimates, perform a retrospective analysis of the prior years estimates for evidence of management bias.
The audit procedures for testing specific accrued liabilities are summarized in Table 19-8.
Review of Related-Party Transactions

AU 550 Related Parties defines related-parties to include (1) the reporting client; (2) its affiliates; (3) principal owners (own more than 10% of
the voting interests), management and members of their immediate families; (4) equity-method investees; (5) trusts for the benefit of employees
(e.g., pension or profit-sharing trusts that are managed by, or under the trusteeship of, management); and (6) any other party that can exercise
significant influence over the reporting client, or over which the reporting client can exercise significant influence.
Examples of related-party transactions include: (1) Parent-subsidiary transactions; (2) Transactions among subsidiaries of a common parent; (3)
Transactions between related parties that are not given accounting recognition, such as, a parent providing free services to a subsidiary; (4)
Transactions between related parties that disclose the legal form but which does not reflect the economic substance of the transactions, such as
(a) Borrowing or lending money without charging interest or at an interest rate significantly lower than current market rate; (b) Making loans
without scheduled repayment terms, (c) Selling real estate at a price considerably different from its appraised value, (d) Exchanging property for
similar property in a non-monetary transaction.
The auditors procedures for identifying and examining related-party transactions are summarized in Table in 19-9.
After identifying and examining related-party transactions, the auditor must evaluate the appropriateness and sufficiency of evidence concerning
the related-party transactions and determine the adequacy of their disclosure. Disclosure (i.e., understandability) is the primary specific audit
objective concerning related party transactions. As a rule of thumb, if the clients financial statement discloses a material related-party
transaction that was not carried out on terms equivalent to those that would have prevailed in an arms length transaction, the auditor would issue
a qualified or adverse opinion.
Recall Table 5-1 in Chapter 5 that Sarbanes-Oxley Act of 2002 specifically prohibits related party transactions that involve personal loans to
executives. It is now illegal for any public company to extend or maintain credit, to arrange for the extension of credit, or to renew the extension
of credit in the form of personal loan to any director or executive officers. These restrictions do not apply to any loan, such as a home loan or
credit card agreement, made by a bank or other insured financial institution under normal banking operation using market terms offered to the
general public.
Review the Work of a Specialist

AU 620 Using the Work of a n Auditors Specialist defines a specialist as a person possessing special skill or knowledge in a particular field other
than accounting or auditing. Specialists include: actuaries (to determine the amount of a pension plan); appraisers (to evaluate assets such work of
art); engineers (to determine the % of completion of a construction project); environmental consultants (to determine the impact of environmental
laws and regulations), and attorneys (to assess the probable outcome of pending litigation).
The auditors procedures on using the work of a specialist are summarized in Table 19-10.
As rule of thumb, after reviewing the work of a specialist, the auditor does not refer to the work of the specialist in the audit report. This is
because such a reference may confuse readers of the audit report. However, the auditor may decide to refer to the work of the specialist in the
audit report. A full spectrum of the auditors reporting alternatives concerning the work of a specialist is as follows:
(1) Auditor issues unqualified opinion in a standard audit report - no reference to the work of the specialist in the audit report.
(2) Auditor issues unqualified opinion with an explanatory paragraph added to the standard audit report make reference to the work of the
specialist in the audit report only if doing so will help clarify the reason for the explanatory paragraph.
(3) Auditor issues qualified or disclaimer of opinion based on scope limitation no reference to the work of the specialist in the audit report.
(4) Auditor issues qualified or adverse opinion based on departure from GAAP make reference to the work of the specialist in the audit report
only if doing so will help clarify the reason for the qualification or adverse opinion.
Evaluation of the Clients Going-Concern Status

AU 570 Going Concern requires the audit to perform analytical procedures (recall Tables 7-10, 7-11 and 7-12 in Chapter 7) and review of
subsequent events at the completing the audit to evaluate whether there is substantial doubt about a clients ability to continue as a going concern.
Obtain a Management Representation Letter

AU 580 Written Representations requires the auditor to obtain a representation letter from the management (see Table 19-3 above) at the
completing the audit phase of the audit process to corroborate oral representations made to the auditor and to reduce misunderstanding
concerning the responses provided by the management to the auditors inquiry.
Final Assessment of Audit Results

The auditors final assessment of audit results is concerned with two issues:
(1) The sufficiency of the audit evidence.
The auditor determines whether there is sufficient evidence to support (a) specific audit objectives, (b) the assessment of IR and CR, and (c) the
planned level of DR. If this final assessment indicates that the evidence is not sufficient to meet the planned level of audit risk, the auditor may
need to gather additional evidence. (Recall Chapter 9 on audit risk).
(2) The effects of detected misstatements in the financial statements.

The auditor compares the total amount of misstatements to the amount of materiality allocated (TM) to the relevant component of the financial
statement. The auditor also considers the effect of unadjusted immaterial misstatements. (Recall Chapter 9 on materiality). Finally, the auditor
considers whether to include the previous year uncorrected (unadjusted) material misstatements to the current year uncorrected (unadjusted)
material misstatements. Historically, the auditor may use either of two methods (approaches):
(1) The rollover method (approach) This method considers only the amount of the misstatement originating in the current year income
statement. For example, if expenses were materially misstated by $20,000 in the previous year and $30,000 during the current year, the rollover
method would quantify the total misstatement as $30,000, ignoring the previous years misstatement.
(2) The iron curtain method (approach) This method considers the balance sheet effect of correcting the total misstatement existing at the end
of the year, regardless of when the misstatement originated. For example, if expenses were materially misstated by $20,000 in the previous year
and $30,000 during the current year, the iron curtain method would quantify the total misstatement as $50,000.
Note that the SEC Staff Accounting Bulletin No. 108 (SAB No.108) decreased the auditors flexibility in choosing between the two methods by
requiring that both the rollover and iron curtain methods be considered. If either method results in a material misstatement, an adjustment
(correction) must be made. Thus, under the rollover method, the current year financial statements would be adjusted (corrected) for the current
year $30,000 misstatement. On the other hand, under the iron curtain method, the current year financial statements would be adjusted (corrected)
for the current year $30,000 misstatement as well as the previous year $20,000 misstatement as carryover misstatement that originated in the
previous year. In addition, the previous year financial statements would be restated for the previous year $20,000 misstatement under both
methods.
Figure 19-7 show an example of the total misstatements documented in a working paper. Note that the misstatements in Figure 20-7 are adjusted
for the effects of income taxes. To illustrate, consider the first misstatement, which represents an overstatement of prepaid expenses of $6,500. If
that adjustment is not made, net income before taxes will be overstated by that amount. However, since taxable income is also overstated by
$6,500, the companys income tax expense is overstated, in this case by $2,600 (40% of $6,500). Also note that the 40 percent rate is used
because it represents the companys marginal tax rate.
Evaluation of Financial Statement Presentation and Disclosure

The auditor reviews a draft copy of the financial statements to ensure compliance with GAAP, proper presentation of accounts, and inclusion of
all necessary disclosures. Most CPA firms use some type of financial statement checklist to assist the auditor in this evaluation process.
Review of Audit Working Papers

(1) During the days of field work.
An audit team member senior to the person preparing the working papers should review all audit work to ensure that (a) The audit was properly
planned and supervised, (b) The evidence supports the audit objectives tested, and (c) The evidence is sufficient for the type of audit report
issued. The senior auditor should conduct a detailed review of the working papers prepared by the staff and follow-up on any unresolved
problems or issues. The audit manager should review the working papers prepared by the senior auditor and to counteract any bias that enters into
the senior auditors judgments. The engagement partner normally reviews working papers related to critical audit areas as well as working papers
prepared by the manager.
(2) On or about the last day of field work.
The engagement partner reviews the entire set of working papers in detail to determine whether the working papers demonstrate compliance with
GAAS and with the CPA firms quality control and performance standards. Usually, the engagement partner uses some type of working paper
review checklist to do the review. Figure 19-6 shows an example of a working paper review checklist.
After such a review, the engagement partner reaches an overall conclusion about the presentation of the financial statements taken as a whole. If
the financial statements taken as a whole are presented fairly, the engagement partner would consider issue an unqualified opinion. Otherwise the
engagement partner would consider issuing a qualified opinion, adverse opinion, or a disclaimer of opinion. Chapter 20 discusses the auditors
opinion in greater detail.
Obtain an Independent Partner Review of the Engagement

Most CPA firms have a policy of requiring an independent partner to review the entire audit engagement, also known as a cold review. The
independent partner focuses on the sufficiency of the audit approach, findings, and conclusion, and the consistency of the audit report, financial
statements, and footnotes for the audit engagement taken as a whole.
Table 19-8 Auditors Procedures for Testing Specific Accrued Liabilities

Auditors Procedures for Testing Specific Accrued Liabilities
(1) Accrued Property Taxes
Property taxes payments are usually few in number and substantial in amount. It is, therefore, feasible for the audit working papers to include an
analysis showing all of the years property tax transactions. Tax payments should be verified by inspection of the property tax bills issued by
local government units and by reference to the related paid checks. If the tax accruals at the balance sheet date differ significantly from those of
prior years, an explanation of the variation should be obtained The auditor should verify that property tax bills have been received on all taxable
property or that an estimated tax has been accrued.
(2) Accrued Payrolls
Accrued gross salaries and wages appear on the balance sheets of virtually all companies. The accuracy of the amount accrued may be significant
in the determination of total liabilities and also in the proper matching of costs and revenue. The verification procedure consists principally of
comparing the amounts accrued to the actual payroll of the subsequent period and reviewing the method of allocation at the balance sheet date.
Payments made at the first payroll dates of the subsequent period are reviewed to determine that no significant unrecorded payroll liability
existed as of the balance sheet date.
(3) Pension Plan Accruals
Auditing procedures for the accrued liability for pension costs may begin with a review of the copy of the pension plan in the auditors permanent
file. Then consideration should be given to the provisions of the Employee Retirement Income Security Act (ERISA). The auditors must
determine that the clients accrued pension liability is presented in accordance with FASB No.87, Employers Accounting for Pensions (as
515
516
Auditors Procedures for Testing Specific Accrued Liabilities

amended by FASB Nos. 132 and 158), including consideration of service cost, interest cost, amortization of transition and service costs, and
gains and losses on pension plan assets. In auditing these amounts the auditor will obtain representations from an actuary and confirm the activity
in the plan with the trustee, In evaluating the evidence from the actuary, the auditors should comply with the requirements of AU 620, Using the
Work of a n Auditors Specialist.
(4) Postemployment Benefits Other Than Pensions
Under FASB No.106, Employers Accounting for Postemployment Benefits Other than Pensions, companies must accrue, during the years that
employees perform services, the expected costs of providing health and similar retirement benefits to the employees, their beneficiaries, and
their dependents. Determining the amount of these liabilities is a very complex procedure, because assumptions must be made about matters such
as employee work lives and increases in medical costs. Since actuaries and other specialists develop these assumptions the auditor should
evaluate the assumptions and the specialists qualifications in accordance with AU 620 Using the Work of a n Auditors Specialist.
(5) Accrued Vacation Pay
This type of liability arises from two situations: (a) an employee entitled by contract to a vacation during the past year may have been prevented
from taking it by an emergency work schedule, and (b) an employee may be entitled to a future vacation of which part of the cost must be
accrued to achieve a proper matching of costs and revenue. The auditors verification of accrued vacation pay may begin with a review of the
permanent file copy of the employment contract or agreement stipulating vacation terms. The computation of the accrual should then be verified
both as to arithmetical accuracy and for agreement with the terms of the companys vacation policy.
(6) Product Warranty Liabilities
The products of many companies are sold with a guarantee of agree service or replacement during a rather extended warranty period. The costs of
rendering such services should be recognized as expenses in the year the product is sold rather than in a later year in which the replacement is
made or the repair service is performed. If this policy is followed, the company will make an annual charge to expense and a credit to a liability
account based on the amount of the years sales and the estimated future service or replacement cost. As repairs and replacements take place, the
costs will be charged to the liability account. The auditor should review the clients annual provision for estimated future expenditures and
compute the percentage relationship between the amount in the liability account and the amount of the years sales. If this relationship varies
sharply from year to year, the client should be asked for an explanation. The auditor should also review the charges to the liability account month
by month and be alert for the improper recording of other expenses in this account. Sudden variation in the monthly charges to the liability
account requires investigation. In general, the auditor should determine that the balance in the liability account for service guarantees moves in
reasonable relationship with the trend of sales. The auditor also should be alert for changes in the clients products or repair costs that might
affect the amount of the warranty liability. Finally, current income tax laws prohibit the deduction of provisions for warranty liabilities;
deductions are permitted only when actual expenditures are incurred. Accordingly, the auditors should ascertain that the client is properly
allocating income taxes attributable to the nondeductible provisions.
(7) Accrued Commissions and Bonuses
Accrued commissions to sales representatives and bonuses payable to managerial personnel also require verification. The essential step in this
case is reference to the authority for the commission or bonus. The basis contracts should be examined and traced to minutes of directors
meetings. If the bonus or commission is based on the total volume of sales or some other objective measure, the auditor should verify the
computation of the accrual by applying the prescribed rate to the amount used as a base.
(8) Income Taxes Payable
Federal, state, and foreign income taxes on corporations represent a material factor in determining both net income and financial position. The
auditor cannot express an opinion on either the balance sheet or income statement of a client without first obtaining evidence that the provision
for income taxes has been properly computed. In the audit of small and medium-size clients, it is customary for the audit engagement to include
the preparation of the clients tax returns. If the clients staff or other persons have prepared the income tax returns. The auditor must
nevertheless verify the reasonableness of the tax liability in order to express an opinion on the fairness of the financial statements. In performing
such a review of a tax return prepared by the clients staff or by others, the auditor may sometimes discover an opportunity for a tax saving that
has been overlooked; obviously such a discovery tends to enhance the clients appreciation of the services rendered by the auditor.
In addition, the auditor should analyze the Income Taxes Payable account and vouch all amounts to income tax returns, paid checks, or other
supporting documents. The final balance in the Income Taxes Payable account will ordinarily equal the computed federal, state, and foreign taxes
on the current years income tax returns, less any payments thereon.
The tax expected to be paid by a client often differs from the actual tax paid due to temporary differences between taxable income and pretax
accounting income. These differences result in the need to establish deferred tax liabilities or assets. The auditor determines the amount of
deferred tax liabilities using schedules referred to as Tax Accrual working papers, which usually are reviewed by one of the CPA firms tax
specialists.
Besides reviewing the computation of the income tax liability for the current year, the auditors should determine the date on which income tax
returns for prior years were examined by IRS agents, as well as the particulars of any disputes or additional assessments. Review of the reports of
revenue agents is also an essential audit procedure. In the first audit of a new client, the auditor should review any prior years income tax returns
not yet examined by revenue agents to make sure that there has been no substantial underpayment of taxes that would warrant presentation as a
liability.
(9) Accrued Professional Fees
Fees of professional firms include charges for the services of attorneys, public accountants, consulting engineers, and other specialists who often
render services of a continuing nature but present bills only at infrequent intervals. By inquiry of officers and by review of corporate minutes, the
auditor may learn of professional services received for which no liability has yet been reflected in the accounts. Review of the expense account
for legal fees is always essential because it may reveal damage suits, tax disputes, or other litigation warranting disclosure in the financial
statements. Recall the discussion on analyzing legal expenses in Chapter 14 Expenditure Cycle.
Table 19-9 Auditors Procedures for Identifying and Examining Related-Party Transactions
Auditors Procedures for Identifying and Examining Related-Party Transactions
(1) Gain an understanding of the clients control environment (recall Table 8-1 in Chapter 8) that deliberately promotes or obscures related-party
transactions. Examples of such control environment include:

Lack of sufficient working capital or credit to continue in business.
Desire for favorable earnings record to support expected stock price.
An overly optimistic earnings forecast.
Significant litigation between stockholders and management.
Excess capacity or a declining industry with a large number of business failures.
Dependence on a single (or relatively few) products, customers, or transactions for the ongoing success of the business.
Significant risk of obsolescence because of being in a high technology industry.

(2) Identify obvious related-party transactions that are material by:
Evaluating the clients procedures for identifying and accounting for related-party transactions.
Requesting the management for the names of all related parties and documenting any related-party transactions among them in the
management representation letter (see point #7a in Figure 19-3 above).
Reviewing prior years audit working papers for the names of known related parties.
Inquiring the predecessor, principal, or other auditors of related parties as to their knowledge of known related-party transactions.
Determining the names of all pensions and trusts established for the benefit of employees and the names of their officers and trustees.
These pension and trust transactions are related-party transactions if managed by or under the trusteeship of the clients management.
Reviewing SEC filings for the names of related parties and for other business in which officers and directors occupy directorship or
management positions.
Reviewing shareholder listings of closely held companies to identify principal stockholders.
Providing the audit team with the names of known related parties.
Reviewing material investment transactions to determine whether the nature and extent of investment during the period create related
parties.
(3) Identify not so obvious related-party transactions that are material by:
Reviewing the minutes of meetings of the board of directors and executive or operating committees for information about material
transactions authorized or discussed at their meetings.
Reviewing proxy statements filed with the SEC for information about material transactions with related parties.
Reviewing conflict-of-interest statements obtained by the client from its management.
Reviewing the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of
previously undisclosed relationships.
Reviewing the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of
guarantees by parties that may be considered related parties.
Reviewing invoices from law firms that have performed special services for indications of the existence of related parties or related-party
transactions.
Reviewing confirmations of loans receivable and payable for indications of guarantees by parties that may be considered related parties.
Inquiring whether non-monetary transactions, such as free accounting or management expertise, are being provided but not recorded.
(4) Apply audit procedures to assess the purpose, nature, extent, and effect of the related-party transactions on the financial statements. The
procedures should extend beyond simply making inquiries of management to include:
(a) Obtain an understanding of the business purpose of the related-party transaction by:
Examining pertinent documents such as invoices, contracts, and receiving and shipping documents.
Determining whether appropriate officials, such as the board of directors, have approved the transaction.
Testing the reasonableness of the amounts to be disclosed (or considered to be disclosed) in the financial statements.
Contacting the auditors of related-parties (or related-party companies) for relevant information.
Inspecting the transferability and value of collateral.

(b) Performing additional procedures needed to fully understand the particular related-party transaction by:
Confirming the amounts and terms of the transactions (including guarantees) with the other parties.
Inspecting evidence that is in the possession of the other party (or parties) to the transaction.
Confirming relevant information with such intermediaries as banks, guarantors, or attorneys.
Referring to trade journals, credit agencies, websites, etc., to verify transactions that disclose the legal form but which does not reflect
the economic substance of the transactions.
517
518
Obtaining information on the financial stability of the other party (parties) with respect to material uncollected balances, guarantees, and
other obligations.
Table 19-10 Auditors Procedures on Using the Work of a Specialist

Auditors Procedures on Using the Work of a Specialist
(1) Evaluate the professional qualifications of the specialist.
The auditor should evaluate the professional qualifications of the specialist to determine that the specialist possesses the necessary skill or
knowledge. This is normally done by considering:
The professional certification, license, or other recognition of competence.

The reputation and standing of the specialist in the views of peers and others.
The specialists experience in the type of work under consideration.

Either the clients management or the auditor may engage the specialist.
(2) Understand the work of the specialist.
The auditor should obtain an understanding of the work performed by the specialist. This understanding covers the following:
The specialists objectives and scope of work.
The specialists relationship to the client. It depends on the client-specialist relationship. For example, if the client has the ability, through
employment or family relationship, to directly or indirectly influence the work of the specialist significantly, then the auditor may not accept
the work of the specialist. As such, the auditor should perform additional auditing procedures or engage another specialist. On the other hand,
if the client does not significantly influence the work of the specialist, such as the client-specialist relationship is strictly a contractual
relationship, then the auditor may accept the work of the specialist.
The specialists methods and assumptions. Ordinarily, the auditor should obtain an understanding of the methods and assumptions used
by the specialist to determine whether the evidence/findings of the specialist are appropriate and sufficient for attesting the managements
assertions in the financial statements.
(3) Form a conclusion about the work of the specialist.
The auditors conclusion about the work of the specialist includes:
The auditor is unable to form a conclusion on whether the work of the specialist provides sufficient appropriate evidence to the related
assertions. Here, the auditor should either perform additional procedures, or should seek the opinion of another specialist to resolve the matter.
If the matter remains unresolved, the auditor issues qualified or disclaimer opinion based on scope limitation.
The auditor concludes that the work of the specialist provides sufficient appropriate evidence to support the related assertions. In this
case, the auditor issues an unqualified opinion.
The auditor concludes that the work of the specialist provides sufficient appropriate evidence that does not support the related assertions.
In this case, the auditor issues a qualified or adverse opinion based on departure from GAAP.
Figure 20-6 An Example of a Working Paper Review Checklist

Working Paper Review Checklist
Mechanical Accuracy:
Trace supporting balances on individual working paper schedules to lead schedules.

Trace lead schedule balances to working trial balances.
Trace trial balance amounts to the financial statements.
Review compliance with restrictive loan covenants.
Review indexing of working papers.
Review cross-referencing within the working papers.
Test significant calculations in the working papers, for example:
Accruals for interest income and expense.

Accruals for state, local, and federal income taxes.
Accruals for pension and profit-sharing plans.
Depreciation.
Inventory price testing.
Lease calculations.
Earnings per share.

Determine that all audit working papers are complete, properly headed, and dated.
Working Paper Review Checklist

Audit Scope:
Determine that the consideration of internal control is adequate and that the scope of year-end tests of balances is justified given
the level of control risk.
Determine that audit programs were appropriate for the circumstances.
Determine that audit procedures adequately addressed the audit assertions of existence or occurrence, completeness, rights and
obligations, valuation and allocation, and understandability.
Determine that the scope and results of the accounts receivable confirmations were reasonable.
Determine that the physical inventory observation procedures were adequate.
Determine that management representation letters are accurate, complete, and signed by the CEO and another official.
Determine that the lawyer representation letters are appropriate and signed.
Determine that related-party transactions are disclosed as necessary.
Review all proposed adjusting journal entries.
Determine that the audited financial statements are properly presented in accordance with GAAP.
Determine that the opinion expressed in the audit report is justified by evidence documented within the working papers.
Determine that all exceptions and review notes within the working papers have been cleared.
Communications with the Audit Committee and Management (Those Charged with Governance)
The auditors communications with the audit committee and management (those charged with governance) at
completing the audit fall into three categories:
1. Communications with the audit committee regarding the general conduct of the audit engagement in compliance
with AU 260 The Auditors Communication with Those Charged With Governance . This communication may be
oral (should keep a memorandum in the working papers) or written (should restrict circulation of the report to
appropriate parties), and it should address the following matters:
The auditors responsibility under GAAS.
Significant accounting policies.
Management judgments and accounting estimates.
Significant audit adjustments.
Disagreement with the management.
Managements consultation with other accountants.
Major issues discussed with management before the auditor was retained.
Difficulties the auditor encountered with management during the audit.
Fraud involving senior management.
Ordinarily, the oral or written communication of recurring matters need not be repeated in each year of audit.
Moreover, as long as the communication is timely, it need not be made before the issuance of the audit report.
2. Communication with those charged with governance including the audit committee regarding material
weaknesses in compliance with AU 265 Communicating Internal Control Related Matters Identified in an Audit.
This communication is in writing and addresses significant deficiencies in the clients internal controls. (See Table
8-4 in Chapter 8 about the material weaknesses report).
3. Communication with the management regarding insignificant weakness in internal controls in a management
letter, also known as a clients advisory comment letter. This letter makes recommendations for improvement to the
clients internal controls. (See Table 8-4 in Chapter 8 about the management letter).
It should be noted that Sarbanes-Oxley Act of 2002 expands the auditors communications with the audit
committee and management to include:
1. Matters related to the auditors review of quarterly financial statements. The auditor committee must be informed
of any significant matter identified during the quarterly review of the financial statements by the external auditor
(Recall Table 2-10 in Chapter 2).
2. Report on managements assessment of internal controls. Under the Sarbanes-Oxley Act of 2002, PCAOB
requires the management to report (and certify) on its assessment of internal control. The auditor is required to issue
an opinion in the audit report on the managements report of its assessment of internal control. In the report, the
auditor is required to disclose any material deficiencies in internal control and any material noncompliance found in
519
520
the auditors understanding and testing of the internal control during the audit of the financial statements. (Recall
Section 404 discussed in Chapter 8).
Consider Subsequently Discovered Facts (SDFs)
Although the auditor has no obligation to perform audit tests for SDFs occurring after the audit report issue date, the
auditor should take certain steps to address the SDFs in accordance to AU 560 Subsequent Events and Subsequently
Discovered Facts. Table 19-11 describes these steps.
Table 19-11 Audit Steps in Considering Subsequently Discovered Facts
Audit Steps in Considering Subsequent Discovery of Facts (SDFs)
(1) When SDFs are encountered that may affect the previously issued financial statements and audit report.
The auditor should:
Consult his or her attorney about the legal implications of the SDFs.
Determine whether the facts are reliable; have material impact on the financial statements, and relate to conditions existing at the audit
report date.
Discuss the matter with the management and request cooperation in investigating the SDFs.
(2) If the auditor determines that the SDFs affect the previously issued financial statements and audit report.
The auditor should:
Request that the client issues an immediate revision to the financial statements and reissue an audit report dated at the revised financial
statements date.
Request that the client contacts the SEC, stock exchanges, and other regulatory agencies concerning the revision to the financial
statement and the new audit report.
Ensure that the client describes the reasons for the revision as footnotes to the revised financial statements.
(3) If the client refuses to cooperate and make the necessary revision to the financial statements.
The auditor should:
Notify the client that the auditors report must no longer be associated with the financial statements. In other words, the auditor
withdraws the previous audit report.
Notify any regulatory agencies having jurisdiction over the client that the auditors report can no longer be relied upon.
Notify each person known to the auditor to be relying on the financial statements either by notifying the stockholders at the stockholders
meeting or notifying the SEC.
Disclose to each person known to the auditor to be relying on the financial statements the effect the SDFs would have had on the
auditors previously issued report had it been known to the auditor.
Figure 19-7 Total Misstatements Documented in a Working Paper

ABC Company
W/P Ref : TM#4-7
Obama
Reviewed by: FC
Total Misstatements
Prepared by:
12/31/201x
Overstatement (Understatement)
Current
Assets
Unadjusted Known
Misstatements:
Overstatement of prepaid
expenses
Overstatement of prior
years depreciation
Unrecorded liabilities
Projected Misstatements:
Overstatement of accounts
receivable (positive
confirmation results)
Other Estimated
Misstatements:
Understatement of
allowance for uncollectable
accounts
Total Likely
Misstatements:
Materiality Threshold
(MT):
Noncurrent
Assets
$6,500
Current
Liabilities
Noncurrent
Liabilities
$2,600
Owners
Equity
Income
before
Taxes
$6,500
$(2,600)
$(10,000)
$4,000
$11,215
$(4,486)
$6,500
$30,000
$(12,000)
$30,000
$12,000
$5,000
$(2,000)
$5,000
$2,000
$(10,000)
$(40,000)
$(11,215)
$30,000
$5,000
Date: 1/1/201x
Date: 1/5/201x
Tax
Expense
$2,600
W/P Ref.
E#-6
P#-3
11,215
$4,486
$12,000
$2,000
$41,500
$(10,000)
$5,871
$25,629
$52,715
$100,000
$12,500
$100,000
$12,500
$50,000
$150,000
$21,086
C#-5
R#-8
C#-2
C#-7
P#-4
Conclusion: The total likely misstatements in each category is below the materiality threshold (MT)
respectively; therefore, the financial statements, taken as a whole, is not materially misstated.
521
522
19-1
The audit step most likely to reveal the existence of contingent liabilities is
a. a review of vouchers paid during the month following the year-end.
b. accounts payable confirmation.
c. an inquiry directed to legal counsel.
d. mortgage-note confirmation.
19-2
When obtaining evidence regarding litigation against a client, the auditor would be least interested in determining
a. an estimate of when the matter will be resolved.
b. the period in which the underlying cause of the litigation occurred.
c. the probability of an unfavorable outcome.
d. an estimate of the potential loss.
19-3
A principal purpose of a letter of representation from management is to

a. serve as an introduction to company personnel and an authorization to examine the records.
b. discharge the auditor from legal liability for the audit.
c. confirm in writing managements approval of limitations on the scope of the audit
d. remind management of its primary responsibility for financial statements.
19-4
The date of the management representation letter should be coincide with the
a. date of the audit report.
b. balance sheet date.
c. date of the latest subsequent event referred to in the notes to the financial statements.
d. date of the engagement agreement.
19-5
Managements refusal to furnish a written representation on a matter that the auditor considers essential constitutes
a. prima facie evidence that the financial statements are not presented fairly.
b. a violation of the Foreign Corrupt Practice Act.
c. an uncertainty sufficient to preclude an unqualified opinion.
d. a scope limitation sufficient to preclude an unqualified opinion.
19-6
Subsequent events for reporting purposes are defined as events that occur subsequent to
a. balance sheet date.
b. date of the auditors report.
c. balance sheet date but before the date of the auditors report.
d. the auditors report issue date.
19-7
Which of the following subsequent events would normally not require disclosure in the financial statements
a. decrease sales volume resulting from a general business recession.
b. serious damage to the clients plant from a flood.
c. issuance of a widely advertised capital stock issue with restrictive covenants.
d. settlement of a large liability for considerably less than the amount recorded.
19-8
With respect to issuance of an audit report that is dual-dated for a subsequent event occurring after the completion of field
work but before issuance of the auditors report, the auditors responsibility for events occurring subsequent to
the completion of field work is
a. extended to include all events occurring until the date of the last subsequent event referred to.
b. limited to the specific event referred to.
c. limited to all events occurring through the date of issuance of the report.
d. extended to include all events occurring through the date of submission of the report to the client.
19-9
A written representation from a clients management that, among other matters, acknowledges responsibility for the fair
presentation of financial statements should normally be signed by the
a. chief executive officer and the chief financial officer.
b. chief financial officer and the chairman of the board of directors.
c. chairman of the audit committee.
d. chief executive officer and the clients lawyer.
19-10
An auditor is obligated to communicate a proposed audit adjustment to a clients audit committee only if the adjustment
a. has not been recorded before the end of the auditors field work.
b. has a significant effect on the clients financial reporting process.
c. is a recurring matter that was proposed to management the prior year.
d. results from the correction of a prior periods departure from GAAP.
19-11
Which of the following subsequent events might result in adjustment of the year-end financial statements?
a. Sale of a major subsidiary.
b. Adoption of accelerated depreciation methods.
c. Write-off of a substantial portion of inventory as obsolete.
d. Collection of 90% of the accounts receivable existing at December 31.
19-12
An auditors decision concerning whether or not to dual date the audit report is based upon the auditors willingness to
a. assume responsibility for events subsequent to the issuance of the auditors report.
b. permit inclusion of a footnote to the date of the audit report.
c. accept responsibility for subsequent events.
d. extend auditing procedures to subsequent events before the issuance of the auditors report..
19-13
In the subsequent period, a charge (credit) to a notes receivable account from the cash disbursements records should alert
the auditor to the possibility that
a. a provision for contingencies is required.
b. a contingent asset has come into existence in the subsequent period.
c. a contingent liability has become a real liability and has been settled.
d. a contingent liability has come into existence in the subsequent period.
19-14
An attorney is responding to an auditor as a result of the audit clients letter of inquiry. The attorney may appropriately
limit the response to
a. asserted claims and litigation.
b. asserted, overly threatened, or pending claims and litigation.
c. items which have an extremely high probability of being resolved to the clients detriment.
d. matters to which the attorney has given substantive attention in the form of legal consultation or representation.
19-15
An auditor has received a lawyers letter in which no significant disagreement with the clients assessments of contingent
liabilities were noted. The resignation of the clients lawyer shortly after receipt of the letter should alert the auditor that
a. a qualified audit opinion will be necessary.
b. undisclosed unasserted claims may have arisen.
c. the auditor must begin a completely new examination of contingent liabilities.
d. the attorney was unable to form a conclusion with respect to the significance of litigation. claims, and assessments.
19-16
Which of the following is not a reason why the auditor requests that the client provide a letter of representation?
a. It provides written documentation of the oral responses already received to inquiries of management.
b. It provides written documentation that is a higher quality of evidence than managements oral responses to inquiries.
c. It impresses upon management its responsibility for the accuracy of the information in the financial statements.
d. Professional auditing standards requires the auditor to obtain a letter of representation.
19-17
The auditors responsibility for reviewing the subsequent events of a public company that is registered to issue new securities is
normally limited to the period of time
a. beginning with the balance sheet date and ending with the date of the auditors report.
b. beginning with the start of the fiscal year under audit and ending with the balance sheet date.
c. beginning with the start of the fiscal year under audit and ending with the date of the auditors report.
d. beginning with the balance sheet date and ending with the date the registration statement becomes effective.
523
524
19-18
Which of the following is the most efficient audit procedure for the detection of unrecorded liabilities at the balance sheet
date?
a. Compare cash disbursement in the subsequent period with the accounts payable trial balance at year-end.
b. Examine purchase orders issued for several days prior to the close of the year.
c. Confirm large accounts payable balances at the balance sheet date.
d. Obtain an attorneys representation letter from the clients attorney.
19-19
Which of the following statements regarding the clients representation letter is not correct?
a. It is prepared on the clients letterhead.
b. It is addressed to the CPA firm.
c. It is signed by two high-level corporate officials.
d. It is optional, not required, that the auditor obtain such a letter from management.
19-20
Which of the following is not an audit procedure that is commonly used by auditor to search for contingent liabilities?
a. Inquiries of management (orally and in writing).
b. Analyze legal expense for the period under audit.
c. Review of the current years tax return (Form 1120)
d. Review the minutes of directors and stockholders meetings.
19-21
Which of the following procedures might be useful in discovering a contingent liability for a lawsuit that management is
intentionally neglecting to disclose?
a. Inquiries of management (orally and in writing)
b. Analyzing legal expense and review invoices and statements from outside legal counsel.
c. Obtaining a management representation letter that it is aware of no undisclosed contingent liabilities.
d. None of the three procedures above because they are all not useful for discovering a contingent liability.
19-22
The standard clients inquiry of lawyer letter should be prepared on

a. plain paper (no letterhead) and signed by a company official.
b. lawyers stationery and signed by the lawyer.
c. auditors stationery and signed by the auditor.
d. clients stationery and signed by a company official.
19-23
When subsequently discovered facts (SDFs) are encountered that may affect the previously issued financial statements and
audit report. The auditor should:
a. consult his or her attorney about the legal implications of the SDFs.
b. determine whether the facts are reliable; has material impact on the financial statements, and relates to condition existed
at the audit report date.
c. discuss the matter with the management and request cooperation in investigating the SDFs.
d. all the three above.
19-24
In auditing accounting estimates, such as intangible assets, an auditor most likely would review or re-compute amortization
and determine whether the amortization period is reasonable in support of managements financial statement assertion of
c. completeness.
19-25
Which of the following procedures would an auditor ordinarily perform first in evaluating managements accounting
estimates for reasonableness?
a. Develop independent expectations of managements estimates.
b. Consider the appropriateness of the key factors or assumptions used in preparing the estimates.
c. Test the calculations used by management in developing the estimates.
d. Obtain an understanding of how management developed its estimates.
19-26
An auditor most likely would modify an unqualified opinion if the clients financial statements include a footnote on
material related-party transactions
a. disclosing loans to related parties at interest rates significantly below prevailing market rates.
b. describing an exchange of real estate for similar property in a non-monetary related party.
c. stating that a particular material related-party transaction occurred on terms not equivalent to those that would have
prevailed in an arms-length transaction.
d. presenting the dollar amount of related party transactions and the effects of any change in the method of establishing
terms from prior periods.
19-27
Which of the following auditing procedures most likely would assist an auditor in identifying related-party transactions?
a. Inspecting correspondence with lawyers for evidence of unreported contingent liabilities.
b. Vouching accounting records for recurring transactions recorded just after the balance sheet date.
c. Performing analytical procedures for indications of possible financial difficulties.
d. Reviewing confirmations of loans receivable and payable for indications of guarantees.
19-28
When auditing related-party transactions, an auditor places primary emphasis on which of the following management
assertions?
a. Ascertaining the rights and obligations of the related parties.
b. Confirming the existence or occurrence of the related parties.
c. Verifying the valuation or allocation of the related-party transactions.
d. Evaluating the presentation and disclosure of the related-party transactions.
19-29
After identifying that a related-party transaction has, in fact, occurred, an auditor should first
a. add a separate paragraph to the auditors standard report to explain the transaction.
b. perform analytical procedures to verify whether similar transactions occurred, but were not recorded.
c. obtain an understanding of the business purpose of the transaction.
d. substantiate that the transactions were consummated on terms equivalent to an arms length transaction.
19-30
Which of the following most likely would indicate the existence of related parties?
a. Writing down obsolete inventory just before year end.
b. Borrowing money at an interest rate significantly below the market rate.
c. Failing to correct previously identified internal control deficiencies.
d. Depending on a single product for the success of the entity.
19-31
Which of the following statements extracted from a lawyers representation letter concerning litigation, claims, and
assessments most likely would cause the auditor to request clarification?
a. I believe that the possible liability to the company is nominal in amount.
b. I believe that the action can be settled for less than the damages claimed.
c. I believe that the plaintiffs case against the company is without merit.
d. I believe that the company will be able to defend this action successfully.
19-32
The refusal of a clients attorney to provide information requested in an inquiry letter generally is considered
a. grounds for an adverse opinion.
b. reason to withdraw from the engagement.
c. a limitation on the scope of the audit.
d. equivalent to a material weakness.
19-33
The scope of an audit is not limited when an attorneys response to an auditor as a result of a clients letter of inquiry
limits the response to
a. matters to which the attorney has given substantive attention in the form of legal representation.
b. an evaluation of the likelihood of an unfavorable outcome of the matters disclosed by the client.
c. the attorneys opinion of the clients historical experience in recent similar litigation.
d. the probable outcome of asserted claims and pending or threatened litigation.
525
526
19-34
The primary reason an auditor requests an inquiry of lawyer letter to be sent to a clients attorney is to provide the audit with
a. the probable outcome of asserted claims and pending or threatened litigation.
b. corroboration of the information furnished by management about litigation, claims, and assessments.
c. the attorneys opinions of the clients historical experiences in recent similar litigation.
d. a description and evaluation of litigation, claims, and assessments that existed at the balance sheet date.
19-35
Which of the following is an audit procedure that an auditor most likely would perform concerning litigation, claims, and
assessments?
a. Request the clients lawyer to evaluate whether the clients pending litigation, claims, and assessments indicate a going
concern problem.
b. Examine the legal documents in the lawyers possession concerning litigation, claims, and assessments to which the
lawyer has devoted substantive attention.
c. Discuss with management its policies and procedures adopted for evaluating and accounting for litigation, claims, and
assessments.
d. Confirm directly with the clients lawyer that all litigation, claims, and assessments have been disclosed in the financial
statements.
19-36
A clients lawyer is unable to form a conclusion about the likelihood of an unfavorable outcome of pending litigation
because of inherent uncertainties. If the litigations effect on the clients financial statements could be material, the auditor
most likely would
a. issue a qualified auditor report because of the lawyers scope limitation.
b. withdraw from the engagement because of the lack of information furnished by the lawyer.
c. disclaim an opinion on the financial statements because of the materiality of the litigations effect.
d. add an explanatory paragraph to the auditors unqualified audit report to emphasize the uncertainty.
19-37
Which of the following statement is correct concerning an auditors use of the work of a specialist?
a. The auditor need not obtain an understanding of the methods and assumptions used by the specialist.
b. The auditor may not use the work of a specialist in matters material to the fair presentation of the financial statements.
c. The reasonableness of the specialists assumptions and their applications are strictly the auditors responsibility.
d. The work of a specialist who has a contractual relationship with the client may be acceptable under certain
circumstances.
19-38
An auditor may refer to the work of a specialist in the audit report if, as a result of the specialists evidence/findings, the
auditor
a. becomes aware of conditions causing substantial doubt about the entitys ability to continue as a going concern; and the
auditor issues an unqualified opinion with an additional paragraph about the going concern status in the audit report.
b. desires to disclose the specialists findings, which implies that a more thorough audit was performed.
c. is able to corroborate another specialists earlier findings that were consistent with managements representations.
d. discovers significant deficiencies in the design of the clients internal control that management does not correct.
19-39
Which of the following matters would an auditor most likely include in a management representation letter?
a. Communications with those charged with governance concerning weakness in internal control.
b. The completeness and availability of minutes of stockholders and directors meetings.
c. Plans to acquire or merge with other entities in the subsequent year.
d. Managements acknowledgement of its responsibility for the detection of employee fraud.
19-40
A purpose of a management representation letter is to

a. reduce audit risk to an aggregate level of misstatement that could be considered material.
b. remove the auditors responsibility to detect material misstatements contained in the letter.
c. promote the managements full disclosure of contingent liability information on litigation, claims and assessment.
d. limit the scope of the auditors procedures concerning related party transactions.
19-41
Which of the following matters would materiality limits to amounts included in the financial statements not apply in a
written management representation letter?
a. Losses from purchase commitments at prices in excess of market value.
b. The availability of minutes of stockholders and directors meetings.
c. The disclosure of compensating balance arrangements involving related parties.
d. Reductions of obsolete inventory to net realizable value.
19-42
An auditor would least likely communicate with a clients audit committee concerning
a. the accounting methods used to account for significant unusual transactions.
b. the maximum dollar amount of misstatements that could exist without causing the financial statements to be materially
misstated.
c. indications of fraud and illegal acts committed by a corporate officer that were discovered by the auditor.
d. disagreements with management as to accounting principles that were resolved during the current years audit.
19-43
Which of the following statements is correct concerning an auditors required communication with an entity audit
committee?
a. Significant audit adjustments proposed by the auditor and recorded by management need not be communicated to the
audit committee.
b. Any significant matter communicated to the audit committee also should be communicated to management.
c. The communication should include managements changes in the application of significant accounting policies.
d. The communication must occur just before the auditor issue the audit report on the financial statements.
19-44
In identifying matters for communication with a clients audit committee, an auditor most likely would ask management
whether
a. the turnover in the accounting department was unusually high.
b. there were any subsequent events of which the auditor was unaware.
c. the management agreed with the auditors assessed level of control risk.
d. the management consulted another CPA firm about accounting matters.
19-45
An auditor completed the fieldwork of a clients December 31, 2001 financial statements on March 6, 2002. A subsequent
event requiring adjustment of the 2001 financial statements occurred on April 10, 2002, and came to the auditors attention
on April 24, 2002. The auditor issue the audit report on April 30, 2002. If the adjustment is made without disclosure of the
event, the auditors report should be dated
a. March 6, 2002.
b. April 10, 2002.
c. April 24, 2002.
d. using dual dating.
19-46
An auditor issued an audit report that was dual dated for a subsequent event occurring after the completion of fieldwork but
before issuance of the auditors report. The auditors responsibility for this subsequent event was
a. extended to the date of the specific subsequent event occurred.
b. extended to the date of the specific subsequent event was aware by the auditor.
c. extended to the date of the issuance of the audit report.
d. extended to the date of the completion of the audit fieldwork.
19-47
An auditor determines that subsequently discovered facts (SDFs) affect a clients previously issued financial statements
and audit report. The client revised the financial statements, and the auditor reissued an audit report. The reissued audit
report should be dated
a. using dual dating.
b. at the date of the reissued audit report.
c. at the date of the revised financial statements.
d. at the date the auditor is aware of the SDFs.
19-48
The primary source of information to be reported about litigation, claims, and assessments is the (Hint: Not primary source
of corroborative information)
a. clients lawyer.
b. court records.
c. clients management.
d. independent auditor.
527
528
19-49
Which of the following is not an audit procedure that the auditor would perform with respect to LCAs?
a. Inquire of and discuss with management the policies and procedures adopted for LCAs.
b. Obtain from management a description and evaluation of LCAs that existed at the balance sheet date.
c. Obtain assurance from management that it has disclosed all unasserted claims that the lawyer has advised are probable of
assertion and must be disclosed.
d. Confirm directly with the clients lawyer that all claims have been recorded in the financial statements.
19-50
Which of the following procedures should an auditor ordinarily perform regarding subsequent events?
a. Compare the latest available interim financial statements with the financial statements being audited.
b. Send second requests to the clients customers who failed to respond to initial accounts receivable confirmation requests.
c. Communicate material weaknesses in internal control to those charged with governance.
d. Review the cutoff bank statements for several months after the year-end.
19-51
Which of the following procedures would an auditor most likely perform to obtain evidence about the occurrence of
subsequent events?
a. Confirming a sample of material accounts receivable established after year-end.
b. Comparing the financial statements being reported on with those of prior period.
c. Investigating personnel changes in the accounting department occurring after year-end.
d. Inquiring as to whether any unusual adjustments were made after year-end.
19-52
subsequent events?
a. Recompute a sample of large-dollar transactions occurring after year-end for arithmetic accuracy.
b. Investigating changes in stockholders equity occurring after year-end..
c. Inquiring of the entitys lawyer concerning LCAs arising after year-end.
d. Confirming bank accounts established after year-end.
19-53
subsequent events?
a. Determining that changes in employee pay rates after year-end were properly authorized.
b. Recompute depreciation charges for plant assets sold after year-end..
c. Inquire about payroll checks that were recorded before year-end but cashed after year-end.
d. Investigate changes in long-term debt occurring after year-end..
19-54
After issuing an audit report, an auditor has no obligation to make continuing inquiries or perform other procedures
concerning the audited financial statements, unless
a. information, which existed at the audit report date and may affect the audit report, comes to the auditors attention.
b. clients management requests the auditor to reissue the auditors report in a document submitted to a third party that
contains information in addition to the basic financial statements.
c. information about an event that existed after the end of field work (audit report date) comes to the auditors attention.
d. final determinations or resolutions are made of contingencies that had been disclosed in the financial statements.
19-55
Which of the following events occurring after the issuance of an auditors report most likely would cause the auditor to
make further inquiries about the previously issued financial statements?
a. An uninsured natural disaster occurs that may affect the clients ability to continue as a going concern.
b. A contingency is resolved that had been disclosed in the audited financial statements.
c. New information is discovered concerning undisclosed lease transactions of the audited period.
d. A subsidiary is sold that accounts for 25% of the clients consolidated net income.
19-56
Subsequent to the issuance of an auditors report, the auditor became aware of facts existing at the report date that would
have affected the report had the auditor been aware of such facts. After determining that the information is reliable, the
auditor should next
a. determine whether the information has material effect on the users of the audited financial statements.
b. request that management disclose the newly discovered information by issuing revised financial statements.
c. issue revised pro forma financial statements taking into consideration the newly discovered information.
d. give public notice that the auditor is no longer associated with the financial statements.
19-57
To which of the following matters would an auditor not apply materiality judgment when obtaining specific written
management representations?
a. Disclosure of compensating balance arrangements involving restrictions on cash balances.
b. Information concerning related party transactions and related amounts receivable or payable.
c. The absence of errors and unrecorded transactions in the financial statements.
d. Fraud involving employees with significant roles in internal control.
19-58
There have been no communications from regulatory agencies concerning noncompliance with, or deficiencies in,
financial reporting practices that could have a material effect on the financial statements. The foregoing passage is most
likely from a
a. report on internal control.
b. special report.
c. management representation letter.
d. letter for underwriters.
19-59
Which of the following statements is correct about an auditors required communication with a clients audit committee?
a. Any matters communicated to the clients audit committee are also required to be communicated to the clients
management.
b. The auditor is required to inform the clients audit committee about fraud involving senior management.
c. Disagreements with management about the application of accounting principles are required to be communicated in
writing to the clients audit committee.
d. Weaknesses in internal control previously reported to the clients audit committee are required to be communicated to
the audit committee after each subsequent audit until the weaknesses are corrected.
19-60
Which of the following statements is correct concerning an auditors required communication with a clients audit
committee?
a. This communication should include disagreements with management about significant audit adjustments, whether or not
satisfactorily resolved.
b. If matters are communicated orally, it is necessary to repeat the communication of recurring matters each year.
c. If matters are communicated in writing, the report is required to be distributed to both the audit committee and
management.
d. This communication is required to occur before the auditors report on the financial statements is issued.
19-61
Which of the following matters is an auditor required to communicate to a clients audit committee?
a. The basis for assessing control risk below the maximum.
b. The process used by management in formulating sensitive accounting estimates.
c. The auditors preliminary judgments about material levels.
d. The justification for performing substantive procedures at interim dates.
19-62
Should an auditor communicate the following matters to a clients audit committee?

Significant Audit Adjustments
Recorded by the client
a.
Yes
b.
Yes
c.
No
d.
No
19-63
Issues Discussed with Management

Prior to the Auditors Retention
Yes
No
Yes
No
In using the work of a specialist, an auditor referred to the specialists findings in the auditors report. This would be an
appropriate reporting practice if the
a. client is not familiar with the professional certification, personal reputation, or particular competence of the specialist.
b. auditor, as a result of the specialists findings, added an explanatory paragraph emphasizing a matter regarding the
c. client understands the auditors corroborative use of the specialists findings in relation to the representations in the
d. auditor, as a result of the specialists findings, decides to indicate a division of responsibility with the specialist.
529
530
19-64
When using the work of a specialist, an auditor may refer to and identify the specialist in the auditors report if the
a. auditor wishes to indicate a division of responsibility.
b. specialists work provides the auditor greater assurance of reliability.
c. auditor expresses a qualified opinion as a result of the specialists findings.
d. specialist is not independent of the client.
19-65
Which of the following statements is correct about the auditors use of the work on a specialist?
a. The specialist should not have an understanding of the auditors corroborative use of the specialists findings.
b. The auditor is required to perform substantive procedures to verify the specialists assumptions and findings.
c. The client should not have an understanding of the nature of the work to be performed by the specialist.
d. The auditor should obtain an understanding of the methods and assumptions used by the specialist.
19-66
An auditor searching for related party transactions should obtain an understanding of each subsidiarys relationship to the
total entity because
a. this may permit the audit of inter-company account balances to be performed as of concurrent dates.
b. inter-company transactions may have been consummated on terms equivalent to arms-length transactions.
c. this may reveal whether particular transactions would have taken place if the parties had not been related.
d. the business structure may be deliberately designed to obscure related party transactions.
19-67
Which of the following events most likely indicates the existence of related parties?
a. Borrowing a large sum of money at a variable rate of interest.
b. Selling real estate at a price that differs significantly from its book value.
c. Making a loan without scheduled terms for repayment of the funds.
d. Discuss merger terms with a company that is a major competitor.
19-68
Which of the following statements is true about related party transactions?

a. In the absence of evidence to the contrary, related party transactions should be assumed to be outside the ordinary course
of business.
b. An auditor should determine whether a particular transaction would have occurred if the parties had not been related.
c. An auditor should substantiate that related party transactions were consummated on terms equivalent to those that prevail
in arms-length transactions.
d. The audit procedures directed toward identifying related party transactions should include considering whether
transactions are occurring but are not being given proper accounting recognition.
19-69
In evaluating the reasonableness of a clients account estimates, an auditor normally is concerned about assumptions that
are
a. susceptible to bias.
b. consistent with prior periods.
c. insensitive to variance.
d. similar to industry guidelines.
19-70
Auditors must obtain and evaluate sufficient appropriate evidence to support significant accounting estimates. Differences
between the estimates best supported by the audit evidence and those estimates in the financial statements
a. are per se unreasonable and should be treated as misstatements if collectively material.
b. may be individually reasonable but collectively indicate possible bias.
c. may be individually unreasonable, but if they collectively indicate no bias, aggregation of the differences with other
likely misstatements is not required.
d. should arouse concern only when estimates are based on hypothetical assumptions or subjective factors.
19-71
At completing the audit, the audit work performed by each assistant should be reviewed to determine whether it was
adequately performed and to evaluate whether the
a. audit procedures performed are approved in the professional standards.
b. audit has been performed by assistants having adequate technical training and proficiency.
c. auditors system of quality control has been maintained at a high level.
d. results are consistent with the conclusions to be presented in the auditors report.
19-72
The auditor with final responsibility for an engagement and one of the assistants have a difference of opinion about the
results of an auditing procedures. If the assistant believes it is necessary to be disassociated from the matters resolution,
the CPA firms procedures should enable the assistant to
a. refer the disagreement to the AICPAs Peer Review Board.
b. document the details of the disagreement with the conclusion reached.
c. discuss the disagreement with the clients management or its audit committee.
d. report the disagreement to an impartial peer review monitoring team.
19-73
After field work audit procedures are completed, a partner of the CPA firm who has not been involved in the audit
performs a second or wrap-up working paper review. This second review usually focuses on
a. the fair presentation of the financial statements in conformity with GAAP.
b. fraud involving the clients management and its employees.
c. the materiality of the adjusting entries proposed by the audit staff.
d. the communication of internal control weaknesses to those charged with governance.
19-74
Which of the following related party transactions is specifically prohibited by the Sarbanes-Oxley Act of 2002?
a. Home loan made by a bank to its executive officers under normal banking operation using market terms offered to the
general public.
b. Real estate sold by a real estate company to its executive officers at a price considerably different from its appraised
value.
c. Exchange of fix assets between a company and its executive officers that is made in a non-monetary transaction.
d. Personal loan made by a company to its executive officers that is not an arms length transaction.
19-75
Sarbanes-Oxley Act expands the auditors communications with the audit committee and management. Which of the
following is not one of the expanded communications?
a. Auditor is required to communicate material subsequently discovered facts to the audit committee and management.
b. Auditor is required to communicate material matters identified in reviewing the clients quarterly financial statements
to the audit committee and management.
c. Auditor is required to communicate material weakness in internal controls identified in the financial audit to the audit
committee and management.
d. Auditor is required to communicate matters relating to an audit engagement to the audit committee and management
prior to the approval and signing of the audit engagement letter.
19-76
Ordinarily, audit procedures for testing accounting estimates of accrual liabilities do not include
a. Appraising the accuracy of the detailed accounting records maintained for this category of liability.
b. Testing the computations made by the client in setting up the accrual.
c. Considering the need for accrual of other accrued liabilities not presently considered.
d. Performing a prospective analysis of the future years estimates for evidence of management bias.
19-77
In auditing accounting estimates of accrual liabilities, the auditor is ordinarily not required to
a. Examine any contracts or other documents on hand that provide the basis for the accrual.
b. Identify and evaluate the reasonableness of the assumptions made that underlie the computation of the liability.
c. Test the computations made by the specialist hired to provide estimates of the accrual liabilities.
d. Perform a retrospective analysis of the prior years estimates for evidence of management bias.
19-78
Which of the following accrued liabilities typically requires the service of a specialist?
I. Accrued vacation pay, product warranty liabilities, and accrued property taxes.
II. Accrued payrolls, accrued commissions and bonuses, and accrued professional fees.
III. Pension plan accruals and postemployment benefits other than pensions.
a. I
b. II
c. III
d. I and II
531
532
19-79
The auditor considers prior year uncorrected (unadjusted) material misstatements at the completion of audit phase. If
accruals were materially misstated by $20,000 in the previous year and $30,000 during the current year; and if the auditor
uses the iron curtain method according to the SEC Staff Accounting Bulletin No.108 (SAB No.108), the total amount of
material misstatements to be corrected (adjusted) in the current year financial statements would be
a. $30,000.
b. $20,000.
c. $50,000.
d. $10,000.

19-1 c. 19-2 a. 19-3 d. 19-4 a. 19-5 d. 19-6 c. 19-7 a. 19-8 b. 19-9 a. 19-10 b. 19-11 c.
19-12 d. 19-13 c. 19-14 d. 19-15 b. 19-16 b. 19-17 d. 19-18 a. 19-19 d. 19-20 c. 19-21 b.
19-22 d. 19-23 d. 19-24 a. 19-25 d. 19-26 c. 19-27 d. 19-28 d. 19-29 c. 19-30 b. 19-31 b.
19-32 c. 19-33 a. 19-34 b. 19-35 c. 19-36 d. 19-37 d. 19-38 a. 19-39 b. 19-40 c. 19-41 b.
19-42 b. 19-43 c. 19-44 d. 19-45 a. 19-46 a. 19-47 c. 19-48 c. 19-49 d. 19-50 a. 19-51 d.
19-52 c. 19-53 d. 19-54 a. 19-55 c. 19-56 a. 19-57 d. 19-58 c. 19-59 b. 19-60 a. 19-61 b.
19-62 a. 19-63 b. 19-64 c. 19-65 d. 19-66 d. 19-67 c. 19-68 d. 19-69 a. 19-70 b. 19-71 d.
19-72 b. 19-73 a. 19-74 d. 19-75 a. 19-76 d. 19-77 c. 19-78 c. 19-79 c.

Simulation Question 19-1 is an adaptation with permission from a case by Eynon, G., and K. Steven in the Issues in Accounting Education , a
Accounting for Contingent Environmental Liabilities
Marietta Nola, chief financial officer (CFO) of Willis, Inc., has worked at Willis for many years and helped it grow from a moderate
leasing operation to a sizable corporation with subsidiaries in several industries. She is now close to retirement and has accumulated a significant
investment in stock options on Willis at favorable prices. At a recent social gathering, she discovered that the Environmental Protection Agency
(EPA) had informed a local manufacturer that it was investigating an abandoned hazardous waste site previously used by the company. In the
ensuing discussion, she learned that the site investigation process and potential subsequent cleanup process was fraught with uncertainty.
Since the chief executive officer (CEO) of the local manufacturer was an old friend, she later called him to see how he was handling
the potential environmental cleanup uncertainty. He told her that his company had deposited one of the byproducts of its production process, a
toxic chemical, in a legal landfill in the 1970s. They had always used a licensed waste hauler and complied with all waste treatment and disposal
requirements. He had been surprised to find that the liability imposed under federal environmental regulations is strict, that is, can be imposed
without regard to fault. Further, the liability for the cleanup costs is joint and several, so it was possible that that it was possible that his firm
would have to bear the bulk of the remediation costs for the site, even though its contribution of waste to the site was small. He stated that he was
currently gathering all the relevant information he could. He was concerned with the legal, regulatory and financial reporting aspects of his firms
new situation and would have to review this information once he obtained it before he could fully assess his position.
After hanging up, Nolan began to worry about Willis most recently acquired subsidiary, a small privately held manufacturer of
machine tools. Until now, Willis had never had any investments in industries at all associated with hazardous waste disposal. She was relatively
uninformed about the manufacturing process at Johnson Manufacturing Co., the new subsidiary, and decided to meet with the CEO of Johnson
for a review of the production process. She specifically asked about the generation and disposal of hazardous wastes and learned that Johnson had
used a solvent in its production in the 1970s that was considered hazardous. Therefore, the CEO was very familiar with hazardous waste disposal
requirements. However, he stressed that Nolan should not be concerned with potential environmental liabilities, since Johnson had always
disposed of its only toxic output (at a legal landfill not far from the one under investigation by the EPA) in accordance with every regulation.
Despite his assurances, she realized that his knowledge of hazardous waste disposal was limited to the dumping requirements in place
in the 1970s and did not extend to the federal Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA, or
Superfund) that governs the cleanup of abandoned hazardous waste sites. After reading an article about environmental matters in the December
1992 issue of The Journal of Accountancy, The auditor, SAS No.54 and environmental violations by Specht, L.B., Nolan decided to conduct an
information gathering process similar to the one used by her friend. She sent letters with general and specific questions to the outside corporate
attorney, Philips and Graham, and the CPA firm, Gibson & Fishburne, which audits Willis financial statements each year. You should access
Data File 19-1 in iLearn for Figures 1 through to 3 for the corporate attorneys responses and attachments.
Philip, the corporate attorney, recommended that Nolan obtain more information by consulting a specialist. The attorney also sent
Nolan a copy of an article that discussed several considerations in the hiring of a reputable consulting firm. Form this she learned that there is no
professional certification in the field of environmental consulting, and that some consultants have obtained their credentials via mail order.
Following the cautions mentioned in the articles, such as reviewing resumes and checking the limits of liability on the consulting firms general,
pollution and professional liability insurance policies; she located two reputable firms, Environmental Assessors and Environmental strategists.
Nolan hired Environmental Assessors (EA) to review the situation at Johnson Manufacturing, Inc. Eventually, EA reported that prior
clients that had disposed of similar types and volumes of waste as Willis (but at different sites) had been held responsible for significant cleanup
costs by the EPA. In EAs opinion, Willis would probably be held responsible and incur significant costs if the EPA investigated this site. Given
the ambiguous nature of environmental claims, Nolan was not satisfied that one experts opinion was sufficient. She decided to obtain the opinion
of the other environmental auditing and consulting firm she had located, Environmental Strategists (ES). After their investigation, this firm
agreed with EA that the costs of cleaning up the entire site could prove to be significant. However, ES also pointed out to Nolan that many other
financially stable companies had contributed far more waste to the site and that the EPA has a tremendous backlog in discovering and identifying
Superfund sites and determining potentially responsible parties (PRPs). Thus, ES concluded that it was unlikely that Willis would be designated a
PRP, and even if so designated, was unlikely to bear significant costs.
Thus, Nolan is confronted with a dilemma. She understands the technical guidance provided by the Financial Standards Board (FASB)
and the Securities and Exchange Commission (SEC), but the reporting standards are based on ambiguous terms such as probable and
reasonably estimated. An additional problem is that the experts in the field have arrived at differing conclusions. Therefore, it is difficult to
estimate both the amount and the materiality of the loss. She must now decide whether she should report a contingent environmental liability to
the SEC in the 10-K and/or in the annual report to the shareholders. Her dilemma is this: the technical reporting requirements do not provide her
with clear guidance on whether, or even what, to report. She must now use her moral reasoning skills to decide who is affected by her decision,
how they are affected and whose interests she should serve.
Required
1. Research Internet and read:
a. FAS No.5 (FASB 1986a), SEC Regulation S-K, Item 303 (SEC1986) and SEC Financial Reporting Release No.36 (FRR 36 (SEC 1989),
which provides interpretive guidance on compliance with SEC Regulation S-K, Item 303.
b. Concept Statement No.1 (CON1), para.24-27 and 50, CON2, glossary and para.80 and 135, and CON6, para.40 of the FASBs Conceptual
Framework (CFW) (FASB 1986b).
c. FASB (FASB 1986b) Interpretation 14 (FIN14), Reasonable Estimation of the Amount of Loss.
d. Statement of Auditing Standards AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related
Disclosures.
e. Statement of Auditing Standards AU 620, Using the Work of an Auditors Specialist.
533
534
2. Based on your research and reading in 1.a, b, c, d, and e; provide written answers to the following question:
Assume you are the in-charge audit partner in Gibson & Fishburne who has received Nolans letter requesting general and specific questions on
reporting environmental liabilities. You are to draft a Client Advisory Comment letter in response to her requests. Your responses should cover
an in-depth discussion of:
i. GAAP requirement on reporting contingent environmental liabilities.
ii. SEC requirement on disclosing contingent environmental liabilities.
iii. GAAS requirement on:
(a) auditors responsibility regarding the two environmental consultant firms hired by Nolan,
(b) the type of audit procedures that the auditor would likely use to investigate the environmental liabilities item, and
(c) the type of audit report that Nolan would be likely to get relating to the environmental liabilities item.
Note: The letter from the law firm (in Data File 19-1 in iLearn) in response to Nolans requests serves as an example of the depth and
professionalism that your letter to Nolan should be.

Simulation Question 19-2 is an adaptation with permission from a case by J. R. Duncan in the Issues in Accounting Education , a publication of
Year-End Adjustments
Cathy Thomas is the controller of a medium-sized division of a Fortune 500 company. Prior to appointment to her current position
approximately two years ago, Cathy worked for the corporate accounting staff at headquarters. The company has a reputation for promoting its
outstanding performers; marginal performers are counseled out. Cathy hopes to spend another year or so in her current position, and then be
promoted to a larger division with more visibility and responsibility. Promotions are typically based on recommendations of division
management, but must receive concurrence of functional heads at corporate headquarters. The division president strongly encourages division
management personnel to be team players; those who fail to demonstrate team behavior are rated negatively in performance evaluations.
Headquarters management expects its divisions to reach their respective earnings targets each year and has removed presidents of
divisions for failing to meet targets in three consecutive years. Cathys division reached its earnings target for the first three quarters of the
current year after failing to achieve targeted earnings the last two years. Divisional management bonuses are based on attaining the earnings
target. Last week, the division president indicated to the company CEO that the division most likely will reach its earnings target in the fourth
quarter and for the full year.
Four accounts remain to be considered for adjustment before divisional earnings are finalized for the fourth quarter and the year.
Bonus calculations will be made after earnings are finalized. The four accounts and related considerations are as follows (all amounts are after-tax
effects):
1. Inventory Reserve
During the year-end physical inventory, approximately $200,000 of raw material was identified as possibly unusable in normal production before
its shelf life would expire. Discussions with the division Purchasing Manager reveal it is possible that $50,000 of the raw material could be sold
to another company. The division Purchasing Manager contacted the other company who indicated a 60 percent chance it could use the $50,000
of material. The division Purchasing Manager promised to contact other companies about buying the remaining $150,000 of material.
2. Litigation Liability
A former manager-level employee sued the division for age discrimination after being dismissed in a downsizing. In two different discussions
with division legal counsel, the former employee offered to settle the lawsuit for $150,000, and later at $150,000 plus $50,000 in legal fee.
Division legal counsel is still considering the settlement, but is not optimistic about the division prevailing in the lawsuit. However, division legal
counsel indicated the trial does not occur for six months, and the legal system provides a series of appeals if the division loses. Therefore, it could
be several years before the outcome is ultimately known.
3. Accrued Consulting
The division received an invoice for $300,000 from a consulting firm relating to work performed on a proposed new product. The invoice relates
to work completed in the most recent quarter, but the division Research & Development (R&D) VP indicated that the invoice contains a
significant overcharge based upon rate discussions held with the consulting firm project manager over lunch last week. Because the invoice is in
dispute, the R&D VP requests that Cathy delay recording the invoice until he can resolve the amount with the consulting firm representative. The
R&D VP believes he can negotiate a $175,000 discount and that the consulting firm will rescind the invoice until the matter is resolved.
4. Allowance for Bad Debts
The division has a $200,000 7% note receivable from a customer who has, for the last ten years, purchased large volumes of the divisions
products. The VP of Sales indicates that the customer is currently experiencing cash flow problems and recommends an extension be granted for
the note. Without an extension, the customer would be forced to default, and the division would likely recover only 75 percent of the amount sold
through repossession of the products. The VP of Sales also believes the customer, upon recovery from its cash difficulties, would purchase its
future product needs from competitors of the division. However, it is too early to tell whether the customers financial difficulties will be resolved
or will worsen. The Sales VP believes that the division president would likely approve an extension.
Required
Research Internet and read:
a. Statement of Financial Accounting Standards (SFAS) No.5, Accounting for Contingencies.
b. Statement of Financial Accounting Standards (SFAS) No.15, Accounting by Debtors and Creditors for Troubled Debt Restructurings.
c. Statement of Financial Accounting Standard (SFAS) No. 114, Accounting by Creditors For Impairment of a Loan.
d. FASB (1986b) Interpretation 14 (FIN14), Reasonable Estimation of the Amount of Loss .
e. SEC Staff Accounting Bulletin No. 99, Materiality.
f. Statement of Auditing Standards AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures.
g. Statement of Auditing Standards AU 501, Audit Evidence Specific Consideration of Selected Items.
If your last names first alphabet is A-M, answer questions in Part A only.
If your last names first alphabet is N-Z, answer questions in Part B only.
Part A (Answer Part A only if your last names first alphabet is A-M)
The divisions preliminary results for the fourth quarter reveal after-tax earnings of $10,200,000 versus a target of $10,000,000.
1. Assume you are Cathy, the controller, provide an estimate of the adjustments you would record in the fourth quarter:
Preliminary Earnings
$ 10,200,000
__________
__________
__________
__________
Total Adjustments
___________
Division Net Earnings after Adjustments
$ ___________
2. Use the following format to document your rational for the adjustments you would record in the fourth quarter
Accounts Adjustments
3.Accrued Consulting
4.Allowance for Bad Debts
List Factors that Contributed to

Your Estimation of the
Adjustments
Describe the Accounting Treatments

Related to Your Adjustments
Reference/Cite Authoritative
Accounting Literature You Used
3. Assume you are the senior auditor-in-charge of completing the audit of this company. Use the following format to document your plan to audit
the adjustments in 1. above.
Explain Your Assessment (in High,
Moderate, Low) of the Risk and
Materiality of the Adjustments
Describe the Auditing Procedures

You Plan to Test the Adjustments
Auditing Literature You Used
Part B (Answer Part B only if your last names first alphabet is N-Z)
The divisions preliminary results for the fourth quarter reveal after-tax earnings of $10,200,000 versus a target of $10,000,000.
1. Assume you are Cathy, the controller, provide an estimate of the adjustments you would record in the fourth quarter:
Preliminary Earnings
$ 10,900,000
__________
__________
__________
__________
Total Adjustments
___________
Division Net Earnings after Adjustments
$ ___________
2. Use the following format to document your rational for the adjustments you would record in the fourth quarter
List Factors that Contributed to

Your Estimation of the
Adjustments
Describe the Accounting Treatments

Related to Your Adjustments
Accounting Literature You Used
535
536
3. Assume you are the senior auditor-in-charge of completing the audit of this company. Use the following format to document your plan to audit
the adjustments in 1. above.
Explain Your Assessment (in High,
Moderate, Low) of the Risk and
Materiality of the Adjustments
Describe the Audit Procedures You

Plan to Test the Adjustments
Auditing Literature You Used

Simulation Question 19-3 is an adaptation with permission from a case by Knipe P. J., and M. E. Bitter in the Issues in Accounting Education, a
Introduction
This Years Audit
The Audit Issue
You are the in-charge (senior) accountant (ICA) on the June 30, 2010, audit of Central Florida Emphysema Foundation (CFEF), an
affiliated, local chapter of the National Emphysema Foundation (NEF). CFEF is a significant client of K&B, a large, local accounting firm
located in Orlando, your employer. K&B is a member of The U.S.A. Group of CPA Firms, commonly referred to as TUSAG. TUSAG, with a
membership of 40 local firms nationwide, was organized to encourage and enhance the open exchange of technical, financial, and practice
management information among its member firms. TUSAG firms pool resources for purposes of presenting continuing professional education
courses, preparing member operating and other statistical surveys, promoting the TUSAG brand, and hiring a staff to oversee joint TUSAG
activities. All of the participating firms of TUSAG operate autonomously in their respective, mutually exclusive, geographic areas; there is no
centralized management in the group and no profit sharing among the group members. Because they are geographically dispersed, the TUSAG
member firms do not compete among themselves for clients or personnel.
NEF, headquartered in Washington, D.C., is a major client of L&M, the TUSAG member firm located in the same city. NEF requires
all of its 120 nationwide chapters to have their financial statements audited annually. The local chapters of NEF are encouraged to use a TUSAG
firm, if one is located nearby, but the Board of Trustees of each chapter has the final say in the auditor selection process. Annually, NEF rolls
up the audited financial statements of its chapters into consolidated financial statements. NEF and all of its affiliated entities are incorporated as
not-for-profit organizations. Last year, total fees for audit, tax, and consulting work amounted to $200,000 for CFEF and over $3,000,000 for
NEF.
NEF is under pressure from its Board to get its audit completed quickly after the end of the fiscal year (also June 30). This pressure is
passed on by the NEF management to its auditors, L&M, and to the local chapters and their auditors.
The audit of CFEF has gone exceptionally well this year, the best in the three years that you have acted as ICA on the engagement. To
this point, there have been no significant audit issues. Although relations between the entity's Executive Director and your firm historically have
been strained, the client's accounting staff has been very cooperative and it looks as if you might beat the tight engagement time budget approved
by your manager. If you do, there is a good chance that you will be recommended for promotion to manager this September, a full year ahead of
your peer group. In fact, your audit manager is away on a week's vacation in the Caribbean and asked you to manage the job in her absence. She
participated in the first two weeks of year-end fieldwork and has thoroughly reviewed the work completed during that time. She does not expect
any problems and has expressed every confidence you are ready for the increased responsibility. While gone, in order to get some much-needed
rest and to recharge her batteries, she has asked for no office contact unless there is an emergency.
Tragically, shortly after your manager leaves for vacation, and near the end of the job, the CFEF audit partner, who is also K&B's
managing partner, received word of a death in his family and leaves suddenly for an out-of-state funeral. He, too, requests no nonemergency
contact until he returns so he can attend to pressing family financial and personal issues. He instructs you to review the client's draft copy
financial statements and approve sending them to the NEF for national consolidation as soon as you are comfortable with the numbers. The audit
partner expects to return in time to complete his review of the audit, sign the report, and meet the final delivery deadline. Being alone now and in
charge, you are a bit nervous, but at the same time anxious to prove that you can perform at the manager level and that you really deserve an early
promotion.
As the audit begins to wrap up, one of the two staff accountants on the job sends you an email message about a possible issue. Earlier
in the engagement, while scanning the client's records for large, post year-end transactions, he had noticed a deposit entry of $5,000,000 posted
on July 9. He wrote a to do note to himself to follow up on this transaction with client personnel. Caught up in the usual time pressures of the
job and not really anticipating the deposit entry would be an issue, the staff accountant had simply moved on to other matters. As the audit was
winding down, the staff accountant noticed the outstanding issue on his to do list and investigated. The amount did not appear as a reconciling
item (i.e., a deposit-in-transit) on the June 30 bank reconciliation prepared by the client, thus indicating the amount presumably was received by
CFEF subsequent to year-end, in July. It was common for CFEF to receive large grants early in its fiscal year, but this amount was exceptionally
large in comparison to amounts received in previous years.
You reprimand the staff accountant for his failure to follow up on the item in a timely manner and for bringing this matter to your
attention so late in the engagement. You ask him to determine the nature and source of the $5,000,000 deposit and report back to you as soon as
possible, as you have received word that the audit partner on the NEF (national) engagement was getting anxious to receive a draft copy of
CFEF's audited financial statements.
Later that day, the staff accountant consults briefly with CFEF personnel regarding the nature and source of the transaction, and
reports back to you the entire $5,000,000 in question represented a bequest made to CFEF in the will of a local philanthropist whose wife had
died several years ago from emphysema. He further reports that the client was in the process of pulling documentation for the staff accountant to
review. Based on what the client had told him, the staff accountant indicates he believes the amount should be recorded in the next fiscal year
(when it was received by CFEF) and perhaps footnote disclosure in the current year financial statements would be appropriate given the
materiality of the amount.
A timeline of various audit-related events is provided in Exhibit 1. You should access Data File 19-3 in iLearn for Exhibit 1, which
presents the event time-line June 30, 2010 CFEF.
Requirement 1
Based on the information you have been provided to this point, answer the following questions:
A. Did the staff accountant's explanation of the facts seem complete and accurate?
B. Do you concur with the staff accountant's conclusion to record the $5,000,000 amount in the next fiscal year and perhaps include a footnote
disclosure in this year's financial statements?
DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 1
After further consideration, you decide to discuss the matter with the CFEF Executive Director yourself. You find that the
philanthropist who made the bequest had died shortly after the completion of last year's audit. At that time, the CFEF Executive Director had
learned from the law firm representing the estate that CFEF was designated as a residual beneficiary in the will. The amount ultimately to be
received by CFEF was not immediately known because the estate had liabilities of an indeterminate amount that had to be paid out of the estate's
assets and because the will had been contested by the children of the philanthropist. Ultimately, the Executive Director did not learn of the
amount of the bequest until she received the check in July.
The CFEF Executive Director also mentioned in passing that receiving the $5,000,000 in July was very good luck, indeed. CFEF had
already surpassed its contributions goal for the year ended June 30, 2010, and simply did not need the additional revenue. But receiving the
bequest in July was great timing because it gave CFEF a real kick start toward meeting next year's aggressive contributions goal that had been
set by its local Board.
You ask the Executive Director if the check had actually been received by CFEF in June and simply held until July for deposit. The
Executive Director assures you the money had been received in July and shows you the letter of transmittal from the estate's attorney dated July
7, 2010, and an envelope from the law firm postmarked July 8, 2010. She provides you with a copy of all correspondence from the attorney
representing the estate, including the letter of transmittal and the postmarked envelope. The Executive Director further states she had specifically
asked your staff accountant for his opinion as to when the $5,000,000 should be recorded. The staff accountant had agreed with the Executive
Director that distributions from estates, in circumstances like this, should be recorded in the year received. In effect, the staff accountant had
sided with the Executive Director in her strong desire to recognize the bequest in the following fiscal year.
Requirement 2
A. Why does the Executive Director want the $5,000,000 to be recognized in the following fiscal year?
B. Was the staff accountant's conversation with the Executive Director appropriate?
C. What would you next discuss with the Executive Director?
D. What would you later discuss with the staff accountant?
As your discussion with the Executive Director continues, you tell her you would like to speak with the attorney representing the
estate. The Executive Director becomes a bit agitated by your continuing pursuit of a matter she believes to be a nonissue. She is frustrated the
audit is not complete and the phone is now ringing off the hook from executives at the NEF asking for CFEF's draft audited financial statements
right away. The Executive Director asks you to hurry up and finish the audit and not to waste time calling the estate attorney.
As you drive back to your office, you think about your predicament and your options. Excluding the $5,000,000 from the fiscal year
2010 financial statements is more conservative, for sure. And, thinking back to your study of auditor litigation in college, you cannot recall any
cases where auditing firms got sued for issuing unqualified opinions on understated operating results and net assets. Overstatements were the
issue. Right? You think about the engagement economics (your time budget), your opportunity for an early promotion, and, in addition to the
pressure you are receiving from your client, the heat you are now feeling from the L&M audit partner running the NEF engagement in
Washington, D.C., to get the job wrapped up. It's a lot to consider, so you circle the block a few times before pulling into the office parking lot.
Requirement 3
A. What is the Executive Director's agenda?
B. Rethink your position on the implications of overstating versus understating an entity's assets and revenues. Were your initial thoughts correct?
Be sure to consider the impact of the financial statements and the audit opinion on third-party users.
C. Why is an engagement time budget so important? What, if anything, is more important than meeting or beating the time budget?
D. Do you need the client's permission to call the estate's attorney? Would you call the estate's attorney against the Executive Director's wishes?
537
538
Once back in your office, you close the door and, against the wishes of the Executive Director, you call the estate's attorney. The
attorney is in a meeting, so you leave a detailed message with his associate. The next afternoon, the attorney returns your call after having
confirmed your identity with CFEF and obtaining written permission to speak to you about the specifics of the bequest. The attorney indicates the
will had been adjudicated and the final court order was entered on June 28, 2010. The attorney states the matter had been concluded while he was
out of the office on a long 4th of July break. When the attorney returned to his office and read the court order, he immediately dictated a letter and
enclosed a check to CFEF for its share of the estate, $5,000,000.
Requirement 4
A. What is meant by adjudicated?
B. What were the contingencies in this estate matter?
C. What would you do to confirm the estate attorney's statement about the date of the final court order?
You could probably use some help at this point, but you are determined to resolve this matter by yourself without disturbing your
audit manager or partner. This is not an emergency, you tell yourself; the situation is not out of control. Besides, to get that early promotion,
you believe you must prove you are capable of handling difficult client and professional situations.
So, with your audit manager and audit partner still out of the office, you decide to call the NEF audit partner at L&M in Washington,
D.C., directly and discuss the situation with him. The NEF audit partner informs you he has many years of experience auditing not-for-profit
organizations. He tells you that you do not recognize a contingent asset (i.e., a gain contingency) until the amount to be received is known. The
residual beneficiary of an estate usually does not know how much will be received until the estate debts are paid and any contesting litigation is
settled. In this case, he says, CFEF did not know how much it would receive until July 9, 2010, the date it got the estate attorney's letter and the
$5,000,000 check.
The NEF audit partner also indicates that the $5,000,000 would be material to this year's NEF consolidated financial statements and,
under pressure from his client, he had already approved the release of a draft copy of the NEF audited financial statements to the NEF Board
earlier that morning. You learn the NEF statements included unaudited financial information provided directly by CFEF, and did not include any
accrual for the estate distribution.
Requirement 5
A. Was the NEF audit partner correct in his explanation of when to record the gain contingency?
B. How, if at all, should CFEF report the $5,000,000 estate distribution in its 2010 financial statements?
C. Assume that the $5,000,000 bequest should have been recognized in fiscal year 2010. Does it matter that the NEF Board had already received
a draft copy of the entity's consolidated financial statements that did not include the $5,000,000 accrual?
D. Was the NEF audit partner trying to persuade you to give up on your investigation of the matter?
E. Would you drop the matter at this point?
F. Should you contact your audit manager or audit partner on an emergency basis or seek help from other available K&B office personnel?
After speaking to the NEF audit partner and giving the situation some more thought, you decide to have another discussion with CFEF's
Executive Director. Before you can say anything, the Executive Director gives you a good tongue-lashing for calling the estate's attorney behind
my back. She explains the attorney had called her to get permission to discuss the nature of the bequest to CFEF with you. She had reluctantly
agreed to grant the permission, but was angry you called the attorney despite her request that you not. The Executive Director also tells you she
had contacted her counterpart at NEF, the National Executive Director, yesterday. The National Director considers himself to be quite
experienced with not-for-profit accounting matters. He and the NEF audit partner are fairly close personal friends. Both had independently
reviewed SFAS No. 116, Accounting for Contributions Received and Contributions Made,1 and the related literature, and both had concluded
the $5,000,000 should be recorded in fiscal year 2011, when notification of the amount was received by CFEF. You then learn the National
Executive Director had directed the CFEF Executive Director to close the CFEF books at June 30 without the $5,000,000 recorded and to submit
the financial statements to NEF immediately for inclusion in the draft copy national consolidation. Now it becomes clear to you how the NEF
audit partner had received unaudited financial information from CFEF.
Requirement 6
A. Whose financial statements are they? Can you dictate how or when a particular transaction is or is not recorded?
B. Do you think an audit adjustment should be proposed for the $5,000,000 distribution?
C. If yes, what should the entry be?
D. Is this beginning to feel like a bit of a conspiracy?
E. Is it time to throw in the towel and just walk away from the issue?
1
Now part of FASB's Accounting Standards Codification (ASC) 958605 (FASB 2010).
You are really feeling the heat now. The job is going over the time budget for sure, the draft audit report is going to be late, and you begin to
worry that K&B may now be at risk of losing the $200,000 CFEF audit. In addition, there could be a risk of L&M, the TUSAG firm in
Washington, D.C., losing the NEF national audit ($3,000,000 in total annual feesremember?). From what you have heard, if the NEF job is
lost, the audit partner at L&M will likely get a poor annual review and might face a forced, early retirement. You decide to call the NEF audit
partner one last time.
Requirement 7
A. How does the potential loss of audit fees by both K&B and L&M impact your thought process?
B. Should you be concerned about the NEF audit partner's situation?
C. What would you discuss on your anticipated call to the NEF audit partner?
Coincidentally, your audit manager and audit partner are both due back in the office on Monday. You know they both expect, based
on their experiences with prior year CFEF audits and the status of this year's audit when they left the office, to see a finished CFEF audit, tied up
neatly in a bow, with an unqualified opinion on the financial statements ready for signing. They will, of course, complete their review of the
engagement, but you know they really do not expect to see any problems. In spite of ongoing shaky relations with the Executive Director, CFEF
has been a good client over the years and audit issues have been minor and minimal.
As you now know from discussions with the NEF audit partner and the local Executive Director, CFEF did not record the $5,000,000
at June 30, 2010. However, it did disclose the matter in a subsequent events footnote to the financial statements. This, of course, is contrary to
your conclusion that the $5,000,000 bequest should have been accrued at June 30, 2010. The statements were sent to the NEF without your final
review.
Requirement 8
Based on the information you have been provided to this point, answer the following question:
A. How would you prepare for your meeting with your audit manager and audit partner?
Your audit manager arrives in the office early the next morning and sees the CFEF audit ready for review. She reads your review notes first,
including those documenting your discussions with the CFEF Executive Director and the NEF audit partner. She is shocked to see such
differences of opinion on a major accounting issue. She quickly understands the CFEF Executive Director's position of wanting to save the
$5,000,000 bequest until the next budget year. But she wonders and worries about the NEF audit partner's agreement with this position. After all,
he is a well-respected partner at L&M and among the TUSAG firms and is widely reputed to have expertise in the not-for-profit area. She calls
the audit partner, who is also back in the office, to schedule a conference and invites you to join the discussion. After thoroughly reviewing the
matter, both the audit manager and audit partner agree with your position.
Requirement 9
A. At this point, what are the options available to K&B relative to the CFEF audit?
B. What, if any, type of leverage can K&B employ to reinforce its position on accounting for the bequest?
Requirement 10
A. What course of action do you think was finally taken by K&B's CFEF audit team?
B. What course of action do you think was taken by the CFEF Executive Director?
Requirement 11
In your estimation, what was the ultimate impact of the events that transpired on the following:
A. The NEF national audit engagement
B. The CFEF local audit engagement
C. The NEF audit partner
D. The CFEF Executive Director
E. You
Note: You must answer all the subparts of the 11 Requirements in order to earn the extra credit point.
539
540
20 Audit Report
Chapter 20
Audit Report
LO20-1 Write the important wordings of a standard unqualified audit report.
LO20-2 Identify 5 common situations for adding explanatory paragraphs to or modifying
wordings of a standard unqualified audit report.
LO20-3 Identify 3 common situations that result in 3 types of qualified audit report
depending on 3 levels of materiality.
LO20-4 Discuss the auditors report concerning comparative financial statements.
LO20-5 Discuss the auditors report concerning financial statements prepared for use in
other countries.
Chapter 20 Audit Report

The final phase in the audit process is issuing the audit report. It is the culmination of a process of collecting and
evaluating sufficient appropriate evidence concerning the fair presentation of managements assertions in the
financial statements. Guidance on audit reporting are provided by the following: PCAOBs Auditing Standard No.1
(AS 1), References in Auditors Reports to the Standards of the Pub lic Company Accounting Oversight Board, and
Auditing Standard No 5 (AS 5), An Audit of Internal Control over Financial Reporting Performed that is Integrated
with an Audit of Financial Statement , and AICPAs AU 700, Forming an Opinion and Reporting on Financial
Statements, AU 705 Modifications to the Audit Opinion in the Independent Auditors Report, AU 706 Emphasis of
Matter Paragraphs and Other Matter Paragraphs in the Independent Auditors Report. Figure 20-1 provides an
overview of audit reporting and Figure 20-2 provides an on overview of the various types of audit report.
Figure 20-1 An Overview of Audit Reporting
The Audit Process
Audit Plan
Tests of Controls
Tests of Balances
Audit Report
Financial Audit
Integrated Audit
One Audit Report (Opinion) on the

Fairness of Financial Statements.

Fairness of Financial Statements.
+
Effectiveness of ICFR.
OR
One Combined Audit Report
(Opinion) on the Fairness of
Financial Statements and the
541
542
20 Audit Report
Figure 20-2 An Overview of the Various Types of Audit Report

___________________________________________________________________________________________________________________
Effect of Materiality
Type of Audit Report
Others Types of Audit Report
____________________________________________________________________________________________
Immaterial
Unqualified with
additional explanatory
paragraph or modified
wordings
Unqualified
Scope limitation:
1. Client imposed
2. Condition imposed
Material
Qualified
Departure
from
GAAP
Qualified
Scope limitation:
1. Client imposed
2. Condition imposed
Departure
from
GAAP
Additional explanatory paragraph for:

1. Lack of consistency in applying GAAP
2. Substantial doubt about going concern
3. Auditor agrees with departure from GAAP
4. Emphasis of a matter
Modified wordings for:
5. Report involving other auditors
Other Types of Audit Report:

Comparative financial statements.
Other information in documents

containing financial statements.
Condensed financial statements and

selected financial data.
Required supplementary information.
Letters for underwriters and certain

other requesting parties.
Pervasively
Material
Disclaimer
Adverse
Issue disclaimer for:

1.A lack of independence in all cases.
2.A substantial doubt about going concern in some cases.
Filing
statutes.
under
federal
securities
Financial statements prepared for use

in other countries.
____________________________________________________________________________________________________________________
The Auditors Standard Unqualified Audit Report

Figure 20-3 presents an example of a standard unqualified audit report (opinion) on financial statements and
describes some important wordings or elements of the report according to AS 1 and AS 5 of the PCAOB in an
integrated audit. As discussed in Chapter 8, AS 5 of the PCAOB also requires the auditor of a public company to
perform an integrated audit and report on the effectiveness of ICFR. Accordingly, the auditor may choose to issue
two separate reports (opinions): one on the fairness financial statements (see Figure 20-3) and one on the
effectiveness of ICFR (see Figure 20-4), or one combined audit report (two opinion) on financial statements and
ICFR (see Figure 20-5).
Figure 20-5 presents an example of a combined unqualified audit report (two opinions) on financial
statements and on the effectiveness of ICFR. Some important wordings or elements of the combined report include:
1. The introductory, scope, and opinion paragraphs are modified to include reference to managements assessment
of ICFR and the scope of the auditors work and opinion on ICFR.
2. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control.
3. The report includes a paragraph after the scope paragraph defining ICFR.
4. The report also includes an additional paragraph before the opinion paragraph that addresses the inherent
limitations of internal control.
5. Although the audit opinion on the financial statements may address multiple reporting periods (fiscal years),
managements assertion about the effectiveness of internal control is as of the end of the most recent fiscal year.
In addition, the auditor may issue a combination of unqualified opinion, qualified opinion, adverse opinion,
or disclaimer of opinion on the effectiveness of ICFR. Figure 20-6 shows all potential variations of audit opinion on
financial statements and audit opinion on the effectiveness of ICFR. Examples of these reports are shown in Figure
20-7, Figure 20-8, and Figure 20-9.
Figure 20-3 An Example of a Standard Unqualified Audit Report (Opinion) on Financial Statements
Title:
The title includes the word independent registered
so that the users know that the audit was conducted
objectively. Include also the city and state where the
auditors report has been issued.

XYZ CPA, LLP
Addressee:
The report should be addressed to the board of
directors and stockholders, and should not be
addressed to the management.

ABC Corporation
Introductory paragraph:
The introductory paragraph should 1. State, We have
audited to indicate that an audit was conducted. 2.
Describe the financial statements that are covered by
the audit. 3. State that the financial statements are the
responsibility of the management. 4. State that the
auditors responsibility is to express an opinion.
We have audited the accompanying balance sheets of ABC Corporation as of

December 31, 20xx, and the related statements of income, retained earnings, and cash
flows for the year then ended. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these financial
statements based on our audits.
Scope paragraph:
The scope paragraph should 1. State the authoritative
standards that were followed in conducting the audit.
2. Emphasize that the audit only provides reasonable
assurance of no material misstatement. 3. Disclose
that the an audit involves examining evidence on a
test basis; assessing the accounting principle used
and significant estimates, and evaluating the overall
financial statement presentation. 4. Express the
auditors belief that there was a reasonable basis for
making an audit opinion.
Opinion paragraph:
The opinion paragraph should 1. State, In our
opinion to indicate that the report is a statement of
opinion not a statement of fact. 2. Use the phrase
present fairly to indicate that it is an unqualified
audit report. 3. Use the phrase in all material
respects to stress the concept of materiality. 4. State,
in conformity with generally accepted accounting
principles to comply with the first standard of
reporting.
Explanatory paragraph referring to the audit of
internal control:
This paragraph refers to a separate report on the
effectiveness of internal control over financial
reporting.
Name of the auditor:

Typically, the CPA firms name rather than individual
partner-in-charge of the engagement is used. Also, it
is common to state LLP (limited liability partnership)
to indicate the partnership structure of the CPA firm.
Audit report date:
The report should be dated on the completion of the
fieldwork date, but it is common to date it the same
date as the clients director report date.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of ABC Corporation as of December 31, 200x, and the
results of its operations and its cash flows for the year then ended in conformity with
generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of XYZ Corporations
internal control over financial reporting as of December 31, 20xx, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO), and our report dated
March 31, 200x expressed an unqualified opinion that XYZ Corporation maintained, in
all material respects, effective internal control over financial reporting.
XYZ CPA, LLP
March 31, 20xx
543
544
20 Audit Report
Figure 20-4 An Example of an Unqualified Audit Report (Opinion) on the Effectiveness of ICFR
[TITLE]
ABC CPA, LLP
[ADDRESSEE]
XYZ Corporation
We have audited XYZ Corporations internal control over financial reporting as of December 31, 20xx, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). XYZ
Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the effectives of the companys internal
control over financial reporting based on our audits.
[SCOPE PARAGRAPH]
require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit of internal control over financial reporting includes obtaining an understanding of internal control
over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control,
and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for
our opinion.
[OPINION PARAGRAPH]
In our opinion, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO).
_____________________________
ABC CPA, LLP
March 31, 20xx
Figure 20-5 An Example of a Combined Unqualified Audit Report (Two Opinions) on Financial Statements
and Effectiveness of ICFR
[TITLE]
ABC CPA, LLP
[ADDRESSEE]
XYZ Corporation
We have audited the accompanying balance sheets of XYZ Corporation as of December 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the year then ended. We also have audited XYZ Corporations internal control over financial reporting as of
December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). XYZ Corporations management is responsible for these financial statements, for
maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on these financial statements, an opinion on managements assessment of internal control
over financial reporting, and an opinion on the effectives of the companys internal control over financial reporting based on our audits.
[SCOPE PARAGRAPH]
require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement
and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used
and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over
financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing
and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the
circumstances. We believe that our audits provide a reasonable basis for our opinion.
companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in
[OPINION PARAGRAPH]
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Corporation as of
December 31, 20xx, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting
principles in the United States of America. Also, in our opinion, XYZ Corporation maintained, in all material respects, effective internal control
over financial reporting as of December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO).

_____________________________
ABC CPA, LLP
March 31, 20xx
545
546
20 Audit Report
Figure 20-6 All Potential Variations of Audit Opinion on Financial Statements and Audit Opinion on the
Audit Opinion on Financial Statements
Unqualified
(U)
Qualified
(Q)
Disclaim Opinion
/Withdraw
(D/W)
Adverse
(A)
Unqualified (U)
(U) and (U)

See Figure 8-11
and Figure 8-12
(Q) and (U)
(D/W) and (U)
(A) and (U)
Qualified (Q)
(U) and (Q)
(Q) and (Q)

See Figure 20-7
(D/W) and (Q)
(A) and (Q)
Disclaim Opinion/Withdraw (D/W)
(U) and (D/W)
(Q) and (D/W)
(D/W) and (D/W)
(A) and (D/W)
Adverse (A)
(U) and (A)

See Figure 20-8
(Q) and (A)
(D/W) and (A)
(A) and (A)

See Figure 20-9
Audit Opinion on the

Figure 20-7 An Example of a Report Expressing a Qualified Opinion on Financial Statements and a Qualified
Opinion on the Effectiveness of ICFR
[TITLE]
ABC CPA, LLP
[ADDRESSEE]
XYZ Corporation
[STANDARD WORDING FOR INTRODUCTORY PARAGRAPH]
[SCOPE PARAGRAPH]
Except as described below, we conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards [STANDARD WORDING FOR THE REMAINDER OF THE SCOPE PARAGRAPH.]
A material weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such
that there is a reasonable possibility that a material misstatement of the companys annual or interim financial statements will not be prevented or
detected on a timely basis. The following material weakness has been identified and included in managements assessment. Prior to December
15, 20xx, XYZ Corporation had an inadequate system for recording cash receipts, which could have prevented the company from recording cash
receipts on accounts receivable completely and properly. Therefore, cash received could have been diverted for unauthorized use, lost, or other
otherwise not properly recorded to accounts receivable. We believe this condition was a significant deficiency in the design or operation of the
internal control of XYZ Corporation in effect prior to December 15, 20xx. Although the company implemented a new cash receipts system on
December 15, 20xx, the system has not been in operation for a sufficient period of time to enable us to obtain sufficient evidence about its
operating effectiveness.
[STANDARD WORDING FOR DEFINITION PARAGRAPH]
[STANDARD WORDING FOR INHERENT LIMITATIONS PARAGRAPH]
[OPINION PARAGRAPH]
In our opinion, except for the effect of matters we might have discovered had we been able to examine evidence about the effectiveness of the
new cash receipt system, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December
31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).
[EXPLANATORY PARAGRAPH REFERING TO THE AUDIT OF FINANCIAL STATEMENTS]
financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed a qualified opinion.

_____________________________
ABC CPA, LLP
March 31, 20xx
Figure 20-8 An Example of a Report Expressing an Unqualified Opinion on Financial Statements and an
Adverse Opinion on the Effectiveness of ICFR
[TITLE]
ABC CPA, LLP
[ADDRESSEE]
XYZ Corporation
[STANDARD WORDING FOR SCOPE PARAGRAPH]
detected on a timely basis. The following material weakness has been identified and included in managements assessment. XYZ Corporation
had an inadequate system for recording cash receipts, which could have prevented the company from recording cash receipts on accounts
receivable completely and properly. Therefore, cash received could have been diverted for unauthorized use, lost, or otherwise not properly
recorded to accounts receivable. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our
audit of the 20xx financial statements, and this report does not affect our report dated March 31, 20xx, on those financial statements.
[OPINION PARAGRAPH]
In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, XYZ
Corporation has not maintained effective internal control over financial reporting as of December 31, 20xx, based on criteria established in
Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
[STANDARD EXPLANATORY PARAGRAPH REFERING TO THE AUDIT OF FINANCIAL STATEMENTS]

_____________________________
ABC CPA, LLP
March 31, 20xx
547
548
20 Audit Report
Figure 20-9 An Example of a Report Expressing an Adverse Opinion on Financial Statements and an Adverse
Opinion on the Effectiveness of ICFR.
[TITLE]
ABC CPA, LLP
[ADDRESSEE]
XYZ Corporation
[STANDARD WORDING FOR SCOPE PARAGRAPH]
detected on a timely basis. We have identified the following material weakness that has not been identified as a material weakness in
managements assessment. [Include a description of the material weakness and its effect on the achievement of the objectives of the control
criteria.] This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 20xx
financial statements, and this report does not affect our report dated March 31, 20xx, on those financial statements.
[OPINION PARAGRAPH]
In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, XYZ
Corporation has not maintained effective internal control over financial reporting as of December 31, 20xx, based on criteria established in
Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
[STANDARD EXPLANATORY PARAGRAPH REFERING TO THE AUDIT OF FINANCIAL STATEMENTS]
financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed an adverse opinion.

_____________________________
ABC CPA, LLP
March 31, 20xx
Five Common Situations for Adding Explanatory Paragraphs or Modifying Wordings to a Standard
Unqualified Audit Report
There are five common situations that may require the auditor to add an explanatory paragraph to or modify the
wordings to a standard unqualified audit report. They are:
1. Lack of Consistency in Applying GAAP
If there is a change in the accounting principle or in the method of its application that materially affects the
comparability of the financial statements, the auditor should report the change by adding an explanatory paragraph
after the opinion paragraph and by pointing to the footnote that discusses the change. For example:

XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY, SCOPE, AND OPINION PARAGRAPHS]
As discussed in Note 8 to the financial statements, the ABC Corporation changed its method of computing depreciation in 20xx.
XYZ CPA, LLP
March 31, 20xx
Examples of accounting changes that require adding an explanatory paragraph:

Change in accounting principle such as a change from straight-line to double declining balance depreciation
method.
Change in reporting entity such as a change from equity to consolidation method of reporting.
Correction of an error in principle such as a change form an unacceptable replacement cost to FIFO method
for inventory.
Examples of accounting changes that do not require adding an explanatory paragraph:
(usually disclosed in the footnotes)
Change in accounting estimate such as a change in the estimated service life of an asset for depreciation.
Correction of an error that does not involve an accounting principle such an adjustment for prior years
mathematical error.
Change in classification and reclassification such as a change from operating expenses to administrative
expenses.
Change expected to have a material future effect such as research and development projects that have
material future effect.
In addition, the selected accounting principle must:
Be appropriate in the circumstances for the client.
Reflect the underlying transactions and events in a manner that presents the financial position, results of
operations, and cash flows (i.e., the financial statements taken as a whole) stated within a range of acceptable
limits.
Reflect information presented in the financial statements that is classified and summarized in a reasonable
manner.
2. Substantial Doubt about Going Concern (AU 570 Going Concern)
When there is substantial doubt about a clients ability to continue as a going concern, the auditor should add an
explanatory paragraph detailing the issues relating to the going concern judgment. For example:
XYZ CPA, LLP
ABC Corporation
The accompanying financial statements have been prepared assuming that ABC Corporation will continue as a going concern. As discussed in
Note 10 to the financial statements, ABC Corporation has suffered recurring losses from operations and has a net capital deficiency that raise
substantial doubt about the companys ability to continue as a going concern.
XYZ CPA, LLP
March 31, 20xx
549
550
20 Audit Report
In addition, the auditor may express a disclaimer of opinion when there is substantial doubt about a clients ability to
continue as a going concern and the clients financial statements adequately disclose its financial difficulties.
3. Auditor Agrees with a Departure from GAAP
In some unusual situations, financial statements may be misleading if a promulgated accounting principle was
followed. In such situations, the auditor should add an explanatory paragraph describing the agreed departure from
GAAP, the effect of the departure, and reasons that compliance with the GAAP would have resulted in misleading
4. Emphasis of a Matter
Under certain circumstances, an auditor may want to emphasize a specific matter, even though s/he intends to issue
a standard unqualified report. The auditor usually adds a paragraph above the opinion paragraph to draw attention to
the emphasized matter. For example:
XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPHS]
As discussed in Note 12 to the financial statements, the ABC Corporation has a number of significant related-party transactions and important
events occurring
balance sheet date of December 31, 20xx.
5. Report
involving after
otherthe
auditors
[STANDARD WORDING FOR THE OPINION PARAGRAPH]
XYZ CPA, LLP
March 31, 20xx
5. Report Involving other Auditors

On some audit engagements, such as auditing consolidated financial statements, part of the audit (of subsidiary
companies) may be completed by another CPA firm. In such cases, the principal auditor (auditor of the parent
company) has three options:
Make no reference in the audit report
This option is usually followed when the other auditor audited an immaterial part of the consolidated financial
statements; the other auditor is well known or closely supervised by the principal auditor, or the principal auditor has
thoroughly reviewed the other auditors work.
Make reference in the audit report (A shared opinion report)
In a shared opinion report, the principal auditor modifies the wording to a standard unqualified audit report to
indicate the shared audits in the introductory paragraph; the shared responsibility in the scope paragraph, and the
shared opinion in the opinion paragraph. An example of the shared opinion report is presented in Figure 20-10.
Issue a qualified audit report
If the principal auditor is not willing to assume any responsibility for the work of the other auditor, s/he may issue a
qualified or disclaimer report. In addition, if the principal auditor is unable to be satisfied as to the independence and
professional reputation of the other auditor, s/he may issue a qualified or disclaimer report. Finally, if the other
auditor qualified his/her part of the audit, the principal auditor may decide to issue a qualified report.
Figure 20-10 An Example of a Shared Opinion Audit Report

XYZ CPA, LLP
ABC Corporation
We have audited the consolidated balance sheets of ABC Corporation as of December 31, 20xx, and the related consolidated statements of
income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial
statements of DEF Company, a consolidated subsidiary in which the ABC Corporation had an equity interest of 70% as of December 31, 20xx.
Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amount
included for DEF Company, is based solely on the report of the other auditors.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of ABC Corporation as of December 31, 20xx, and the consolidated results of its
operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
XYZ CPA, LLP
March 31, 20xx
The Auditors Qualified Audit Report

There are three types of qualified audit report (qualified, disclaimer, or adverse) depending on three situations
(scope limitation, departure from GAAP, or lack of independence) and three levels of materiality (immaterial,
material, or pervasively material). The three types of qualified audit report are:
Type 1 Qualified Opinion
The auditor issues a qualified opinion when either a scope limitation or a departure from GAAP exists, but overall
the financial statements present fairly in conformity with GAAP. In a qualified report, the auditor describes the
nature of the scope limitation and effects of the GAAP departure on the financial statements and indicates in the
opinion paragraph that the financial statements present fairly except for the departure or scope limitation.
Type 2 Disclaimer of Opinion
The auditor disclaims an opinion on the financial statements either because there is insufficient appropriate evidence
to form an opinion on the overall financial statements or because there is a lack of independence. In a disclaimer, the
auditor explains the reasons for withholding an opinion and explicitly indicates that no opinion is expressed.
Type 3 Adverse Opinion
The auditor issues an adverse opinion when the financial statements do not present fairly due to a GAAP departure
that materially affects the overall financial statements. In an adverse report the auditor explains the nature, size, and
effects of the misstatement and states in the opinion paragraph that the financial statements do not present fairly in
accordance with GAAP.
551
552
20 Audit Report
The three situations resulting in a qualified audit report are:

Situation 1 Scope Limitation
When the auditor has not accumulated sufficient evidence to conclude whether financial statements are stated in
accordance with GAAP, a scope limitation exists. There are two major causes of scope limitations: limitations
imposed by the client and those caused by circumstances beyond the either the clients or auditors control. An
example of a client limitation is managements refusal to permit the auditor to confirm material accounts receivables
or to physically observe inventory count. An example of a limitation caused by circumstances is the clients lawyer
refuses to sign and return the lawyer representation letter.
When there is a scope limitation, the auditor should perform alternative procedures to gather sufficient
evidence. If there is sufficient evidence using alternative procedures, an unqualified report is appropriate. However,
if alternative procedures cannot be performed, a qualified opinion or disclaimer of opinion is appropriate depending
on materiality.
A qualified opinion on scope limitation requires adding a third paragraph before the opinion paragraph to
describe the limitation. A disclaimer of opinion on scope limitation requires modifying the wordings of the
introductory paragraph from We have audited ... to We were engage to audit ... The scope paragraph is deleted
to avoid stating anything that might lead readers to believe that other parts of the financial statements were audited
and therefore might be fairly stated. A second paragraph is added to describe the limitation and state unable to
gather evidence by using alternative audit procedures.
Situation 2 Departure from GAAP
A departure from GAAP exists when the financial statements are prepared or presented in a manner that departs
from GAAP, whether due to error or fraud. An example of a departure from GAAP is when the client insists on
using replacement costs for fixed assets or values inventory at selling price rather than historical cost. If the financial
statements are materially affected by a departure from GAAP, the auditor should issue a qualified or adverse
opinion, depending on materiality.
A qualified opinion on departure from GAAP requires adding an explanatory paragraph before the opinion
paragraph to disclose the effects of the departure on the financial statements and the opinion includes the words
except for... An adverse opinion on departure from GAAP also requires adding an explanatory paragraph before
the opinion paragraph to disclose the effects of the departure on the financial statements and the opinion paragraph
is modified to state that the financial statements do not present fairly in conformity with GAAP.
Situation 3 Lack of Independence
A lack of independence arises when the auditor and the client have any financial or business relationship that does
not comply with the second general standard of the GAAS and Rule 101 of the Code of Professional Conduct. If the
auditor is not independent, a disclaimer of opinion must be issued at all-time regardless of materiality. In a
disclaimer of opinion, the auditor should not state the reasons for the lack of independence not describe any audit
procedures performed. This requirement is intended to prevent the auditor from attempting to minimize or explain
away the circumstances. Also, a title is not required in the disclaimer report.
A common definition of materiality is that a misstatement in the financial statements can be considered material if
knowledge of the misstatement will affect a decision of a reasonable user of the financial statements. The three
levels of materiality consideration in issuing an audit report are:
Level 1 Immaterial
When a misstatement in the financial statements exists but is unlikely to affect the decisions of a reasonable user, it
is considered to be immaterial. An unqualified opinion is therefore appropriate. For example, management recorded
prepaid insurance as an asset in the previous year and decides to expense it in the current year to reduce recordkeeping costs. Management has failed to follow GAAP, but if the amounts are small that is unlikely to affect the
decisions of a reasonable user of the financial statements, a standard unqualified audit report is appropriate.
Level 2 Material
The second level of materiality exists when a misstatement in the financial statements would affect a users decision,
but the overall statements are still fairly stated and therefore useful. In other words, amounts are material but do not
overshadow the financial statements as a whole. For example, a large misstatement in fixed assets might affect a
users willingness to loan money to a client if the assets were the collateral. However, a misstatement of fixed assets
does not mean that cash, accounts receivable, and other parts of the financial statements, taken as a whole, are
materially misstated. When the auditor concludes that a misstatement is material but does not overshadow the
financial statements, taken as a whole, a qualified opinion using the words except for is appropriate.
The auditor judges whether a GAAP departure (Situation 2) misstatement is material based on three factors:
1. The concept of materiality discussed in Chapter 9. The auditor compares the total amount of misstatement to an
appropriate base (e.g., total assets) and uses a rule of thumb (e.g., the 5% rule) to evaluate the materiality of the
misstatement. To evaluate materiality of the financial statements, taken as whole, the auditor should combine all
unadjusted misstatements and consider whether there are individually immaterial misstatements that, when
combined, become material. The extent (pervasiveness) to which these misstatements affect other parts of the
financial statements should also be considered.
2. Measurability. The dollar amount of some misstatements may not be accurately measured. For example, any
misstatement in the fair value measurement of an acquisition (in business combination) subsequent to the balance
sheet date may be difficult to determine during the year-end audit. In this situation, the auditor should consider the
effect on statement users of the failure to make the disclosure.
3. Quality. The decision of a user may be affected by the quality of the misstatement. Qualitative factors include:
a. A immaterial misstatement that is illegal or fraudulent.
b. A misstatement may materially affect some future periods, even though it is immaterial when only the current
period is considered.
c. A misstatement has a psychic effect, for example, the misstatement changes a small loss to a small profit,
maintains a trend of increasing earnings, or allows earnings to exceed analysts expectation.
d. A misstatement may be important in terms of possible consequences arising from contractual obligations. For
example, the effect of failure to comply with a debt covenant may result in a material loan being recalled.
The auditor judges whether a scope limitation (Situation 1) misstatement is material based on the same
three factors above, but with one difference the effect of potential misstatements, rather than known misstatements
(as in the case of departure from GAAP) in determining whether an unqualified opinion, a qualified opinion, or a
disclaimer of opinion is appropriate. For example, if the auditor is prevented from observing physical inventory
count, the auditor must evaluate the potential misstatement in inventory account and decide how materially the
financial statement could be affected.
Level 3 Pervasively Material
The highest level of materiality exists when users are likely to make incorrect decisions if they rely on the overall
financial statements. When determining whether a misstatement is highly material, the extent to which the
misstatement affects different parts of the financial statements must be considered this is called pervasiveness. For
example, if inventory is the largest balance on the financial statements, a large misstatement would extensively
affect other parts of the financial statement that the auditors report should indicate the financial statements, taken
as a whole, cannot be considered fairly stated. When the highest level of materiality exists, the auditor should issue
either a disclaimer of opinion or an adverse opinion, depending on which situations (scope limitation or departure
from GAAP) exist. In the case of a lack of independence (Situation 3), a disclaimer must be issued at all-time
regardless of the level of materiality. This strict requirement reflects the importance of auditor independence under
Rule 101 of the Code of Professional Conduct (Recall Chapter 3).
553
554
20 Audit Report
Table 20-1 presents a matrix of the three types of qualified audit report depending on the three situations and the
three levels of materiality.
Table 20-1 Three Types of Qualified Audit Report Depending on Three Situations and Three Levels of
Materiality
Type of Qualified Audit Report
Qualified
The auditors opinion states,
except for the financial
statements present fairly
Disclaimer
The auditors opinion states, we do
not express an opinion on the
Adverse
The auditors opinion states,
the financial statements do not
present fairly
Scope limitation
When the auditor is unable to
accumulate
sufficient
evidence. The scope limitation
can be client-imposed (e.g.,
managements
refusal
to
provide certain evidence;
missing part of the financial
statements) or conditionimposed (e.g., auditor is
unavailable to observe the
inventory count; inadequate
accounting records; clients
lawyer refusal to sign lawyer
representation letter).
Material Users decisions

are likely to be affected by the
exceptions.
(1) Add a third paragraph to
explain the scope limitation and
state unable to gather the evidence
by
applying
other
audit
procedures.
(2) State in the opinion paragraph
the possible effects of the scope
limitation
on
the financial
statements.
See Figure 20-11.
Pervasively material Users

decisions are likely to be
extensively affected by the
exceptions.
(1) Modify introductory paragraph to
We were engaged to audit
(2) Omit the scope paragraph.
(3) Add a second paragraph to
explain the scope limitation and state
unable to gather the evidence by
applying other audit procedures.
See Figure 20-12.
Not Applicable the

auditor has no reasonable
basis to state that the
financial statements do not
present fairly.
Departure from GAAP

When the financial statements
are affected by a departure
from GAAP (e.g., fail to
disclose illegal act; omit
certain financial statements;
fail to justify/report accounting
change).
Material Users decisions

are likely to be affected by the
exceptions.
Add a third paragraph to describe
the departure from GAAP.
See Figure 20-13
Situation
Lack of independence
When the auditor does not
comply with the second
standard and Rule 101 of the
Code of Professional Conduct.
In addition, when the auditor
is associated with financial
statements that were not
audited or reviewed by
him/her.
Not Applicable
Not Applicable the

auditors are expected to determine
the effect of a departure from
GAAP.
Regardless of materiality
the auditor issues a disclaimer at
all time.
(1) No title is required.
(2) No reasons for the lack of
independence are offered.
(3) Must not include piece meal
opinions on specific accounts of the
See Figure 20-15
Pervasively material
Users decisions are likely to
be extensively affected by
the exceptions.
Add a third paragraph to
describe the departure from
GAAP.
See Figure 20-14
Not Applicable
Figure 20-11 Qualified Opinion due to Scope Limitation

XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH]
Except as discussed in the following paragraph, we conducted our audit [SAME WORDING AS FOR THE REMAINDER OF THE
STANDARD SCOPE PARAGRAPH].
We were unable to obtain audited financial statements supporting the Corporations investment in a foreign affiliate stated at $10,000,000 at
December 31, 20xx, or its equity in earnings of that affiliate of $1,000,000, which is included in net income for the years then ended as
described in Note 14 to the financial statements, nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign
affiliate or the equity in its earnings by other audit procedures.
In our opinion, except for the effects of such adjustments, if any, as might have been determined to be necessary had we been able to examine
evidence regarding the foreign affiliate and earnings, the financial statements referred to [SAME WORDING AS FOR THE
REMAINDER OF THE STANDARD OPINION PARAGRAPH].
XYZ CPA, LLP
March 31, 20xx
Figure 20-12 Disclaimer of Opinion due to Scope Limitation

XYZ CPA, LLP
ABC Corporation
We were engaged to audit [SAME WORDING AS FOR THE REMAINDER OF THE INTRODUCTORY PARAGRAPH]
[THE STANDARD SCOPE PARAGRAPH IS OMITTED]
We were unable to obtain audited financial statements supporting the Corporations investment in a foreign affiliate stated at $10,000,000 at
December 31, 20xx, or its equity in earnings of that affiliate of $1,000,000, which is included in net income for the years then ended as
described in Note 14 to the financial statements, nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign
affiliate or the equity in its earnings by other audit procedures.
Since we were unable to obtain audited financial statements and we were unable to satisfy ourselves as to the carrying value of the
investment, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements.
XYZ CPA, LLP
Figure
Qualified Opinion due to Departure from GAAP
March 21-6
31, 20xx
555
556
20 Audit Report
Figure 20-13 Qualified Opinion due to Departure from GAAP

XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPH]
The Corporation has excluded, from property and debt in the accompanying balance sheets, certain lease obligations that, in our opinion,
should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property
would be increased by $8,000,000, long-term debt by 7,000,000, and retained earnings by $600,000 as of December 31, 20xx, respectively.
Additionally, net income would be increased by $600,000 and earnings per share would be increased by $2.50, respectively.
In our opinion, except for the effects of not capitalizing obligations as discussed in the preceding paragraph, the financial statements referred
to [SAME WORDING AS FOR THE REMAINDER OF THE STANDARD OPINION PARAGRAPH].
XYZ CPA, LLP
March 31, 20xx
Figure 20-14 Adverse Opinion due to Departure from GAAP

XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPH]
should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized,
property would be increased by $8,000,000, long-term debt by 7,000,000, and retained earnings by $600,000 as of December 31, 20xx,
respectively. Additionally, net income would be increased by $600,000 and earnings per share would be increased by $2.50, respectively.
In our opinion, because of the effects of the matters discussed in the preceding paragraph, the financial statements referred to above do not
present fairly, in conformity with generally accepted accounting principles, the financial position of ABC Corporation as of December 31,
20xx, or the results of its operation or its cash flows for the years then ended.
XYZ CPA, LLP
March 31, 20xx
Figure 20-15 Disclaimer of Opinion due to Lack of Independence

We are not independent with respect to ABC Corporation, and the accompanying balance sheet as of December 31, 20xx, and the related
statements of income, retained earnings, and cash flows for the year then ended were not audited by us. Accordingly, we do not express
an opinion on them.
Other Types of Audit Report

In addition to the type of audit reports discussed above, auditors report several other types of audit reports. A brief
discussion on seven other types of audit report is provided in Table 20-2.
Table 20-2 Other Types of Audit Report
Comparative financial
statements.
Other information in
documents containing
The phrase financial statements taken as a whole in the fourth reporting standard applies to current period
statements and prior period comparative statements. AU 700 Forming an Opinion and Reporting on Financial
Statements states the requirements concerning comparative financial statements as follows:
(1) General requirements
Continuing auditor (include continuing auditor through merger of CPA firms) should: (a) Update (not
reissue) the prior period audit report. (b) Date the comparative statements as of the date of completion of the
most recent audit. (c) Alert for circumstances or events affecting prior period financial statements.
(2) No update of prior period audit report is required
For example, prior years financial statements are restated following a pooling of interest in the current year,
which is a change in the reporting entity that requires restating financial statements of all prior periods
presented, but which does not affect the audit report (opinion) issued in all periods. Continuing auditor may
issue different opinions on comparative statements, for example, (a) a standard unqualified opinion on prior
years financial statements but qualifies the current year opinion. See Figure 20-16 for an example. (b) a
standard unqualified opinion for the current year financial statements but qualified or disclaimed prior years
financial statements. See Figure 20-17 for an example.
(3) Update of prior period audit report is required
For example, prior years financial statements are restated to conform with GAAP, which removes the
previously qualified opinion due to a departure from GAAP, and should be updated in the current period audit
report. The current auditor should update the opinions of prior period financial statements by adding an
explanatory paragraph above the opinion paragraph of current period financial statement to disclose: (a) The
date of the previous report. (b) The type of opinion previously expressed. (c) The circumstances or events that
resulted in a different opinion. (d) Notification that the updated opinion differs from the previous opinion. See
Figure 20-18 for an example.
(4) Client specifically requests the predecessor auditor (not the continuing auditor) to reissue audit
reports of prior period financial statements
The predecessor auditor should: (a) Read the financial statements of the current period. (b) Compare the prior
period financial statements reported on with the current year financial statements. (c) Obtain a representation
letter from the successor auditor which should state whether the successor auditor discovered any material
items that might affect, or require disclosure in, the financial statements reported on by the predecessor
auditor. (d) Obtain a representation letter from the management which should state whether the management
knew of new events that might affect, or require disclosure in, the financial statements reported on by the
predecessor auditor. (e) Make inquiries and perform any procedures considered necessary on items or events
that affect prior period financial statements.
(5) Report options involving predecessor auditor include:
(a) Predecessor auditor may reissue the prior period report without any revision by using the date of the
previously issued report. (b) Predecessor auditor may revise the prior period report by dual dating (recall dual
date concept in Chapter 20) the reissued report. (c) Predecessor auditors report is not presented (included): (i)
The prior report is unqualified (standard). The successor auditor should indicate in the introductory paragraph
that the prior period statements were audited by another auditor (should not name the predecessor auditor) and
mention the date and the type of report issued by the predecessor auditor. See Figure 20-19 for an example.
(ii) The prior report is qualified (not standard). The successor auditor should describe in the introductory
paragraph the nature of and reasons for an explanatory paragraph added to the predecessors report. See
Figure 20-20 for an example.
6. Prior period comparative statements were un-audited (e.g., a nonpublic company) but current period
statements are audited
In these circumstances, the audit report on comparative statements presented in documents filed with the SEC
would not refer to the un-audited statements, and these statements should be clearly marked as un-audited,
and either (1) the audit report on the prior period should be reissued, or (2) the audit report on the current
period should include as a separate paragraph an appropriate description of the responsibility assumed for the
financial statements of the prior period.
See Figure 20-22 for a memory aid diagram.
A client may publish many documents that contain other information in addition to audited financial
statements and the audit report. For example, the presidents letter in the annual report. AU 720, Other
Information in Documents Containing Audited Financial Statements , states that the auditor has no
responsibility to other information; and no obligation to perform any audit procedures to corroborate the other
information. However, the auditor is required to read the other information and consider whether such
information is consistent with the information contained in the audited financial statements. If a material
inconsistency exists, the auditor should request the client to revise the other information. If the other
information were not revised, the auditor should revise the audit report to include an explanatory paragraph in
557
558
20 Audit Report
Required
supplementary information.
Condensed financial
statements and selected
financial data.
Letters for underwriters

and certain other requesting
parties
Filling under federal

securities status.
Financial statements
prepared for use in other
countries.

the audit report, withhold the audit report, or withdraw from the engagement.
AU 730 Required Supplementary Information describes procedures in an audit of financial statements
containing supplementary information required by the FASB and GASB as follows:
(1) The auditor does not need to audit the supplementary information. However, the auditor should apply
limited procedures and report deficiencies in, or the omission of, such information.
(2) Examples of limited procedures include (a) Inquiry of management about the methods of preparing the
information, and (b) Comparing the information for consistency within audited financial statements.
(3) Deficiencies in, or the omission of, the supplementary information include (a) Information is omitted. (b)
Measurement or presentation departs materially from prescribed FASB or GASB guidelines. (c) Auditor is
unable to complete the prescribed procedures. (d) Auditor has substantial doubt about conformity with
prescribed guidelines.
(4) Deficiencies in, or the omission of, the supplement information do not affect the auditors opinion on the
basic financial statements. However, the auditor needs to add an explanatory paragraph to the audit report to
refer to the deficiencies in, or the omission of, the supplementary information. See Figure 20-21 for an
example.
AU 810 Engagements to Report on Summary Financial Statements states that the auditor may report (e.g.,
when asked by the client to do so) on condensed financial statements and selected financial data that are
derived from audited financial statements as follows: The auditors report should
(1) State that the auditor has audited and expressed an opinion on the complete financial statements.
(2) Provide the date of the report on the complete statements.
(3) Indicate the type of opinion expressed on the complete statements.
(4) Express an opinion as to whether the information in the condensed financial statements or selected
financial data is fairly stated in all material respects in relation to the complete statements.
Investment banking firms that underwrite a securities issue often request independent auditors who audited
the financial statements and schedules in the registration statement to issue a letter, known as a comfort
letter, for the underwriters. The comfort letter helps the underwriters in fulfilling their obligation to perform
a reasonable investigation of the securities registration statement. AU 920 Letter for Underwriters and
Certain Other Requesting Parties , provides guidance that an auditors comfort letter may include the
following subjects:
(1) The independence of the auditors.
(2) Whether the audited financial statements and schedules included in the registration statement comply with
the accounting requirements of the Securities Act of 1933 and related regulations.
(3) Un-audited financial statements; condensed interim financial information, and pro forma financial
information. For these financial statements and information, known as capsule information, the auditor may
provide negative assurance if the auditor has reviewed them in accordance with AU 930 Interim Financial
Information.
(4) Changes in selected financial statement items during a period subsequent to the date and period of the
latest financial statements included in the registration statement.
(5) Table, statistics, and other financial information included in the registration statements.
(6) Negative assurance as to whether certain non-financial statement information included in the registration
statement complies with SEC regulations.
According to AU 925 Filings With the U.S. Securities and Exchange Commission Under the Securities Act of
1933:
(1) When an auditor issues a review report after reviewing un-audited interim financial information; and if the
review report is presented in a registration statement filed with the SEC, the prospectus (filed with the
registration statement) should include a statement clarifying that the auditors review report is not part of the
registration statement within the meaning of the Securities Act of 1933.
(2) The auditor is responsible to make a reasonable investigation on subsequent events occurred from the
date of the review report to the effective date of the registration statement. The auditors reasonable
investigation includes (a) Apply the normal audit procedures on subsequent events. (b) Read the prospectus
and the registration statements. (c) Obtain written representation from the client about subsequent events.
(3) A predecessor auditor has the same responsibility for material subsequent events affecting the prior period
financial statements. Ordinarily, the predecessor auditor would obtain a letter of representation concerning the
subsequent events from the successor auditor.
The auditors report on financial statements prepared in conformity with GAAP of another country depends
on the intended use of the financial statements. AU 910 Financial Statements Prepared in Accordance With a
Financial Reporting Framework Generally Accepted in Another Country states that:
(1) If the use is only outside of the U.S., the report may either be (a) the U.S. - style auditors report modified
for the accounting principles of another country, or (b) the standard report of the other country.
(2) If the use is also within the U.S., the U.S. - style auditors report should be used with a qualified or
adverse opinion, depending on the materiality of departures from the U.S. GAAP.
(3) In the case of 1(a) above, the modification to the U.S. - style audit report include: (i) The introductory
paragraph should state that the financial statements are prepared on the basis of accounting principles
generally accepted in (name of country). (ii) The scope paragraph should indicate that the audit was made in
accordance with the standards of the Public Company Accounting Oversight Board in the United States and,
if appropriate, the auditing standards of (name of country). (iii) The opinion paragraph should state in
conformity with generally accepted accounting principles in (name of country).
(4) In the case of 1(b) above, the auditor should (i) ascertain that the report would be used by auditors in the

other country in similar circumstances, and (ii) understand, and be in a position to make, the attestations
contained in such a report. The attestations may include explicit or implicit assurance of statutory compliance
with the local laws.
The U.S. auditor is responsible to clearly understand the accounting principles generally accepted in the other
country; obtain written representations from management about the purpose and uses of the statements, and
comply with the general and field work standards of the U.S. GAAS.
Figure 20-16 Unqualified in Prior Years but Qualified in Current Year for Not Been in Conformity with
GAAP
XYZ CPA, LLP
ABC Corporation
should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property
would be increased by $8,000,000, long-term debt by 7,000,000, and retained earnings by $600,000 as of December 31, 2011, respectively.
Additionally, net income would be increased by $600,000 and earnings per share would be increased by $2.50, respectively.
In our opinion, because of the effects of the matters discussed in the preceding paragraph, the financial statements referred to above do not
present fairly, in conformity with generally accepted accounting principles, the financial position of ABC Corporation as of December 31,
2011, or the results of its operation or its cash flows for the years then ended.
XYZ CPA, LLP
March 31, 2012
Figure 20-17 Disclaimer for a Scope Limitation in Prior Years but Unqualified in Current Year
XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH]
Except as explained in the following paragraph [SAME WORDING AS FOR THE REMAINDER OF THE STANDARD SCOPE
PARAGRAPH]
We did not observe the taking of the physical inventory as of December 31, 2011, since that date was prior to our appointment as auditors
for the Corporation, and we were unable to satisfy ourselves regarding inventory quantities by means of other auditing procedures.
Inventory amounts as of December 31, 2011, enter into the determination of net income and cash flows for the year ended December 31,
2012.
Because of the matter discussed in the preceding paragraph, the scope of our work was not sufficient to enable us to express, and we do not
express, an opinion on the results of operations and cash flows for the year ended December 31, 2012.
In our opinion, the balance sheets of ABC Corporation as of December 31, 2013 and 2012, and the related statements of income, retained
earnings, and cash flows for the year ended December 31, 2013, presented fairly, in all material respects, the financial position of ABC
Corporation as of December 31, 2013 and 2012, and the results of its operations and its cash flows for the year ended December 31, 2013, in
conformity with generally accepted accounting principles, the financial position of ABC Corporation.
XYZ CPA, LLP
March 31, 2014
559
560
20 Audit Report
Figure 20-18 Update Prior Year Report in Current Year Report

XYZ CPA, LLP
ABC Corporation
In our report dated March 31, 2012, we expressed an opinion that the 2011 financial statements did not fairly present financial position,
results of operations, and cash flows in conformity with generally accepted accounting principles because of two departures from such
principles: (1) the Corporation carried its property, plant, and equipment at appraisal values, and provided for depreciation on the basis of
such values, and (2) the Corporation did not provide for deferred income taxes with respect to differences between income for financial
reporting purposes and taxable income. As described in Note 10, the Corporation has changed its method of accounting for these items and
restated its 2011 financial statements to conform with generally accepted accounting principles. Accordingly, our present opinion on the
2011 financial statements, as presented herein, is different from that expressed in our previous report.
XYZ CPA, LLP
March 31, 2013
Figure 20-19 Example of a Successor Auditors Unqualified Report When the Predecessor Auditors
Unqualified Report is Not Presented
XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH] We have audited the balance sheet of ABC Corporation as of
December 31, 2012 [BUT ADD A REFERENCE TO PREDECESSORS REPORT] The financial statements of ABC Corporation as
of December 31, 2011, were audited by other auditors whose report dated March 31, 2012, expressed an unqualified opinion on those
statements.
[STANDARD WORDING FOR THE SCOPE PARAGRAPH]
[STANDARD OPINION PARAGRAPH EXCEPT CHANGE THE FIRST LINE] In our opinion, the 2012 financial statements referred to
above presented fairly, in all material respects, the financial position of ABC Corporation as of December 31, 2012, and the results of its
operation or its cash flows for the years then ended in conformity with generally accepted accounting principles.
XYZ CPA, LLP
March 31, 2013
Figure 20-20 Example of a Successor Auditors Unqualified Report When the Predecessor Auditors
Qualified (Not Standard) Report is Not Presented
XYZ CPA, LLP
ABC Corporation
[STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH] We have audited the balance sheet of ABC Corporation as of
December 31, 2012 [BUT ADD A REFERENCE TO THE EXPLANATORY PARAGRAPH OF THE PREDECESSORS REPORT]
The financial statements of ABC Corporation as of December 31, 2011, were audited by other auditors whose report dated March 31, 2012,
on those statements included an explanatory paragraph that described the change in the Corporations method of computing depreciation
discussed in Note 16 to the financial statements.
[STANDARD WORDING FOR THE SCOPE PARAGRAPH]
[STANDARD OPINION PARAGRAPH EXCEPT CHANGE THE FIRST LINE] In our opinion, the 2012 financial statements referred to
above presented fairly, in all material respects, the financial position of ABC Corporation as of December 31, 2012, and the results of its
operation or its cash flows for the years then ended in conformity with generally accepted accounting principles.
XYZ CPA, LLP
March 31, 2013
Figure 20-21 Auditor Adds an Explanatory Paragraph to Refer to Deficiencies in, or the Omission of,
Required Supplementary Information
XYZ CPA, LLP
ABC Corporation
The ABC Corporation has not presented a schedule of insurance coverage that the Financial Accounting Standards Board has determined is
necessary to supplement, although not required to be part of, the basic financial statements.
XYZ CPA, LLP
March 31, 20xx
561
562
20 Audit Report
Figure 20-22 A Memory Aid on Audit Reports for Comparative Financial Statements
Comparative Financial Statements
Prior A/R
no update
is required
Prior A/R
update is
required
Provide a different
opinion in the
current A/R
is acceptable
(See Figure 20-17)
Add an explanatory
paragraph above the
opinion paragraph
in the current A/R
(See Figure 20-18)
Reissue with
no change in the
prior A/R date
OR
Prior A/R
reissue is
requested
Mark prior F/S not audited

and either reissue prior A/R
or add an explanatory paragraph
in the current A/R to describe
the assumed responsibility for
the prior F/S
Reissue with
dual-dating in
the prior A/R
Prior A/R is not

included in
the current A/R
Prior A/R is
Unqualified
No naming the prior

auditor but mention the
date and type of prior
A/R in the introductory
paragraph of the current
A/R
(See Figure 20-19)
A/R = Audit Report

F/S = Financial Statements
Prior F/S
is not
audited
Prior A/R is
Qualified
No naming the prior auditor

but mention the nature
of and reasons for an
explanatory paragraph
added to the prior A/R in the
introductory paragraph
of the current A/R
(See Figure 20-20)
SECs Corporate Responsibilities Rules on Financial Reporting

responsibilities are to oversee the audits of public companies that are subject to the securities laws. These
responsibilities include overseeing the corporate responsibilities rules on financial reporting under the Act. If the
PCAOB determines that any public company has engaged in practices in violation of the rules, the Board may
impose sanctions, including a fine of not more than $5 million and/or imprisonment of up to 20 years. Sections of
the corporate responsibilities rules on financial reporting are as follows:
Section 302 Corporate Responsibilities for Financial Reporting
Section 302 of the Sarbanes-Oxley Act requires the SEC to adopt rules requiring the CEO and CFO to certify in
each quarterly and annual report filed by the company in accordance with the Securities Exchange Act of 1934. In
response, in August 2002, the SEC issued a final rule, Certification in Companies Quarterly and Annual Repor ts,
which requires a public companys CEO and CFO each to certify, with respect to the companys quarterly and
annual reports filed under new Sections 13a-15 and 15d-15 of the Securities Exchange Act of 1934, that:
1. They have reviewed the report being filed.
2. Based on their knowledge, the report does not contain any untrue statement or omit any material facts.
3. Based on their knowledge, the financial statements fairly present in all material respects the financial condition,
results of operations, and cash flows of the company (terms are not similar to AU 700 Forming an Opinion and
Reporting on Financial Statements, see discussion below).
4. They are responsible for establishing and maintaining disclosure controls and procedures (new terms see
discussion below) for the company and have:
a. Designed such disclosure controls and procedures to ensure that material information is made known to them.
b. Evaluated the effectiveness of the disclosure controls and procedures within 90 days prior to the filing date of the
report.
c. Present in the report their conclusions about the effectiveness of the disclosure controls and procedures.
5. Based on their evaluation of the effectiveness of the disclosure controls and procedures, they have disclosed to
the audit committee:
a. All significant deficiencies in the design or operation of internal controls, that could adversely affect the
companys ability to record, process, summarize, and report financial data.
b. Any fraud, whether or not material, that involves management or other employees with a significant role in the
companys internal control.
6. They have indicated in the report any significant changes in internal controls subsequent to their evaluation of the
effectiveness of the disclosure control and procedures.
The terms financial condition, results of operations, and cash flows in point 3 above refer to all financial
information in the annual or quarterly report, including the financial statements, footnote disclosures, selected
financial data, managements discussion and analysis (MD&A), results of operations, and other financial
information in the report. The terms fairly present in point 3 above does not limit the certification to a
representation that financial information is fairly presented in accordance with GAAP. Footnote 55 of the final rule
states that presenting financial information in conformity with [GAAP] may not necessarily satisfy obligations
under the antifraud provisions of federal securities laws. The SECs interpretation is that Congress intended this
certification to provide assurances that the financial information presented in the annual or quarterly report meets a
standard of accuracy and completeness that is broader than the financial reporting requirements of GAAP. The new
terms disclosure controls and procedures in point 4 above refer to controls and other procedures of a company that
are designed to ensure that information required to be disclosed by the company in the reports that it files with the
SEC is recorded, processed, summarized and reported, in a timely manner. Note that existing Section 13 (b) (2) (B)
of the Securities Exchange Act of 1934 requires that companies establish and maintain systems of internal controls
with respect to financial reporting. The disclosure controls and procedures required by the new Section 13a-15 and
15d-15 of the Securities Exchanges Act of 1934 are in addition (and not in lieu of) those existing requirements. A
complete summary of the rule, Certification in Companies Quarterly and Annual Reports (Release No.33-8124, 3446427, IC-25722) is posted on the SECs Web site at http://www.sec.gov/rules/final/33-8124.htm/
563
564
20 Audit Report
Section 906 Failure of Corporate Officers to Certify Financial Reports

The CEO and CFO of a company must certify that the financial statements and disclosures fully comply with
provisions of the Securities Exchange Act and that they fairly present, in all material respects, the operations and
financial condition of the issuer. Maximum penalties for willful certification of the financial statements knowing
that they dont fully comply with the requirements are a fine of not more than $5million and/or imprisonment of up
to 20 years.
20-1
An auditors unqualified report

a. implies only that items disclosed in the financial statements and footnotes are properly presented and takes no position
on the adequacy of disclosure.
b. implies that disclosure is adequate in the financial statements and footnotes.
c. explicitly states that disclosure is adequate in the financial statements and footnotes.
d. explicitly states that all material items have been disclosed in conformity with generally accepted accounting principles.
20-2
The date of the audits opinion on a clients financial statements should be the date of the
a. closing the clients book
b. receipt of the clients letter of representation
c. completion of all important audit procedures.
d. submission of the report to the client.
20-3
If a principal auditor decides to refer in his report the audit of another auditor, the principal auditor should disclose the
a. name of the other auditor.
b. nature of the principal auditors review of the other auditors work.
c. portion of the financial statements audited by the other auditor.
d. reasons why the principal auditor is unwilling to assume responsibility for the other auditors work.
20-4
A client changed from the straightline method to the double declining-balance method of depreciation for all newly acquired assets.
This change has no material effect on the current years financial statements but is reasonably certain to have a substantial effect in
later years. If the change is disclosed in the notes to the financial statements, the auditor should issue a report with a (n)
a. qualified opinion.
b. unqualified opinion with explanatory paragraph.
c. unqualified opinion.
d. qualified opinion with explanatory paragraph regarding consistency.
20-5
An auditor will issue an adverse opinion if

a. the scope of the audit is limited by the client.
b. exception to the fairness of presentation is so material that an except for qualified opinion is not justified.
c. the auditor did not perform sufficient auditing procedures to form an opinion on the financial statements taken as a
whole.
d. major uncertainties exist concerning the companys future.
20-6
Under which of the following sets of circumstances should an auditor issue a qualified opinion?
a. The financial statements contain a departure from generally accepted accounting principles, the effect of which is
material.
b. The principal auditor decides to make reference to the report of another auditor who audited a subsidiary.
c. There has been a material change between periods in the method of the application of accounting principles.
d. There are significant uncertainties affecting the financial statements.
20-7
In which of the following situations would an auditor ordinarily choose between expressing an except for qualified
opinion and expressing an adverse opinion?
a. The auditor did not observe the clients physical inventory and is unable to become satisfied as to its balance by other
auditing procedures.
b. The financial statements fail to disclose information that is required by generally accepted accounting principles.
c. The auditor is asked to report only on the clients balance sheet and not on the other basic financial statements.
d. Events disclosed in the financial statements cause the auditor to have substantial doubt about the entitys ability to
continue as going concern.
20-8
An auditor includes a separate paragraph in an otherwise unmodified report to emphasize that the entity being reported
upon had significant transactions with related parties. The inclusion of this separate paragraph
a. is appropriate and would not negate the unqualified opinion.
b. is considered an except for qualification of the opinion.
c. violates generally accepted auditing standards if this information is already disclosed in footnotes to the financial
statements.
d. necessitates a revision of the opinion paragraph to include the phrase with the foregoing explanation.
565
566
20 Audit Report
20-9
When the limitation in scope is so material that a disclaimer opinion is required, the scope paragraph would
a. be qualified.
b. be deleted.
c. be expanded.
d. be unchanged.
20-10
A clients financial statements contain a departure from generally accepted accounting principles because, due to unusual
circumstances, the statements would otherwise be misleading. The auditor should express an opinion that is
a. unqualified but not mention the departure in the auditors report.
b. unqualified and describe the departure in a separate paragraph.
c. qualified and describe the departure in a separate paragraph.
d. qualified or adverse, depending on materiality, and describe the departure in a separate paragraph.
20-11
In which of the following circumstances would an auditor usually choose between issuing a qualified opinion and issuing a
disclaimer of opinion?
a. Departure from generally accepted accounting principles.
b. Inadequate disclosure of accounting policies.
c. Inability to obtain sufficient appropriate evidential matter.
d. Unreasonable justification for a change in accounting principle.
20-12
In which of the following situations would an auditor ordinarily issue an unqualified audit opinion without an explanatory
paragraph?
a. The auditor wishes to emphasize that the entity had significant related-party transactions.
b. The auditor decides to refer to the report of another auditor as a basis, in part, for the auditors opinion.
c. The entity issues financial statements that present financial position and results of operations but omits the statement of
cash flows.
d. The auditor has substantial doubt about the entitys ability to continue as a going concern, but the circumstances are fully
20-13
When an auditor encounters a situation involving more than one of the conditions requiring a departure from a standard
unqualified report, the auditor should modify his or her opinion of each condition unless one has the effect of neutralizing
the others. In which of the following situations would the auditor not include more than one modification in the report?
a. There is a material scope limitation, and there is a material GAAP violation.
b. There is a material GAAP violation, and the auditor is not independent.
c. There is a material scope limitation, and the auditor has substantial doubt about the companys going concern status.
20-14
Which of the following is not a cause of an explanatory paragraph or modified wording to be added to the standard
unqualified report?
a. Emphasis of a matter.
b. Reports involving other auditors.
c. Auditor disagrees with clients departure from GAAP.
d. Lack of consistent application of GAAP.
20-15
Which of the following is not one of the principal CPA firms options when issuing a report for which another CPA firm
performed part of the audit?
a. A qualified opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume
any responsibility for the work of the other auditor.
b. Make reference to the other auditor in the report by using modified wording (a shared opinion or report).
c. Make no reference to the other auditor in the report, and issue the standard unqualified report.
d. issue a joint report signed by both CPA firms.
20-16
For the audit report containing a disclaimer for lack of independence, the disclaimer is in the
a. fourth (explanatory) paragraph.
b. third (opinion) paragraph.
c. second (scope) paragraph.
d. first and only paragraph.
20-17
When there is uncertainty about an audit clients ability to continue as a going concern, the auditors concern is the
possibility that the client may not be able to continue its operations or meet obligations for a reasonable period of time.
For this purpose, a reasonable period of time is considered not to exceed
a. six months from the date of the financial statements.
b. six months from the date of the audit report.
c. one year from the date of the financial statements.
d. one year from the date of the audit report.
20-18
An audit client has presented all required financial statements with the exception of the statement of cash flows. The
auditor has completed the audit and is satisfied that the financial statements, with the exception of the missing statement of
cash flows, are presented fairly. In such a situation, the auditor
a. must issue a qualified opinion.
b. must issue an adverse opinion.
c. may issue either an unqualified or a qualified opinion.
d. may issue an unqualified opinion.
20-19
Whenever an auditor issues a qualified opinion, the implication is that the auditor
a. does not know if the statements are present fairly.
b. does not believe the statements are present fairly.
c. is satisfied that the statements are present fairly.
d. is satisfied that the statements are presented fairly except for a specific aspect of them.
20-20
When a misstatement in the financial statements would materially affect a users decision but the financial statements taken
as whole are still fairly stated, the auditor should issue
a. a qualified opinion.
b. an unqualified opinion.
c. an adverse opinion.
d. a disclaimer of opinion.
20-21
For a clients financial statements to be presented fairly in conformity with GAAP, it is not required that the accounting
principles selected
a. be appropriate in the circumstances for the particular client.
b. reflect transactions in a manner that presents the financial statements within a range of acceptable limits.
c. present information in the financial statements that is classified and summarized in a reasonable manner.
d. be applied on a basis consistent with those followed in the prior year.
20-22
For a clients financial statements to be presented fairly in conformity with GAAP, it is required that the accounting
principles selected
a. be approved by the Auditing Standards Board or the appropriate industry subcommittee.
b. reflect transactions in a manner that presents the financial statements within a range of acceptable limits.
c. match the principles used by most other clients within the clients particular industry.
d. be applied on a basis consistent with those followed in the prior year.
20-23
When financial statements contain a departure from GAAP because, due to unusual circumstances, the statements would
otherwise be misleading, the auditor should explain the unusual circumstances in a separate paragraph and express opinion
that is
a. unqualified.
b. qualified.
c. adverse.
d. a disclaimer.
567
568
20 Audit Report
20-24
How are managements responsibility and the auditors responsibility represented in the standard auditors report?
a.
b.
c.
d.
20-25
Managements Responsibility
Explicitly
Implicitly
Implicitly
Explicitly
Auditors Responsibility
Explicitly
Implicitly
Explicitly
Implicitly
An auditors responsibility to express an opinion on the financial statements is

a. implicitly represented in the auditors standard report.
b. explicitly represented in the opening paragraph of the auditors standard report.
c. explicitly represented in the scope paragraph of the auditors standard report.
d. explicitly represented in the opinion paragraph of the auditors standard report.
20-26
Which paragraph of an auditors standard report on financial statements should refer to GAAS and GAAP?
a.
b.
c.
d.
20-27
GAAS
Opening
Scope
Scope
Opening
GAAP
Scope
Scope
Opinion
Opinion
Which of the following statements is included in a standard audit report?

a. The auditor provides assurance that the financial statements are free of misstatement.
b. The auditor evaluates the overall internal controls relating to the financial statements.
c. An auditor includes assessing significant estimates made by management.
d. The auditor provides an opinion about the consistency of the financial statements with those of the prior period.
20-28
Which of the following representations does an auditor make explicitly and which implicitly when expressing an
unqualified opinion? (Hint: Think about the third standard of reporting)
a.
b.
c.
d.
20-29
Conformity with GAAP

Explicitly
Implicitly
Implicitly
Explicitly
Adequacy of Disclosure
Explicitly
Implicitly
Explicitly
Implicitly
A CPA is engaged by AA Corp., a client, to audit the financial statements of BB Corp., a company that is not the CPAs
client. AA Corp. expects to present BBB Corp.s audited financial statements with the CPAs audit report to Bank of
America to obtain financing in AA Corp.s attempt to purchase BB Corp. In these circumstances, the CPAs audit report
would usually be addressed to
a. AA Corp., the client that engaged the CPA.
b. BB Corp., the company audited by the CPA.
c. Bank of America.
d. Both AA Corp. and Bank of America.
20-30
In which of the following circumstances would an auditor usually choose between expressing a qualified opinion and
disclaiming opinion?
a. Departure from generally accepted accounting principles.
b. Inadequate disclosure of accounting policies.
c. Inability to obtain sufficient appropriate evidential matter.
d. Unreasonable justification for a change in accounting principle.
20-31
An auditor is prevented by the clients senior management and legal counsel from obtaining sufficient appropriate
evidence concerning a suspected illegal bribery scheme. Under these circumstances, the auditor should
a. express an unqualified opinion.
b. express a qualified opinion.
c. express a disclaimer opinion.
d. express an adverse opinion.
20-32
In which of following circumstances would an auditor issue a qualified opinion?

a. There has been a material change between periods in accounting principles.
b. Quarterly financial data required by the SEC have been omitted.
c. The auditor wishes to emphasize an unusually important subsequent event.
d. The auditor is unable to obtain audited financial statements of a consolidated investee.
20-33
A limitation on the scope of an audit sufficient to preclude an unqualified opinion will usually result when management
a. presents financial statements that are prepared in accordance with the cash receipts and disbursements basis of
accounting.
b. states that the financial statements are not intended to be presented in conformity with generally accepted accounting
principle.
c. does not make the minutes of the board of directors meetings available to the auditor.
d. asks the auditor to report on the balance sheet and not on the other basic financial statements, and the auditor is not
restricted to apply any audit procedures and access to any audit-related information.
20-34
When qualifying an opinion because of an insufficiency of audit evidence, an auditor should refer to the situation in the
a.
b.
c.
d.
20-35
Opening Paragraph
No
Yes
Yes
No
Scope Paragraph
No
No
Yes
Yes
If an auditor issues a qualified opinion because a major inadequacy of a clients computerized accounting records prevents
the auditor from applying necessary procedures, the opinion paragraph of the audit report should state that the qualification
pertains to
a. a client-imposed scope limitation.
b. a departure from generally accepted auditing standards.
c. the possible effects on the financial statements.
d. inadequate disclosure of necessary information.
20-36
Under which of the following circumstances would a disclaimer of opinion not be appropriate?
a. The auditor is unable to observe physical inventory counts or apply alternative procedures to verify their significant
balances.
b. The auditor is unable to determine the amount associated with significant fraud committed by the clients management.
c. The financial statements fail to contain adequate disclosure concerning related-party transactions.
d. The client refuses to permit its lawyer to furnish information requested in a letter of audit inquiry.
20-37
Which of the following situations would an auditor ordinarily choose between expressing a qualified opinion or an adverse
opinion?
a. The auditor did not confirm the clients accounts receivable and is unable to become satisfied as to its balance by
other auditing procedures.
b. The financial statements neither account for nor disclose a clients illegal act.
c. The auditor asked to report only the clients balance sheet and not the other basic financial statements.
d. Events disclosed in the financial statements cause the auditor to have substantial doubt about the clients ability to
continue as a going concern.
20-38
Which of the following phrases would an auditor most likely include in the auditors report when expressing a qualified
opinion because of inadequate disclosure?
a. Subject to the departure from generally accepted accounting principles, as described above.
b. With the foregoing explanation of these omitted disclosures.
c. Except for the omission of the information discussed in the preceding paragraph.
d. Does not present fairly in all material respects.
569
570
20 Audit Report
20-39
If a client issues financial statements that purport to present its financial position and results of operations but omits the
statement of cash flows, the auditor ordinarily will express a(n)
a. disclaimer of opinion.
b. qualified opinion.
c. review report.
d. unqualified opinion with a separate explanatory paragraph.
20-40
An auditor would express an unqualified opinion with an explanatory paragraph added to the auditors report for
a.
b.
c.
d.
20-41
An Unjustified Accounting Principle Change

Yes
Yes
No
No
A Material Weakness in Internal Control

Yes
No
Yes
No
When management does not provide reasonable justification for a change in accounting principle, and it presents
comparative financial statements, the auditor should express a qualified opinion
a. only in the year of the accounting principle change.
b. each year that the financial statements initially reflecting the change are presented.
c. each year until management changes back to the accounting principle formerly used.
d. if the change to an accounting principle is justified.
20-42
An auditor concludes that a clients illegal act, which has a material effect on the financial statements, is neither properly
accounted for nor disclosed. Depending on its materiality effect on the financial statements, the auditor should express
either a (an)
a. qualified opinion or an adverse opinion.
b. adverse opinion or a disclaimer of opinion.
c. unqualified opinion or a disclaimer of opinion.
d. unqualified opinion or adverse opinion.
20-43
An auditor may not express a qualified opinion when

a. a scope limitation prevents the auditor from completing a significant part of the audit.
b. the auditors report refers to the work of a specialist.
c. an accounting principle that is inconsistent with prior period is used.
d. the auditor lacks independence with respect to the client.
20-44
In which of the following circumstances would an auditor be most likely to express an adverse opinion?
a. Information comes to the auditors attention that raises substantial doubt about the clients ability to continue as a going
concern.
b. The CEO refuses the auditor access to minutes of board of directors meetings.
c. TOC show that the clients internal control is so poor that it cannot be relied upon.
d. The financial statements are not in conformity with the FASB Statements regarding the capitalization of leases.
20-45
An auditors report includes the following statement: The financial statements do not present fairly the financial position,
results of operations, or cash flows in conformity with generally accepted accounting principles. This auditors report was
most likely issued in connection with financial statements that are
a. inconsistent.
b. based on prospective financial information.
c. misleading.
d. affected by a material uncertainty that is properly disclosed.
20-46
When an auditor expresses an adverse opinion, the opinion paragraph should include
a. the principle effects of the departure from GAAP.
b. a direct reference to a preceding paragraph explaining the basis for the opinion.
c. the substantive reasons for the financial statements being misleading.
d. a description of the scope limitation that prevents an unqualified opinion.
20-47
Under which of the following circumstances would a disclaimer opinion not be appropriate?
a. The auditor is unable to determine a significant amounts associated with an employee kiting scheme.
b. The client refuses to permit the auditor to confirm a significant amount of accounts receivable balances or apply
alternative procedures to verify their balances.
c. The management does not provide reasonable justification for a change in accounting principles.
d. The CEO is unwilling to sign the management representation letter.
20-48
When disclaiming an opinion because of a client-imposed scope limitation, an auditor should omit the
a.
b.
c.
d.
20-49
Scope Paragraph
No
Yes
No
Yes
Opinion Paragraph
Yes
Yes
No
No
When an auditor is associated with the financial statements of a public company (e.g., assists in preparing its financial
statements) but has not audited or reviewed such statements, the associated report to be issued must include a(n)
a. regulation S-X exemption.
b. report on pro forma financial statements.
c. unqualified association report.
d. disclaimer of opinion.
20-50
Due to scope limitation, an auditor disclaimed an opinion on the financial statements taken as a whole, but the auditors
report included a statement that the current asset portion of the clients balance sheet was fairly stated. The inclusion of this
statement is
a. not appropriate because it may tend to overshadow the auditors disclaimer of opinion.
b. not appropriate because the auditor is prohibited from reporting on only one basic financial statement.
c. appropriate provided the auditors scope paragraph adequately describes the scope limitation.
d. appropriate provided the statement is in a separate paragraph preceding the disclaimer of opinion paragraph.
20-51
Auditor A was engaged to audit the financial statements of XYZ Company, a new client, for the year ended 12.31.2001.
Auditor A obtained sufficient audit evidence for all XYZ Companys financial statement items except its opening
inventory, which has a significant balance. Auditor A could not verify XYZ Companys 1.1.2001 inventory balances by
applying alternative audit procedures. Auditor A s opinion on XYZ Companys 2001 financial statements most likely will
be (Hint: Think in which basic financial statements is/are the opening inventory balance)
a.
b.
c.
d.
20-52
Balance Sheet
Disclaimer
Unqualified
Disclaimer
Unqualified
Income Statement
Disclaimer
Disclaimer
Adverse
Adverse
When part of an audit is performed by another auditor, the principal auditor may issue a qualified audit report when
a. the other auditor refers to the findings of a specialist.
b. the other auditor issue an unqualified audit report on the part of the audit performed by him.
c. the clients financial statements are prepared on the cash receipts and disbursement basis of accounting.
d. the principal auditor is not willing to assume responsibility for the work of another auditor.
20-53
A principal auditor decides not to refer to the audit of another auditor who audited a subsidiary of the principal auditors
client. After making inquiries about the other auditors professional reputation and independence, the principal auditor
most likely would
a. add an explanatory paragraph to the auditors report indicating that the subsidiary s financial statements are not material
to the consolidated financial statements.
b. document in the engagement letter that the principal auditor assumes no responsibility for the other auditors work.
c. obtain written permission from the other auditor to omit the reference in the principal auditors report.
d. contact the other auditor and review the audit program and working papers pertaining to the subsidiary.
571
572
20 Audit Report
20-54
In which of the following situations would a principal auditor least likely make reference to another auditor who audited a
subsidiary of the audit client?
a. The other auditor was retained by the principal auditor, and the work was performed under the principal auditors
guidance and control.
b. The principal auditor finds it impractical to review the other auditors work or otherwise be satisfied as to the other
auditors work.
c. The financial statements audited by the other auditor are material to the consolidated financial statements covered by the
principal auditors opinion.
d. The principal auditor is unable to be satisfied as to the independence and professional reputation of the other auditor.
20-55
When a principal auditor decides to refer to another auditors audit, the principal auditors report should always indicate
clearly, in the introductory, scope, and opinion paragraphs, the
a. magnitude of the portion of the financial statements examined by the other auditor.
b. disclaimer of responsibility concerning the portion of the financial statements examined by the other auditor.
c. name of the other auditor.
d. division of responsibility in terms of shared audit, shared responsibility, and shared opinion.
20-56
The following explanatory paragraph was included in an auditors report to indicate a lack of consistency:
As discussed in note #2 to the financial statements, the company changed its method of computing depreciation in 2001.
How should the auditor report on this matter if the auditor concurred with the change?
a.
b.
c.
d.
20-57
Type of Opinion
Unqualified
Unqualified
Qualified
Qualified
Location of Explanatory Paragraph

Before opinion paragraph
After opinion paragraph
Before opinion paragraph
After opinion paragraph
When there has been a change in accounting principles, but the effect of the change on the comparability of the financial
statements is not material, the auditor should
a. refer to the change in an explanatory paragraph.
b. explicitly concur that the change is preferred.
c. not refer to consistency in the auditors report.
d. refer to the change in the opinion paragraph.
20-58
When the auditor concurs with a change in accounting principle that materially affects the comparability of the
comparative financial statements, the auditor should
Concur Explicitly with the Change Express a Qualified Opinion Refer to the Change in an Explanatory Paragraph
a.
No
No
Yes
b.
Yes
No
Yes
c.
Yes
Yes
No
d.
No
Yes
No
20-59
Management believes and the auditor is satisfied that a material loss probably will occur when pending litigation is
resolved. Management is unable to make a reasonable estimate of the amount or range of the potential loss but fully
discloses the situation in the notes to the financial statements. If management does not make an accrual in the financial
statements, the auditor should express a(n) (Hint: Think of LCAs in Chapter 19)
a. qualified opinion due to a scope limitation.
b. qualified opinion due to a departure from GAAP.
c. Unqualified opinion with an explanatory paragraph.
d. Unqualified opinion in a standard auditors report.
20-60
An auditor most likely would express an unqualified opinion and would not add explanatory paragraph to the report if the
auditor
a. wishes to emphasize that the entity has significant transactions with related parties.
b. concurs with the clients change in its method of computing depreciation.
c. discovers that supplementary information required by FASB has been omitted.
d. believes that there is a remote likelihood of a material loss resulting from an uncertainty arising from pending litigation.
20-61
An auditor concludes that there is substantial doubt about a clients ability to continue as a going concern. If the clients
financial statements adequately disclose its financial difficulties, the auditors report should
Include an Explanatory
Paragraph following the
Opinion Paragraph____
a.
Yes
b.
Yes
c.
Yes
d.
No
20-62
Possible Discontinuance of Operations

Yes
Yes
No
No
Reasonable Period of Time, Not to Exceed One year

Yes
No
Yes
No
financial statements adequately disclose its financial difficulties, the auditors report may express
a.
b.
c.
d.
20-64
Specifically Use
Words
Substantial Doubt
Yes
No
Yes
Yes
financial statements adequately disclose its financial difficulties, the auditors report should include an explanatory
paragraph that specifically used the phrase(s)
a.
b.
c.
d.
20-63
Specifically Use
the Words
Going Concern
Yes
Yes
No
Yes
Disclaimer of Opinion
Yes
No
No
Yes
Qualified Opinion
Yes
No
Yes
No
An auditor includes a separate paragraph in an unqualified audit report to emphasize that the client has significant
transactions with related parties. This inclusion
a. Violates GAAS if this information is already disclosed in the footnotes.
b. necessitates a revision of the opinion paragraph to include the phrase with the foregoing explanation.
c. is appropriate and would not negate the unqualified opinion.
d. is considered a qualification of the opinion.
20-65
How does an auditor make the following representations when issuing the standard auditors report on comparative
a.
b.
c.
d.
20-66
Examination of Evidence on a Test Basis

Explicitly
Implicitly
Implicitly
Explicitly
Consistent Application of Accounting Principles

Explicitly
Implicitly
Explicitly
Implicitly
Auditor A had substantial doubt about C Corp.s ability to continue as a going concern when reporting on C Corp.s
audited financial statements for the year ended December 31, 2001. That doubt has been removed in 2002. What is auditor
As reporting responsibility if C Corp.s is presenting its financial statements for the year ended December 31, 2002, on a
comparative basis with those of 2001?
a. The explanatory paragraph included in the 2001 auditors report should not be repeated.
b. The explanatory paragraph included in the 2001 auditors report should be repeated in its entirety.
c. A different explanatory paragraph describing auditor As reasons for the removal of doubt should be included.
d. A different explanatory paragraph describing C Corp.s plan for financial recovery should be included.
573
574
20 Audit Report
20-67
When a predecessor auditor reissues the report on the prior periods financial statements at the request of the former client,
the predecessor auditor should
a. indicate in the introductory paragraph of the reissued report that the financial statements of the subsequent period were
audited by another CPA.
b. obtain a representation letter from the successor auditor but obtain no such a letter from the management.
c. compare the prior periods financial statements that the predecessor reported on with the financial statements to be
presented for comparative purposes.
d. add an explanatory paragraph to the reissued report stating that the predecessor has not performed additional auditing
procedures on the prior periods financial statements.
20-68
When reporting on comparative financial statements, an auditor ordinarily should change the previously issued opinion on
the prior years financial statements if the
a. prior years financial statements are restated to conform with GAAP.
b. auditor is a predecessor auditor who has been requested by a former client to reissue the previously issued report with
the current period report date.
c. prior years opinion was unqualified and the opinion on the current years financial statements is modified due to a lack
of consistency.
d. prior years financial statements are restated following a pooling interest in the current year.
20-69
The predecessor auditor, who is satisfied after properly communicating with the successor auditor, has reissued a report
because the audit client desires comparative financial statements. The predecessor auditors report should
a. refer to the report of the successor auditor only in the scope paragraph.
b. refer to the report of the successor auditor in the scope and opinion paragraphs.
c. refer to both the work and the report of the successor auditor only in the opinion paragraph.
d. not refer to the report or the work of the successor auditor.
20-70
P, the predecessor auditor audited C Corp.s prior-year financial statements. These financial statements are presented with
those of the of the current year for comparative purposes but without (i.e., not include) P, the predecessor auditors report,
which expressed a qualified opinion. In drafting the current years auditors report, S, the successor auditor, should
I. Not name P as the predecessor auditor.
II. Indicate the type of report issued by P, the predecessor auditor.
III. Indicate the substantive reasons for P, the predecessor auditors qualification in the introductory paragraph.
a. I only.
b. I and II only.
c. II and III only.
d. I, II, and III.
20-71
When un-audited financial statements are presented in comparative form with audited financial statements in a document
filed with the SEC, such statements should be
a.
b.
c.
d.
20-72
Marked as Un-audited
Yes
Yes
No
No
Withheld Until Audited

No
No
Yes
Yes
Referred to in the Auditors Report

No
Yes
Yes
No
When un-audited financial statements of a nonpublic company are presented in comparative form with audited financial
statements in the subsequent year, the un-audited financial statements should be clearly marked to indicate their status and
I. The report on the un-audited financial statements should be reissued.
II. The report on the audited financial statements should include a separate paragraph describing the responsibility assumed
for the un-audited financial statements.
a. I only.
b. II only.
c. both I and II.
d. either I or II
20-73
When audited financial statements contain other information, the auditor should
a. perform inquiry and analytical procedures to ascertain whether the other information is reasonable.
b. add an explanatory paragraph to the auditors report without changing the opinion on the financial statements.
c. perform the appropriate substantive auditing procedures to corroborate the other information.
d. read the other information to determine that it is consistent with the audited financial statements.
20-74
An auditor concludes that there is a material inconsistency in the other information in annual report to shareholders
containing audited financial statements. If the auditor concludes that the financial statements do not require revision, but
the client refuses to revise or eliminate the material inconsistency, the auditor may
a. revise the auditors report to include a separate explanatory paragraph describing the material inconsistency.
b. express a qualified opinion after discussing the matter with the clients directors.
c. consider the matter closed because the other information is not in the audited statements.
d. disclaim an opinion on the financial statements after explaining the material inconsistency in a separate paragraph.
20-75
If management declines to present supplementary information required by the Governmental Accounting Standards Board
(GASB), the auditor should express
a. an adverse opinion.
b. a qualified opinion with an explanatory paragraph.
c. an disclaimer of opinion.
d. an unqualified opinion with an additional explanatory paragraph.
20-76
An auditor may report on condensed financial statements that are derived from complete audited financial statements if the
a. condensed financial statements are not read in conjunction with the most recent complete financial statements.
b. auditor indicates whether the condensed financial statements are fairly stated in all material respects in relation to the
audited complete financial statements.
c. auditor describes the additional review procedures performed on the condensed financial statements.
d. condensed financial statements are distributed only to management and the board of directors.
20-77
For condensed financial statements that are derived from a public companys audited financial statements, a CPA should
indicate that the
a. condensed financial statements are prepared in conformity with other comprehensive basis of accounting.
b. CPA has audited and expressed an opinion on the complete financial statements.
c. condensed financial statements are not fairly presented in all material respects.
d. CPA expresses limited assurance that the financial statements conform with GAAP.
20-78
An auditor is engaged to report on selected financial data that are included in a client-prepared document containing
audited financial statements. Under these circumstances, the report on the selected data should
a. be limited to data derived from the audited financial statements.
b. be distributed only to senior management.
c. state that the presentation is a comprehensive basis of accounting other than GAAP.
d. indicate that the data are not fairly stated in all material respects.
20-79
Comfort letters ordinarily are signed by the clients

a. independent auditor.
b. underwriters of securities.
c. audit committee.
d. senior management.
20-80
Comfort letters ordinary are addressed to

a. the SEC.
b. the intermediary who negotiated the agreement with the client.
c. creditor financial institutions.
d. the clients audit committee.
20-81
Which of the following matters is covered in a typical comfort letter?

a. Negative assurance concerning whether the entitys internal control activities operated as designed during the period
being audited.
b. An opinion regarding whether the entity compiled with laws and regulations under Government Auditing Standards and
the Single Audit Act.
c. Positive assurance concerning whether un-audited condensed financial information compiled with GAAP.
d. Negative assurance as to whether the audited financial statements comply, in all material respects, with the applicable
accounting requirements of the SEC.
575
576
20 Audit Report
20-82
When an auditor issues to an underwriter a comfort letter containing comments on data that have not been audited, the
underwriter most likely will receive
a. positive assurance on supplementary disclosures.
b. negative assurance on capsule information.
c. a disclaimer on prospective financial statements.
d. a limited opinion of pro forma financial statements.
20-83
Which of the following statements is correct concerning letters for underwriters, commonly referred to as comfort letter?
a. Letters for underwriters are required by the Securities Act of 1933 for the initial public offering of registered securities.
b. Letters for underwriters typically give negative assurance on un-audited interim financial information.
c. Letters for underwriters usually are included in the registration statement accompanying a prospectus.
d. Letters for underwriters ordinarily update auditors opinion on the prior years financial statements.
20-84
An auditor issued a review report based on a review of the clients interim financial information. If this review report is
presented in a registration statement filed with the SEC, a prospectus should include a statement clarifying that the
a. auditors review report is not a part of the registration statement within the meaning of the Securities Act of 1933.
b. auditor assumes no responsibility to update the report for subsequent events occurring after the date of the report.
c. auditors review was performed in accordance with standards established by the SEC.
d. auditor obtained corroborating evidence to determine whether material modifications are needed for such information.
20-85
A registration statement filed with the SEC contains the audit reports of two independent auditors on their audits of
financial statements for different periods. The predecessor auditor who audited the prior period financial statements
generally should obtain a letter of representation from the
a. principal underwriter.
b. clients audit committee.
c. successor auditor.
d. SEC.
20-86
Before reporting on the financial statements of a U.S. entity that have been prepared in conformity with another countrys
accounting principles, an auditor practicing in the U.S. should
a. be certified by the appropriate auditing or accountancy board of the other country.
b. notify management that the auditor is required to disclaim an opinion on the financial statements.
c. receive a waiver from the auditors state board of accountancy to perform the engagement.
d. understand the accounting principles generally accepted in the other country.
20-87
The financial statements of America Corp., a U.S. entity, are prepared for inclusion in the consolidated financial statements
of its non-U.S. parent Corporation. These financial statements are prepared in conformity with the accounting principles
generally accepted in the parent Corporations country and are for use only in that country. How may America Corp.s
auditor report on these financial statements?
I. A U.S. style audit report (unmodified).
II. A U.S. style audit report modified to report on the accounting principles of the parents country.
III. The audit report style of the parents country.
a.
b.
c.
d.
20-88
I_
Yes
No
Yes
No
II_
No
Yes
No
Yes
III
No
No
Yes
Yes
New Sections of the Securities Exchange Act of 1934 on corporate responsibility for financial reports contain the terms
disclosure controls and procedures which refer to
a. control and other procedures that disclose significant deficiencies in the design and operation of internal controls.
b. control and other procedures that ensure information that is filed with the SEC is processed and reported in a timely
manner.
c. control and other procedures that prevent and detect fraud involves management and other employees.
d. control and other procedures that establish and maintain systems of internal controls with respect to financial reporting.
20-89
Under Sarbanes-Oxley Act of 2002, the CEO and CFO of a public company must certify their quarterly and annual reports.
Which of the following is not covered by that certification?
a. Their reports do not contain any untrue statement or omit any material facts.
b. The financial statements in their reports fairly present in all material respects the financial condition, results of
operations, and cash flows of the company.
c. The financial statements in their reports are limited to the presentation requirements of the GAAP.
d. Their reports indicate any significant changes in internal controls subsequent to the evaluation of the effectiveness of
the disclosure control and procedures.
20-90
Which of the following best describes the relationship between the audit report issued by the auditor and the certified
report filed by the management?
a. The auditors audit report attests to the accuracy of the managements certified report filed with the SEC.
b. The managements certified report and the auditors audit report are filed independently with the SEC.
c. The auditors audit report must be completed before the management can certify its report.
d. The managements certified report supports the opinion issued in the auditors audit report.
20-91
When reporting on comparative financial statements, which of the following is not a consideration to the auditor?
a. If the management requested the prior audit report to be reissue, the auditor should consider reissuing the prior audit
report under the dual-dating concept.
b. If the management requested the prior audit report to be reissue, the auditor should consider not naming the prior auditor
and mentioning the date and type of prior audit report in the introductory paragraph of the current audit report.
c. If the management requested the prior audit report to be reissue, the auditor should consider not including the prior audit
report in the current audit report.
d. If the management requested the prior audit report to be reissue, the auditor should consider naming the prior auditor
and not mentioning the nature of an explanatory paragraph added to the prior audit report.
20-92
Auditing Standard 5 (AS 5) of the PCAOB requires the auditor to perform an integrated audit and to report on the clients
effectiveness of ICFR (Internal Control Over Financial Reporting). Which of the following is an appropriate form of
report(s) to be issued by the auditor ?
a. One report on the auditors opinion on the financial statements and a separate report on the auditors opinion on the
effectiveness of ICFR.
b. One report on the auditors opinion on the financial statements, and a separate report on the managements assessment of
the effectiveness of ICFR and the auditors opinion on the effectiveness of the ICFR.
c. A combined report of the auditors opinion on the financial statements and the auditors opinion on the effectiveness of
the ICFR.
d. A combined report of the auditors opinion on the financial statements and the managements assessment of the
effectiveness of ICFR.
20-93
The wordings of a combined audit report on financial statements and ICFR differs from the wordings of a standard
unqualified audit report in several ways. Which of the following is not one of the differences?
a. The combined report includes an additional paragraph after the opinion paragraph that addresses the inherent limitations
of internal control.
b. The combined report includes a paragraph after the scope paragraph defining internal control over financial reporting.
c. The combined report includes a reference to the framework of the COSO (Committee of Sponsoring Organizations) in
the introductory paragraphs.
d. The combined report includes a reference to the framework of the COSO (Committee of Sponsoring Organizations) in
the opinion paragraphs.
577
578
20 Audit Report
20-94
In an integrated audit, the auditor encountered a minor scope limitation in identifying a reasonably possible and significant
deficiency that has no material magnitude; assuming everything else stays constant, which of the following opinions would
the auditor normally issue in a combined audit report? (Hint: Refer to Chapter 8)
A Combined Audit Report
I.
II.
III.
IV.
Auditors Opinion on
Adverse
Disclaimer
Unqualified
Qualified
Auditors Opinion on
Managements
Assessment of ICFR
Unqualified
Disclaimer
Unqualified
Unqualified
Auditors Opinion
on the
Qualified
Disclaimer
Unqualified
Unqualified
a. All the three opinions in I.

b. All the three opinions in II.
c. All the three opinions in III .
d. All the three opinion in IV.
20-95
In an integrated audit, the auditor chooses to issue separate reports for the clients financial statements and its effectiveness
of ICFR. The management makes an adverse assessment of internal control because of a material weakness (i.e., ICFR is
not effective). The auditor agrees with the managements assessment and the auditors opinion of the ICFR is also not
effective. However, the auditor concludes that the financial statements taken as a whole is not affected by the material
weakness. Assuming everything else stays constant, which of the following opinions would the auditor normally issue in
separate audit reports? (Hint: Refer to Chapter 8)
An Audit Report
I.
II.
III.
IV.
A Separate Audit Report
Auditors opinion on
Auditors Opinion on
Managements
Assessment of ICFR
Unqualified
Adverse
Unqualified
Qualified
Adverse
Disclaimer
Adverse
Unqualified
Auditors Opinion
on the
Adverse
Disclaimer
Unqualified
Unqualified
a. All the three opinions in I.

b. All the three opinions in II.
c. All the three opinions in III .
d. All the three opinion in IV.
20-96
In evaluating the materiality level between a scope-limitation-misstatement and a departure-from-GAAP-misstatement, a

key factor that distinguishes between them for the purpose of issuing an appropriate audit opinion is
a. a scope-limitation-misstatement is usually related to some illegal or fraudulent acts, whereas a
departure-from-GAAP-misstatement is usually not the case.
b. a scope-limitation-misstatement has a psychic effect on users of the financial statements, whereas a
departure-from-GAAP-misstatement has no such an effect.
c. a scope-limitation-misstatement generally does not affect future accounting periods, whereas a
departure-from-GAAP misstatement does so.
d. a scope-limitation-misstatement is evaluated by its potential effect on users of the financial statements,
whereas a departure-from-GAAP is evaluated by its known effect on the users.

20-1 b. 20-2 c. 20-3 c. 20-4 c. 20-5 b. 20-6 a. 20-7 b. 20-8 a. 20-9 b. 20-10 b. 20-11c.
20-12 b. 20-13 a. 20-14 c. 20-15 d. 20-16 d. 20-17 c. 20-18 a. 20-19 d. 20-20 a. 20-21 d.
20-22 b. 20-23 a. 20-24 a. 20-25 b. 20-26 c. 20-27 c. 20-28 d. 20-29 a. 20-30 c. 20-31 c.
20-32 d. 20-33 c. 20-34 d. 20-35 c. 20-36 c. 20-37 b. 20-38 c. 20-39 b. 20-40 d. 20-41 b.
20-42 a. 20-43 d. 20-44 d. 20-45 c. 20-46 b. 20-47 c. 20-48 d. 20-49 d. 20-50 a. 20-51 b.
20-52 d. 20-53 d. 20-54 a. 20-55 d. 20-56 b. 20-57 c. 20-58 a. 20-59 d. 20-60 d. 20-61 a.
20-62 d. 20-63 d. 20-64 c. 20-65 d. 20-66 a. 20-67 c. 20-68 a. 20-69 d. 20-70 d. 20-71 a.
20-72 d. 20-73 d. 20-74 a. 20-75 d. 20-76 b. 20-77 b. 20-78 a. 20-79 a. 20-80 b. 20-81 d.
20-82 b. 20-83 b. 20-84 a. 20-85 c. 20-86 d. 20-87 d. 20-88 b. 20-89 c. 20-90 d. 20-91 d.
20-92 b. 20-93 a. 20-94 c. 20-95 a. 20-96 d.
579
580
20 Audit Report

Simulation Question 20-1 is an adaptation with permission from a case by Eckstein C., P. Kyviakidis, and D. Tinkelman in the Issues in
set of facts.
Introduction
The Company
The Market
Joe Hooker is an audit partner at the accounting firm of Burnside & Polk (hereafter, BP), a regional firm with 30 partners. Due to the
sudden illness of Polk, Hooker has been assigned to take over the audit of InterActive Inc. (hereafter, IA). While the company has been a client of
his firm for years, Hooker has had no prior experience with it. Hooker reviewed the firms audit and correspondence files to obtain a general
understanding of IAs business and industry. Relations with the client are excellent, and the companys management has understood about the
change in partners.
The 1995 audit is nearly complete. IA is planning to go public shortly, with an offering of a million shares, to be priced at $8.25 per
share. The company has submitted a draft SEC registration statement on Form S-1, containing draft 1995 financial statements and a draft
unqualified audit report, to the SEC for preliminary comments. BPs policies provide that all companies making an initial public offering (IPO)
be automatically considered high-risk clients. Accordingly, the quality control partner, Georgia Meade, reviewed the prospectus and key audit
working papers and memoranda. In prior years, there was no review by any partner other than Polk, and he had always rendered unqualified audit
opinions. Meade raised a number of questions that must be addressed before the audit report can be issued. See Meades comments and
questions in her Review Notes that is presented in Question 1 below. The remainder of this simulation question should be considered in
responding to her concerns.
Bill Sedgewick, an inventor, founded IA in 1990. He contributed to the company its key asset, a patented, proprietary interactive video
compression technology involving both specialized equipment and unique computer software. This technology allows viewers to interact
specially prepared television programming, and to personalize the programs. Each program, when viewed, has potentially thousands of
permutations available for a viewer to experience. The advertisements shown differ for viewers who chose different versions, allowing marketers
to better target their audience. The particular show any viewer sees is based on the viewers individual selections, input through a remote keypad.
For example, viewers would be able to continually choose among several camera angles when watching a baseball game, or to switch between
live feeds of different sports as they watch the Olympics, or event to change the plot of a movie as they watch it.
The company is a pioneer in the development, marketing and distribution of interactive television programming. Management expects
markets for interactive television technology and programming to develop in cable television, industrial and educational training, distance
learning, in-room hotel entertainment, and business television. The company has produced a number of interactive programs that performed well
in market tests.
Through the end of 1995, IA has been unprofitable on an operating basis. You should access Data File 20-1 in iLearn for Table 1,
which presents IAs 1995 financial statements, Table 2, which presents excerpts from the draft Form S-1, and Table 3, which presents
excerpts from SEC comment letter. The companys technology requires four channels to operate at its best, and cable operators do not believe
they can charge enough of a premium to justify the number of channels used. IA is attempting to overcome this problem, both by refining its
compression technology so that its programs will require fewer channels, and by making more attractive programs. It has spent significant funds
attempting to adapt its technology for commercial use and developing an inventory of video programs. The general expenditures for adapting the
technology were charged to research and development expense. However, all the expenditures of producing videos, including costs of trying to
adapt existing videos to use fewer channels, were capitalized to inventory. The only significant revenues IA has ever had were from licensing
programs and producing interactive videocassette programs.
IA believes its best opportunity for future success lies in continuing to develop and market interactive technology. However, if
required, it could reduce research efforts and change its operations to raise immediate cash. Its inventory of programs and commercials, while
designed specifically for use with interactive technology, can be used with conventional television technology. The company has received offers
from conventional television outlets to license or buy these programs. These offers have been refused, since management believes that using the
programs interactively will ultimately prove more profitable.
Since its inception, IA required outside financing parties to develop and market its technology. When the company started in 1990,
capital was provided by venture capitalists. During the next several years, various arrangements were made to obtain additional financing. The
most significant was the arrangement with Cable Co., a large Canadian-based cable network. Under the terms of the agreement, a separate
corporation, Entertainment (hereafter, E), was founded in 1993, owned 50 percent each by IA and Cable Co. IA contributed the right to use its
proprietary technology in cable television applications in return for shares, and Cable Co. contribute $9 million and promised to contribute an
additional $9 million when the interactive programs achieved commercial acceptance.1 Cable Co. later changed its business strategy, and
declined to make the second $9 million payment. The two companies then agreed that IA would become the 100 percent owner of E and that
Cable Co. would have the right to air some of Es programs over its networks in Canada and Europe without paying further royalties,2 as long as
Es name was prominently displayed. As a result of this agreement, IAs 1995 royalty income was zero, although the display of its name had
resulted in numerous inquiries about its products from potential customers.
At the present time, there is significant uncertainty regarding the market for interactive television products. Interactive television
programs must compete with other forms of entertainment, including standard television and movies. The size of the market that will ultimately
develop will depend on consumer demand as well as developments in technology. Interactive technologies allow viewers to engage in dialogue
with their television. The company performed successful market tests of its products, and received favorable responses from consumers.
However, some research on peoples motivations for watching television suggests factors that may limit demand. Interactive television requires
The technology had been recorded on IAs books at a nominal value and IA recorded a $9 million gain upon its contribution to E. IA continued
to pursue markets for its technology other than cable television.
2
Because of the change in licensing arrangements with Cable Co., there were no licensing revenues in 1995.
attention from users, and tends to be an individual activity, while much television viewing is a social activity, and viewers often prefer devoting
less than their full attention to the television.
Various other companies have developed interactive systems, although none allow the viewer to affect what is seen on the television
in the same manner or to the same extent as IAs products. For example, some companies market play-along systems that allow the Viewer,
using a game console, to receive data and play along with a game show, without affecting what is shown on the television screen. Other
companies have systems, used primarily for interactive shopping, that allow viewers to choose various still frames and audio about topics of
particular interest.
Required
Assume you are Hooker, the audit partner in-charge of IAs 1995 audit; prepare a memorandum that responds to the issues raised by Meade in
her Quality Control Partner Review Notes below.
You should access Data File 20-1 in iLearn for Table 4, which contains excerpts from various authoritative pronouncements that would
help you in drafting the memorandum.
Quality Control Partner Review Notes

Prepared by: G. Meade
The following points need to be resolved and properly documented before issuance of our report. Either support the treatment now used in the
financial statements, or propose to the client appropriate changes in the financial statements.
1. The company has had losses, and currently has an accumulated deficit. Should our report mention a concern over the companys
ability to continue as a going concern?
2. The prospectus says the companys major asset is proprietary technology, which uses both special equipment and software. The
company has booked a $9 million asset and recorded a 1994 gain based on the joint venture transaction. It has also recorded
amortization expense in both 1994 and 1995 based on the $9 million value.
I see the SEC staff wants no value placed on the technology (see Table 3). They cite SAB No.48. Do you agree? Please explain to me what
GAAP is on this topic and how you plan to address the SECs concerns. I suspect they will not budge on their interpretation. If the company
accepts the SEC staffs position, how would the financial statements be affected? (Assume 40 percent tax rate). Since we have previously
rendered an unqualified opinion on the 1994 income, what are our responsibilities with regard to a change in accounting treatment?
3. The companys assets include video program inventory and demonstration programs and commercials, both classified as
noncurrent assets. This raises a number of issues
(a) Since Cable Co. can use some of the inventory without paying royalties; does that part of the inventory have value?
(b) Do we agree with treating inventory as a long-term asset?
(c) Should there be amortization? If so, over what life? The working papers apply FASB standards for motion picture
accounting to television program costs, which is a reasonable approach in the absence of specific standards. Motion
picture accounting rules would try to set amortization to match costs against expected revenues. Can the amount and
timing of future revenues be predicted here?
(d) Using motion picture accounting, the company has capitalized all production costs. By my reading of the working papers
and discussions with staff, about $100,000 of these costs each year represent payroll for programmers trying to adapt
existing programs to run on two cable channels. Should this be expensed as R & D? The client apparently feels these costs
are similar in nature to the usual situation in film production costs, where all the costs of experimenting with various
special effects are capitalized. We need a clearly researched and documented position on this.
4.
The files do not contain our standard form discussing the desirability of retaining the client. Considering both my comments and the
risk factors cited in the draft Form S-1, do we want to keep this audit client? (See Table 3 for excerpts from the draft Form S-1).

Simulation Question 20-2 is an adaptation with permission from a case by M. Kohlbeck in the Issues in Accounting Education , a publication of
the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
The Company
A group of M.B.A. students formed Summer Technology, Inc. (hereafter, the Company) after graduation in 1989. The Company
design and manufactures home technology applications. Although the Company has not been profitable in the past, this year it has reached a
turning point as the profits from past R&D expenditures are being realized in product innovations and in increased sales. To further ensure its
success, the company has embarked on a focused effort to control costs. As the result of these efforts, the Company expects to recognize its first
profit in 2003. However, the Companys ultimate success depends on whether it will continue to be profitable over the next few years.
The Companys strength is its management, research and development, and production employees. The average employee is 35 years
old, educated, and dedicated. Starting salaries are above average (although salary increases are close to average), moral is strong, and the
Company has experienced little turnover. In addition, to good salaries and healthcare benefits, all employees are covered by a defined benefit
pension plan. The pension plan provides retirement benefits based on the employees pre-retirement salary levels and years of service with the
firm. The Company amortizes any unrecognized prior service costs and gains/losses using the straight-line method over the average remaining
service life.
581
582
20 Audit Report
The future outlook for the Company has improved, but it is still uncertain. Analysts are bullish on the Company and have rated its
common stock a buy. The current market price of the Companys common stock is $4.25 per share and the 2003 average price was $3.65 per
share. The Company has also discussed a major borrowing package from a consortium of banks. These banks are considering a $100 million
long-term package bearing interest at 5.8 percent. Continued support from the financial markets will allow the Company to enter a growth stage
as additional products are introduced to the consumer markets.
At the beginning of the current year, the Company had accumulated substantial net operating loss carry-forwards totaling $35 million
that will begin to expire in five years. In the past, management provided a valuation allowance at 100 percent of the deferred tax asset from the
net operating loss based on the Companys uncertain future. In 2003, management reevaluated the need and the amount of the deferred tax asset
valuation allowance because of the current profitability and improved outlook for the Company. Management now believes there is only a 10
percent probability that ll of the net operating loss carry-forwards will be used and a more likely scenario is that the Company will report annual
pretax profits over the next five years between 0.5 and 1 percent of total assets. Based on the Companys analysis, management determined that it
was more likely than not that 80 percent of the deferred tax assets would not be realized.
Major Transactions during the Past Year
Economic Conditions
Preliminary Financial Statements
During the past year, the Company was party to a number of major transactions that impacted the financial statements. These
transactions are discussed in the following paragraphs.
Litigation
In 2003, the Company was named as a defendant in a patent infringement lawsuit. The plaintiff is seeking over $100 million in
economic, noneconomic and liquidated damages, plus punitive damages. The companys counsel reviewed the preliminary court rulings and
believes that some payment will probably be required, although an amount cannot be determined. In December, after extensive discussion with
the Companys counsel, management offered the plaintiffs $1 million to settle the claim. As of today, the offer has not been accepted or rejected.
The Company does not know what it will do if the offer is rejected, but it has accrued $1 million as a minimum loss contingency for this claim.
In the ordinary course of its business, the Company is also a party to a number of other lawsuits. Management believes, however, that
the outcome of any other such litigation would not have a material adverse effect on its financial statements.
Investment in Airtime
In 2002, the Company invested $25 million in bonds (par value of $25 million) issued by Airtime Inc. Airtime is a publicly held
company that produces highly specialized home area network that the Company uses in its home technology packages. The investment is
classified as available-for sale.
On January 1, 2003, the Company purchased an 18 percent interest in the common stock of Airtime for $20 million and became
Airtimes largest shareholder. At this point, no other firm or individual other than the Company owns more than 10 percent. Additionally, the
Company names one member of Airtimes board of directors. Because the ownership of common stock is less than 20 percent, the Company is
following SFAS No.115 for passive investments and has classified the equity investment as available for sale.
Lease
The Company entered into a lease agreement for the use of a $12 million high-speed assembly line at its main production facility with
General Capital. The five-year lease (January 1, 2003 to December 31, 2007) requires annual payments of $2.52 million beginning on January 1,
2003. Moreover, the lease does not contain a bargain purchase option or transfer at the end of the lease term. Due to the assembly lines reliance
on current technology, the Company estimated the useful life of the assembly line to be six years. The Company is unaware of General Capitals
implicit interest rate and used an 8 percent interest rate in its lease analysis. Amortization of the capitalized lease asset for financial statement and
tax purposes, however, is the same.
A synopsis of key economic factors, including overall economy, interest rates, unemployment, and inflation that describe the
conditions that the Company faces are as follows:
Overall Economy
The Conference Boards index of leading economic indicators continues to post small gains. The overall figure, however, is based on
increases in just four of the ten components in the index. Over the past six months, the positive trend looks more solid. The index rose 2.1
percent, with seven of the ten components showing improvement. The S&P500 Index continues to increase, although the average annual returns
are only 6.2 percent.
Interest Rates
The Federal Reserve Boards Open Market Committee left its target for the federal funds rate unchanged at a 25-year low of 1.5
percent. The federal funds rate, which is the interest rate that banks charge each other for overnight loans needed to meet reserve requirements,
has a strong influence on other short-term rates. In the committees judgment, the risk of deflation still exceeds that of a rise in inflation. The
Open Market Committee also said that because of weakening in the labor market, there probably would be no increase in the target rate for a
considerable period. The yield of the ten-year U.S. treasury note fell 10 basis points to 4.16 percent last week and has ranged from 4.16 to 4.65
percent during 2003. Yields on investment grade bonds are slightly higher at 5.5 percent.
Unemployment
Overall, unemployment remains at 6.2 percent. However, the labor market in the Companys region is slightly stronger with 5.8
percent unemployment.
Inflation
Over the past 12 months, the CPI rose just 1.3 percent, the lowest full-year rate recorded since January 1966. Much of the increase
was due to a large jump in energy prices, which in turn resulted from a 6.0 percent rise in gasoline prices. The sore CPI figure, which excludes
volatile food and energy prices to better gauge the breadth and sustainability of any inflation pressures, rose just 0.1 percent.
The Companys CFO, Mr. Kevin Marksman, has prepared:
1. The preliminary financial statements and summary of selected accounting policies. You should access Data File 20-2 in iLearn for Exhibit
1, which presents the Companys preliminary financial statements, and Exhibit 2, which presents the summary of selected accounting
policies.
2. Investments Analysis. You should access Data File 20-2 in iLearn for Exhibit 3, which presents the investment analysis.
3. Pension Analysis. You should access Data File 20-2 in iLearn for Exhibit 4, which presents the pension analysis.
4. Lease Analysis. You should access Data File 20-2 in iLearn for Exhibit 5, which presents the lease analysis.
5.Tax Analysis. You should access Data File 20-2 in iLearn for Exhibit 6, which presents the tax analysis.
Required
Part 1: Review of Preliminary Financial Statements
Assume you are the audit partner in-charge of Summer Technology, Inc.s 2003 audit. Review the preliminary financial statements and prepare a
Review Notes that addresses the issues relating to each of the following five items. Use the format provided below and reference/cite relevant
authoritative accounting/auditing standards where applicable.
You should also refer to Chapter 19 on Fair Value Measurements and Disclosures.
Items
1. Litigation
Refer to Accrued Liabilities in
Exhibit 1.
2. Investment in Airtime
Refer to Available-for-Sale in
Exhibit 1 and Investments
Analysis in Exhibit 3.
3. Lease
Refer to Capital Lease
Obligation in Exhibit 1 and
Lease Analysis in Exhibit 5.
4. Pension Expense
Refer to Selling, General, and
Administrative in Exhibit 1 and
Pension Analysis in Exhibit 4.
5. Valuation Allowance for
Deferred Tax assets
Refer to Taxes in Exhibit 2
and Tax Analysis in Exhibit 6.
Explain the
appropriateness/inappropriatenes
s of the assumption(s)
Explain the
appropriateness/inappropriateness
of the amount
Explain your acceptance/rejection

of the presentation/disclosure
Part 2: Consider Earnings Management

After you have completed your analysis in Part 1 above, Kevin Marksman, the CFO, stopped by your office to discuss the earnings release.
Preliminary and unreported basic earnings per share are $0.19 per share for 2003. However, Mr. Marksman indicated that the consensus analyst
forecast for annual basic earnings per share is $0.20 per share. He emphasized how important it is for a growth company with a history of losses
such as the Company to meet or beat the consensus forecast. If the Company were to miss the consensus forecast, the share price would likely
suffer and may inhibit future expansion plans of the company. In additional, it is likely that annual bonuses will be reduced or eliminated. Mr.
Marksman implied that he was looking for alternative ways of accounting that would increase basic earnings per share from $0.19 to $0.20.
Given Mr. Marksmans motivation to engage in earnings management; for each of the five items in Part 1 above, explain how Mr.
Marksman could possibly use alternative accounting ways to increase basic earnings per share from $0.19 to equal or greater than $0.20. Use the
format provided below and reference/cite relevant authoritative accounting/auditing standards where applicable.
Items
1. Litigation
Refer to Accrued Liabilities in
Exhibit 1.
2. Investment in Airtime
Refer to Available-for-Sale in
Exhibit 1 and Investments
Analysis in Exhibit 3.
3. Lease
Refer to Capital Lease
Obligation in Exhibit 1 and
Lease Analysis in Exhibit 5.
4. Pension Expense
Refer to Selling, General, and
Administrative in Exhibit 1 and
Pension Analysis in Exhibit 4.
5. Valuation Allowance for
Deferred Tax assets
Refer to Taxes in Exhibit 2
and Tax Analysis in Exhibit 6.
Explain clearly how each of the five items could be

subjected to earnings management.
Show all your calculations on how alternative

accounting ways could increase the earnings per
share from $0.19 to equal or greater than $0.20.
583
584
20 Audit Report
Part 3: Preliminary Audit Report

Assume Mr. Marksman engaged in earnings management on all five items in Part 2 above, form an overall audit opinion about the Company and
draft a preliminary audit report given the Companys preliminary financial statements (Exhibits 1 through to 6) and your review in Part 1 and
analyses in Part 2.
Note:
1. You should refer to Figure 20-2 and Table 20-1 (in this Chapter 20) to formulate your overall audit opinion.
2. You should also refer to Figures 20-3 through to 20-15 (in this Chapter 20) to draft your preliminary audit report in the proper format.

Simulation Question 20-3 is an adaptation with permission from a case by Bierstaker, J., T. F. Monahan, and M. F. Peters in the Issues in
set of facts.
Introduction
Industry Background
Overview of Company
Sourcing and Procurement Software Market
Competition
You have recently been assigned to HT Company as a staff auditor. HT is a technology company that began a few years prior to the
dot-com debacle and operates in a very competitive environment. The senior on the job has asked you to provide an initial analysis of whether
HT should be classified as a going concern and to identify potential audit issues associated with non-GAAP earnings. Since this is a new
assignment, you set out to build your background on HT's industry, the history of the company and their product and service lines, and their
overall competitive position in the industry.
HT Company operates in a technology niche that helps companies manage how they spend money on their business. In the last
decade, technology-based solutions have emerged to help companies increase the efficiency of the procurement and cash management processes
and, as a result, more effectively manage their spending (i.e., operating expenditures). These solutions allow organizations to automate critical
tasks such as identifying global suppliers, sourcing goods and services, negotiating and managing contracts, processing invoices and payments,
and managing trading relationships.
Procurement organizations were among the first to embrace spend management solutions as a way to achieve corporate savings
targets. Today, finance departments are leveraging these solutions to drive improved cost management, business unit decision making and
planning, budgeting, forecasting, and cash and working capital management. Legal departments are implementing them to more effectively
author and manage contracts, and IT departments are deploying them to enhance the value of existing systems and increase returns on investment.
In its 10-K, HT describes itself as the leading provider of on-demand spend management solutions, which are ways of monitoring
operating expenditures such as raw materials, legal, administrative, etc. Its mission is to transform the way companies of all sizes, industries, and
geographies operate by delivering software, service, and network solutions that enable them to holistically source, contract, procure, pay, manage,
and analyze their spending and supplier relationships. Delivered on demand, its enterprise-class offerings empower companies to achieve greater
control of their operating expenditures and to drive continuous improvements in financial and supply chain performance. The company claims
that HT Spend Management solutions are easy to use, cost effective, and quick to deploy and integrate with enterprise resource planning
(ERP) and other software systems. More than 1,000 companies, including more than half of the 2011 Fortune 500 companies, use HT solutions
to manage their operating expenditures, from sourcing and orders through invoicing and payment.
HT was incorporated in Delaware in September 1996 and went public in 1999. The company's stock price moved from $944.30 per
share on August 1, 2000, to $99.00 per share on February 1, 2001, and settled at $13.68 per share on August 1, 2001. This represented a 98.5
percent reduction in price over a one-year period, while the founders took out a considerable amount of money from stock sales over a two-year
period prior to the stock's collapse. This resulted in a Securities and Exchange Commission (SEC) investigation and the resignation of the CEO
and chairman of the board, along with most of the other board members. The newly hired CFO became CEO and has run the company
successfully for the past ten years.
In a 2011 Supply Management Market Sizing Report, AMR Research, a third-party research firm, projected the spend management market to
grow at 10 percent Compound Annual Growth Rate (CAGR), becoming a $4.3 billion market in 2015 (i.e., $4.3 billion in revenues). Further, it
noted that the highest growth segments within the spend management market over the next five years are projected to be in areas in which HT
participates (CAGR in these areas is predicted to be between 1011 percent). Contract management is another area that HT is expected to be
involved with, and this area is also expected to grow substantially during 2012 and 2013.
You recognize that the market for spend management applications is highly competitive, rapidly evolving and fragmented and subject to
changing technology and shifting customer needs. Moreover, the following description in HT's preliminary 10-K makes you feel somewhat
uneasy:1
Our principal direct competition comes from ERP vendors whose software is installed by customers directly. We also compete with
specialty vendors that offer their software on a hosted basis or under a perpetual license. In our services business, we compete with
several large and regional service providers. We anticipate additional competition from other established and emerging companies as
the spend management market continues to expand.
1
This disclosure is adapted from a company's actual 10-K. Companies will often disclose these types of risks in an attempt to avoid investor
litigation.
Our current principal competitors include:

Enterprise software application vendors, including SAP AG and Oracle;
Smaller specialty vendors, including Emptoris, BravoSolution, Zycus, and American Express S2S;
Smaller niche SaaS vendors, including Perfect Commerce, cc-Hubwoo, Ketera Technologies, and Iasta; and
Service providers, including A.T. Kearney and McKinsey & Company.
We believe the principal competitive factors considered with respect to, and the relative competitive standing of, our spend
management software solutions are:
Interoperability with existing commonly used ERP systems;
Ease of use and rates of user adoption;
Price and demonstrable cost-effective benefits for customers;
Performance, security, scalability, flexibility, and reliability of the software;
Vendor reputation and referenceable customers;
Quality of customer support; and
Financial stability of the vendor.
Many of our current and potential competitors, such as ERP software vendors, including Oracle and SAP, have longer operating
histories, greater name recognition, larger marketing budgets and significantly greater resources, and a larger installed base of
customers than we do. They may be able to devote greater resources to the development, promotion, and sale of their products than
we can to ours, which can enable them to respond more quickly to new technology, introduce new spend management modules, and
respond to changes in customer needs. In addition, many of our competitors have well-established relationships with our current and
potential customers and have extensive knowledge of our industry. In the past, we have lost potential customers to competitors for
various reasons, including lower prices and other incentives not matched by us. Current and potential competitors have established or
may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address
customer needs and achieve greater market acceptance. The industry has experienced consolidation, with both larger and smaller
competitors acquiring companies to broaden their offerings or increase scale. As a result, we may not be able to successfully compete
against our current and future competitors.
HTs GAAP Financial Performance
Over the past few years, HT Company has experienced strong growth in revenue from its existing product lines (i.e., particularly, the
recurring high growth revenue from cloud computing-based subscriptions has increased 31 percent from 2010 to 2011), but has been unable to
generate positive income from operations. In fact, during fiscal year 2011, its overall revenue increased 8 percent while, at the same time, its net
loss before income taxes increased from $13 million (in 2010) to over $40 million (in 2011). However, HT maintained a significant cash balance,
experienced strong cash flows over this two-year period, and enjoyed limited leverage (see Appendix A). You should access Data File 20-3 in
iLearn for Appendix A, which presents the consolidated financial statements.
Rational for Reporting Non-GAAP Earnings
Going Concern Provisions
HT's financial performance (as viewed from a GAAP income statement perspective) is less than impressive. Over the years, however,
HT has emphasized the importance of non-GAAP earnings, especially to investors. As often discussed by HT and the Street, the basic argument
for reporting non-GAAP earnings is that these numbers more accurately capture financial measures that are comparable across years and across
firms and that will impact future operations. Non-GAAP earnings are often referred to in press releases.
The non-GAAP financial measures disclosed in Company press releases are thought to be used by boards of directors and senior
management teams to evaluate operating performance. Non-GAAP adjustments represent certain income statement items that are non-recurring
and/or non-cash, although not every adjustment fits into these two categories. In addition, the use of a particular non-GAAP adjustment may
differ based on the type of analysis. For example, investors may use certain non-GAAP adjustments for valuation purposes (i.e., as proxies for
recurring cash flows) while auditors may use different non-GAAP adjustments for going concern assessments. As a result, the non-GAAP
adjustments that are arrived at by an investor may differ from the non-GAAP adjustments that are arrived at by an auditor. In the case of HT,
although it had three years of GAAP losses, the firm's stock price increased from around $7 to $18 over this same period. This raises the issue
that non-GAAP earnings could have an important impact on company valuations (See Appendix B). You should access Data File 20-3 in
iLearn for Appendix B, which presents HT's non-GAAP adjustments.
The going concern assumption relates to the entity's inability to continue to meet its obligations as they become due without
substantial changes to their operations (i.e., disposition of assets outside the ordinary course of business, restructuring of debt, externally forced
revisions of its operations, or similar actions). The time period generally used for measuring a going concern is not to exceed one year beyond the
date of the financial statements being audited. Once the auditors believe there is substantial doubt about the entity's ability to continue as a going
concern, they should obtain information about management's plans to mitigate the effect of such conditions or events, and assess the likelihood
that such plans can be effectively implemented. The current audit guidelines for determining a going concern are presented in detail in Appendix
C. You should access Data File 20-3 in iLearn for Appendix C, which current auditing guidelines dealing with a going concern.
The above information on the competitive risk faced by HT, its net losses over the past few years, its positive non-GAAP earnings
over this same time period, and the role of non-GAAP earnings in general has raised the issue of a going concern for the audit team. In addition,
you recognize that the audit is targeted at GAAP and that there is no requirement to audit non-GAAP earnings (however, the audit of non-GAAP
earnings is under review by the PCAOB).
585
586
20 Audit Report
Required
1. In reviewing Appendix C in iLearn (Current Auditing Guidelines Dealing with a Going Concern), comment on which provisions are most
applicable to this case.
(a) Should HT be assigned a going concern classificationwhy or why not? Consider whether the amounts in question would be material (i.e.,
impact the decision-making of investors). For example, a cash-only business would not have a material amount of receivables. Use Appendices A
and B to support your answer.
(b) Identify key ratios derived from the financial statements that:
Support your position regarding a going concern.
Do not support your conclusion regarding a going concern. For example, profit margins (net income/sales) would potentially support a
going concern qualification, whereas free cash flow percentage (operating cash flows/investing cash flows) may not.
Note: See the following link for common ratio formulas: http://beginnersinvest.about.com/od/financialratio/Financial_Ratios.htm or refer to the
discussion on applying analytical procedures on a going concern in Chapter 7.
2. As the staff auditor examining this issue, your audit team has asked you to provide brief summaries about the following with regard to nonGAAP earnings (see Appendix B in iLearn):
(a) In general, why do firms report non-GAAP earnings?
(b) In general, are certain components of non-GAAP earnings more appropriate for certain decisions (e.g., going concern), but not so for other
decisions (e.g., valuation)?
Note: You may find it helpful to consult Regulation G, which provides the SEC rules for disclosing non-GAAP metrics and reconciling nonGAAP and GAAP earnings (see the link below): http://www.sec.gov/rules/final/33-8176.htm
For
current
research
on
non-GAAP
earnings,
see
Curtis
et
al.
(2012)
at
the
following
link:
http://www.business.utah.edu/sites/default/files/documents/school-of-accounting/whipple_2nd_year_paper.pdf
In addition, the Canadian Institute of Chartered Accountants (CICA) has a document on non-GAAP earnings that may serve as helpful
background reading. It is available at: http://www.cica.ca/publications/list-of-publications/manual/item12848.pdf
3. For HT, are there any audit risks that you foresee with the Street relying on non-GAAP earnings to evaluate and make predictions about
changes in stock price and HT separately reporting such earnings?
4. Review the non-GAAP adjustments listed for this company in Appendix B in iLearn.
(a) Put yourself in the position of a company spokesperson. Explain a rationale that the company would communicate to the investment
community that supports the use of these specific adjustments.
(b) Now put yourself in the position of the staff auditor (Q1 and Q2). Are there characteristics with some of these adjustments that were more
important when finalizing this opinion?
Note: For another example of a press release that describes a significant difference between GAAP and non-GAAP earnings, please see the link
below for the press release from Salesforce.com: http://www.salesforce.com/company/news-press/press-releases/2012/02/120223.jsp Although
the company has a net loss per share (which might concern an auditor), an analyst might be excited about its revenue growth and positive nonGAAP earnings (with stock-based compensation being one of the major adjustments to GAAP earnings), leading to its $20 billion market
capitalization.
5. Research two other company earnings releases and identify two additional non-GAAP adjustments that would be important in a going concern
designation, and explain why they would be important.
(a) Company 1:
(b) Company 2:
Note: You must fully answer all five questions in order to earn the extra credit point.
587
588
Chapter 21
Other Audit Engagements
LO21-1 Identify the authoritative guidance for other audit engagements.
LO21-2 Identify the types of procedure performed for other audit engagements.
LO21-3 Describe specific procedures for review; compilation; specific elements or
accounts; prospective financial statements, and internal control engagements.
LO21-4 Identify the types of assurance/opinion for other audit engagements.
LO21-5 Differentiate the forms of report for other audit engagements.
LO21-6 Describe some future other audit engagements.
Chapter 21 Other Audit Engagements

Recall as discussed in Chapter 1, CPA firms offer four broad types of attestation services (financial/integrated audit,
examination, review, and agreed-upon procedures) and a wide variety of other assurance services (web trust, risk
assessment, etc.). This chapter discusses some of these attestation and assurance services as other audit
engagements in addition to the usual audit engagement discussed thus far from Chapter 1 through to Chapter 20.
Specifically, fourteen other audit engagements are discussed and presented in Figure 21-1 and Table 21-1.
Figure 21-1 Other Audit Engagements 4. Audit of Financial Statements that Use a Financial Reporting Framework Other
Than GAAP
Other Audit
Engagements
1. Review of Financial
Statements
2. Compilation of Financial
Statements
3. Review of Interim
Financial Information of
Public Companies
4. Audit of Financial
Statements that Use a
Financial Reporting
Framework Other than
GAAP
5. Audit of Specific Elements,
Accounts or Items
6. Audit of Information
Accompanying the basic
7. Audit of Compliance with
Debt Agreement
8. Attestation of Prospective
9. Attestation of Internal
Control over Financial
that Is Integrated with an
Audit of Its Financial
Statements
10. Attestation of Websites
11. Attestation of Information
Systems
12. Attestation of Management
Discussion and Analysis
13. Service Organization
Control
14 Agree-upon Procedures
Engagements
Authoritative
Guideline
Type of
Procedure
PCAOB ASs
Examination
Positive
AICPA AUs
Audit
Negative
AICPA ATs
Review
No Opinion
AICPA ARs
Compilation
Agreed-upon
findings
Agreed-upon
Procedures
Type of
Assurance
Form of
Report
A Special Report Similar to a

Standard Audit Report Except
Modified Wordings/Paragraphs
A Review Report Similar to a
Standard Audit Report Except
Modified Wordings/Paragraphs
A Compilation Report
Depending on Managements
Required Disclosure
A WebTrust/SysTrust Report
A Service Organization Report
An Agreed-upon Report
589
590
Authoritative Guideline
Each of the fourteen other audit engagements follows one or more of the following authoritative guidelines:
1. Statements on Auditing Standards issued by the AICPA. These are referred to as AICPAs auditing standards and
are labeled as AUs. See Appendix A for a list of AUs.
2. Auditing Standards issued by the PCAOB. These are referred to as PCAOBs auditing standards and are labeled
as ASs. See Appendix B for a list of ASs.
3. Standards for Attestation Engagements (SSAE) issued by the AICPA. These are referred to as AICPAs
attestation standards and are labeled as ATs. See Appendix C for a list of ATs.
4. Statements on Standards for Accounting and Review Services (SSARS) issued by the AICPA. These are referred
to as AICPAs accounting and review standards and are labeled as ARs. See Appendix D for a list of ARs.
Type of Procedure
Each of the fourteen other audit engagements involves one or more of the following types of procedure:
1. Audit (financial/integrated) In an audit, the CPA obtains and evaluates evidence about a clients financial
statements which contain assertions made by the management. Based on the audit, the CPA issues a positive
(means certain or confident) expression of opinion on whether the financial statements are presented fairly in
conformity with established criteria such as GAAP.
2. Examination In an examination, the CPA obtains and evaluates extensive evidence about a variety of situations,
which contain assertions made by another party, to provide the highest level of assurance on the assertions. Based on
the examination, the CPA issues a positive expression of opinion on whether the other partys assertion, in all
material respects, conforms to certain applicable criteria.
3. Review In a review, the CPA makes inquiries of a clients management performs comparative analyses of
financial information. The scope of this service is significantly less than that of an audit or examination in that it
usually does not involve obtaining and evaluating evidence. Based on the review, the CPA issues a negative
(means uncertain or unconfident) expression of opinion on whether the financial information is presented fairly in
conformity with established criteria such as GAAP.
4. Agreed-upon procedures In agreed-upon procedures, the procedures to be performed on specified financial
statement/non-financial statement matters are agreed upon by the CPA, the responsible party making the assertions,
and the intended users of the CPAs report. The level of assurance provided on the assertions depends on the nature
and scope of the procedures agreed upon with the specified users. Based on the agreed-upon procedures, the CPA
issues a summary of findings report, which does not include an opinion.
5. Compilation In a compilation, the CPA undertakes to present, in the form of financial statements, information
that is the representation of management without undertaking to express any assurance on the statements (i.e.,
express no opinion).
Type of Assurance
Each of the fourteen other audit engagements issues one of the following types of opinions:
1. Positive opinion A positive (means certain or confident) opinion is an expression of opinion on whether the
financial statements are presented fairly in conformity with the GAAP and Auditing Standards AUs/ASs.
2. Negative opinion A negative (means uncertain or unconfident) opinion is an expression of opinion on whether
the financial information is presented fairly in conformity with established criteria such as GAAP. Thus, instead of
stating a positive opinion that the financial statements are presented fairly in conformity with GAAP, a
negative opinion is usually stated as that we are not aware of any material modifications that should be made to
the statements in order for them to be in conformity with GAAP.
3. No opinion A disclaimer of opinion that explains the reasons for withholding an opinion and explicitly indicates
that no opinion is expressed.
4. Agreed-upon findings Usually a summary of findings report that does not include an opinion.
Form of Report
Each of the fourteen other audit engagements comprises one of the following forms of report:
1. A special report similar to a standard audit report except modified wordings/paragraphs.

2. A review report similar to a standard audit report except modified wordings/paragraphs.
3. A compilation report depending on managements required disclosure.
4. A WebTrust/SysTrust report.
5. A service organization report.
6. An agreed-upon report.
Note that since all standards issued by the ACIPA were adopted as interim auditing standards by the
PCAOB, all other audit engagements involving public companies must follow the standards issued by the AICPA as
if they were issued by the PCAOB. This means that the paragraph on authoritative standards in the reports of all
other audit engagements should be worded appropriately according to whether the engagements involve public or
private (nonpublic) companies. For example, a report on a forecast (see Figure 21-12) for private companies should
state, Our examination was made in accordance with the Statements on Standards for Attestation Engagements
issued by the American Institute of Certified Public Accountants ... On the other hand, the same report for public
companies should state, Our examination was made in accordance with the standards of the Public Company
Accounting Oversight Board ...
Table 21-1 Fourteen Other Audit Engagements
Key Feature and

Type of
Procedure
1. Review of Financial Statements

A review engagement is performed
on the financial statements of nonpublic
companies (also referred to as nonissuers)
to express a limited assurance that the
financial statements are prepared in
accordance with GAAP.
Review
Inquiries of management.
Apply Analytical
procedures.
See Table 21-2 for
details.
Type of
Assurance
/Opinion
Negative
Form of Report
A review report is similar to a standard audit
report, except
In the opening paragraph, substitute the

word audit by review and state All
information is the representation of the
management ....
In the scope paragraph, state that a

review consists of inquiry of management and
application of analytical procedures. Also, the
testing is less in scope than an audit.
The engagement is performed in

accordance with the Statements on
Standards for Accounting and Review
Services (SSARS) AR 90 Review of
Financial Statements.
Change the opinion paragraph to We

are not aware of any material exceptions
(Negative assurance).
This engagement does not review the

effectiveness of a clients internal controls.
If the client departs from GAAP, issue a

modified negative opinion with the wordings,
With the exception of the matter described in
the following paragraph, we are not aware of
an material modifications ... and add a
separate paragraph in the report to describe the
departure.
See Figure 21-2 for an example of the review
report.
In a review engagement, each page of

the clients financial statements should be
marked See accountants review report to
clearly indicate that an audit engagement
was not performed.
Unlike an audit, the auditor is not

required to communicate with predecessors
in a review engagement. However, AR 400
points out that such communication is
desirable in certain situations, such as when
the auditor has limited knowledge of the
clients industry.
Note: The auditor is not required to determine

the effect of the departure from GAAP.
Note: PCAOBs AS 5 prohibits a review of

ICFR for public companies (also referred
to as issuers).
2. Compilation of Financial Statements

A compilation engagement is
preparation of financial statements
nonpublic companies for which
assurance is expressed about
presentation of the financial statements.
the
for
no
the
Compilation
Preparation of financial
statements.
See Table 21-3 for
details.
Do not
express an
opinion or
any other
form of
assurance.
Form of report depends on managements

required disclosures with the financial statements:
Compilation with full disclosure in

accordance
with
GAAP
or
other
comprehensive basis.
Compilation that omits substantially all
591
592
Key Feature and

Type of
Procedure
Type of
Assurance
/Opinion

Services (SSARS) AR 80 Compilation of
Financial Statements.
The auditor is not required to assess

control risk or to perform any evidencegathering procedures.
In a review engagement, each page of

the clients financial statements should be
marked See accountants compilation
report.
Compilation without independence in

accordance with CPC. Add a separate
paragraph in either Figure 21-3 or 21-4: We
are not independent with respect to XYZ
Company.
Unlike an audit, the auditor is not

required to communicate with predecessors
in a compilation engagement. However,
AR
400
points
out
that such
communication is desirable in certain
situations, such as when the auditor has
limited knowledge of the clients industry.
Add another separate paragraph to each

of the above three reports if the client departs
from GAAP.
All compilation reports should include a
statement that:
The compilation is limited to financial

statement representation of the management.
Note: The following engagements are not

subject to AR 80: (1) preparing a working
trial balance; (2) assisting in adjusting the
books of account; (3) consulting on
accounting, tax, and similar matters; (4)
preparing tax returns; (5) providing various
manual or computerized bookkeeping or
processing financial data services unless
the output consists of year-end financial
statements, and (6) processing financial
data for clients of other accounting firms.
3. Review of Interim Financial Information

of Public Companies
A review of interim financial

information is performed to:
(1) help management of public companies
meet their filings of 10Q reports with the
SEC, and
(2) report whether material modifications
should be made for the interim financial
information to conform with GAAP.
The review engagement is performed

in accordance with the Statements on
Services (SSARS) AR 90 Review of
Financial Statements for nonpublic
companies.
The review engagement is performed

in accordance with the AICPAs Auditing
Standards AU 930 Interim Financial
Information and the Sarbanes-Oxley Acts
requirement for a review of ICFR and
interim financial information filed with the
SEC for public companies.
The auditor performing the review

engagement must also be engaged to
perform the audit of the clients annual
financial statements for the current year.
The interim review engagement does
Form of Report
disclosures in accordance with GAAP or other
comprehensive basis. Add a last sentence, The
financial statements are not designed for those
who are uninformed about the omitted
disclosures. Also, the omission must not be
intended to mislead the users of the financial
statements.
The compilation is
accordance with the SSARS.
performed
in
The CPA has not reviewed or audited the

statements.
The CPA doses not express an opinion or

any form of assurance.
Note: The auditor has no responsibility to
assess the conformity of the clients financial
statement with GAAP.
Review
Use the same review
procedures under AR 90
in Table 21-2, but differ
in (1) The auditor must
obtain an understanding
of the clients internal
control, and (2) The
auditor reads the minutes
of the directors and
stockholders meetings,
instead of inquiries of
management.
To
obtain
an
understanding of the
clients internal control,
the auditor (1) Reads
working papers of prior
years
review,
(2)
Reviews results of TOC
on
current
years
financial statements, and
(3)
Determines
any
changes in the clients
business activities that
might affect the internal
control.
Negative
A report similar to a review report in Figure 21-2,

except
Substitute the standards of SSARS by

the standards of PCAOB. Also, if the client
departs from GAAP, issue a modified negative
opinion with the wordings, With the exception
of the matter described in the following
paragraph, we are not aware of any material
modifications ... and add a separate paragraph
in the report to describe the departure.
Communicate to the audit committee

about significant adjustments found during the
review.
Mark un-audited on each page of the

interim financial information.
Key Feature and

Type of
Procedure
Type of
Assurance
/Opinion
Form of Report
not require a complete assessment of

control risk each quarter or gathering
sufficient appropriate evidential matter on
which to base an opinion on interim
financial information.
4. Audit of Financial Statements that Use a

Financial Reporting Framework Other
Than GAAP
Financial statements that use a GAAP

financial reporting framework is referred to
as financial statements that use a generalpurpose financial reporting frameworks.
On the other hand, financial statements that
use a financial reporting framework other
than a GAAP financial reporting
framework is referred to as a specialpurpose financial reporting frameworks.
Audit
Audit in accordance with
AU 800.
See Table 21-4 for
details.
Positive
Add a third paragraph to disclose the

basis used to prepare the financial statements.
Add a paragraph that restricts the

distribution of the report to those within the
entity if the financial statements are prepared
on a regulatory basis in accordance with AU
905, Alerts as to the Intended Use or Purpose
of the Auditors Written Communication.
AU 800 requires the auditor to consider

whether the financial statements are suitably
titled. If they are not, the auditor should
disclose any reservations in an explanatory
paragraph and qualify the opinion. For
example, a cash basis Balance Sheet should
be appropriately titled as Statement of Assets
and
Liabilities
Arising
from
Cash
Transactions.
Audit of financial statements that use

a special-purpose financial reporting
framework is performed in accordance with
the AICPA AU 800 Special Considerations
Audits of Financial Statements Prepared
in Accordance With Special Purpose
Frameworks.
Examples of this engagement include

a report on rentals, royalties, and profit
participation. It may be performed as a
separate engagement or as part of an audit
of a clients complete financial statements.
For profit participation, it must be
performed as part of an audit of the clients
complete financial statements.

accordance with the AU 805 Special
Considerations-Audits of Single Financial
Statements
and
Specific
Elements,
Accounts, or Items of a Financial
Statement.
6. Audit of Information Accompanying the

Basic Financial Statements
Information accompanying the basic

financial statements includes comparative
statements supporting the control totals,
State the specific type of financial

statements in the introductory paragraph.
AICPA AU 800 defines four such

special-purpose
financial
reporting
frameworks: (1) Regulatory basis, (2) Tax
basis, (3) Cash basis, and (4) Contractual
basis financial reporting frameworks.
5. Audit of Specified Elements, Accounts

or Items
A special report similar to a standard audit report,

except
Note: In the case of financial statements

prepared in accordance with a regulatory or
contractual basis of accounting, describe in the
auditors report the purpose for which the
financial statements are prepared or refer to a
note in the special purpose financial statements
that contains that information.
Audit
It is like an audit but is
applied to less than the
full financial statements.
Materiality is defined in
terms of the elements,
accounts,
or
items
involved rather than in
relation to the overall
See Table 21-5 for
details.
Positive
Audit
It is like an audit but is
usually performed with
fewer details (i.e., apply
limited audit procedures)
and the auditor should
Positive or
disclaimer

except
The specified elements, accounts, or

items are identified.
The basis on which the specified

elements, accounts, or items are presented is
described.
A paragraph that restricts the distribution

of the report is added in accordance with AU
The report is also known as a long-form

audit report.
The report is a standard audit report

except additional wordings are added to the
593
594
Key Feature and

supplementary
FASB or SEC,
of insurance
comments on
statements.
Type of
Procedure
information required by
statistical data, a schedule
coverage, and specific
changes in the financial
This engagement is performed in

accordance
with
the
AU
725
Supplementary information in Relation to
the Financial Statements as a Whole.
7. Audit of
Agreement
Compliance
with
Debt
This engagement is to report whether

an audit client that enters into loan
agreements complies with certain debt
agreements or regulatory requirements
related to audited financial statements.
An example is the auditor provides
assurance that the client has complied with
bond indenture provisions relating to the
maintenance of certain financial ratios and
restrictions on the payment of dividends.
report any deficiencies in,

or the omission of,
supplementary
information required by
FASB or SEC.
The measurement of
materiality is the same as
that used in the basic
financial statements taken
as whole.
Audit
It is like an audit but the
auditor
should
be
qualified to evaluate the
debt agreement, e.g., s/he
is a qualified CPA and an
attorney.

accordance with the AU 806 Reporting on
Compliance With Aspects of Contractual
Agreements or Regulatory Requirements in
Connection With Audited Financial
Statements.
Exercise of due care and professional

skepticism about noncompliance are
prerequisites for this engagement.
8. Attestation of Prospective Financial

Statements (i.e. Prospective Financial
Statements based on Financial Forecasts
or Projections).
Prospective financial statements are

financial information representing the
financial position, results of operations, and
cash flows for some period of time in the
future.
Financial forecasts are prospective

financial statements that present a clients
expected financial position, results of
operations, and cash flows, to the best of
the responsible partys knowledge and
belief. Banks commonly require this
information as a part of loan applications.
Financial projections are prospective

financial statements that present a clients
financial position, results of operations, and
cash flows, to the best of the responsible
partys knowledge and belief, given one or
more hypothetical assumptions. For
example, projected financial statements
might assume the clients is able to
increase the price of its primary product by
Type of
Assurance
/Opinion
Examination
Compilation
Agreed-upon procedures
A review engagement of
prospective
financial
statements is prohibited
by AT 301.
See Table 21-6 for
details.
Note: If an auditor
concurrently
provides
more than one level of
service (i.e., concurrently
performs several types of
procedures) such as a
compilation, an agreedupon procedures, and an
audit or examination, the
CPA ordinarily issues a
report that is appropriate
for the highest level of
assurance
service
rendered (i.e., the audit or
examination
engagement).
Form of Report
opinion paragraph of the standard audit report
to express an opinion on all the supplementary
information depending whether sufficient
evidence had been gathered (positive opinion)
or had not been gathered (disclaimer of
opinion) in relation to the basic financial
statements taken as a whole.
Negative
Note: An
audit usually
provides a
positive
opinion; but
it provides a
negative
opinion here
because the
substance of
this
engagement
involves
reviewing
documents
and
regulations.
Therefore, it
is essentially
a review
service that
results in a
negative
opinion.

except
Positive
Express no
opinion
The type of
assurance
varies with
the specific
procedures
agreed to and
performed.
An attestation report similar to a standard audit

report, except
The opinion is in the form of a negative

assurance and is worded as nothing came
to our attention that caused us to believe that
the Company failed to comply with the
A paragraph that restricts the distribution

of the report is added in accordance with AU
The opinion paragraph states the

reasonableness of the underlying and
hypothetical assumptions and the preparation
and presentation of the prospective financial
statements.
Note: The opinion paragraph also state the
reasonableness of the hypothetical assumptions
for projections because projections may contain
certain underlying assumptions and hypothetical
assumptions. On the other hand, forecasts only
contain certain underlying assumptions (i.e., no
hypothetical assumptions); therefore, the opinion
paragraph for forecasts only states the
reasonableness of the underlying assumptions.
A caveat statement that the prospective

results may not be met.
A statement that the CPA assumes no

responsibility to update the report for events
and circumstances occurring after the dates of
the report.
The date of the examination report.

Because the report is a forecast or projection,
the date of the forecasted or projected financial
Key Feature and

Type of
Procedure
Type of
Assurance
/Opinion
10 per cent based on a hypothetical

assumption of no reduction in units sold.
Prospective financial statements

based on financial forecasts or projections
contain certain underlying assumptions
whereas prospective financial statements
based on projections contain certain
underlying assumptions as well as certain
hypothetical assumptions.
This engagement does not attest to

the accuracy of the prospective financial
statements; rather, it attests to the
reasonableness of the underlying and
hypothetical assumptions in the preparation
and presentation of the prospective

Standards for Attestation Engagements
(SSAE) AT 301 Financial Forecasts and
Projections.
Financial forecasts are for general use

(i.e., available to any users).
Financial projection and agreed-upon

procedures are for limited use (i.e.,
available only to restricted and identified
users).
9. An Examination of an Entitys Internal

Control over Financial Reporting that Is
Integrated with an Audit of Its Financial
Statements
This engagement is usually done for a

clients management or audit committee, or
for meeting the requirements of a
regulatory agency.
Examination under AT
501 for private
companies:
All areas of internal
control are examined
unless
specifically
excluded by agreement.
See Table 21-7 for
details.
Presence or
absence of
material
weaknesses
according to
AU 265.
An attestation report similar to a standard audit

report.
Note: If the managements assertion about the
effectiveness of internal control includes a
statement that the cost of corrective action
exceeds
the benefits
of
implementing
new/additional controls, the auditor should
include, as a last paragraph to the attestation of
internal control report, a disclaimer opinion on
the managements cost-benefit statement.
See Figure 21-14 for an example of an
examination report on internal control over
financial reporting that is integrated with an
audit of its financial statements of private
companies.
Integrated Audit under

AS 5 for public
companies:
As a part of the audit of
internal control over
financial
reporting
(ICFR) performed in
conjunction with an audit
of financial statement.
See Table 8-6 in
Chapter 8 for details.
Positive
according to
PCAOBs
AS 5.
Recall in Chapter 8, the PCAOBs AS 4,

Reporting on Whether a Previously Reported
Material Weakness Continue to Exist , provides
guidance for the auditor in reporting on whether a
material weakness continues to exist at an interim
date. According to this standard AS 4, rather than
making a client wait twelve months to receive an
unqualified opinion regarding its ICFR in the
next year-end ICFR report, the auditor can
provide an interim opinion once management has
remediated the material weakness. This standard
The engagement may be performed

on a specified date or during a specified
period of time.
The conditions necessary for an

auditor to accept this engagement are: (1)
Management accepts responsibility for the
effectiveness of internal control, (2)
Management evaluates the effectiveness of
internal control using reasonable criteria,
(3) Sufficient evidence exists, and (4)
Management provides its written assertion
to the auditor
For
private
companies,
the
engagement is performed in accordance
with AICPAs AT 501 An Examination of
an Entitys Internal Control Over
Financial Reporting That Is Integrated
Form of Report
statements should be after the audit report date
of a normal audit of the historical financial
statements.
examination report on a financial projection
examination report on a financial forecast.
Note: Because a financial projection is for limited
use, an examination report on a financial
projection must include a statement that the
report distribution is restricted to the identified
users. On the other hand, because a financial
forecast is for general use, an examination report
on a financial forecast does not contain such a
statement.
In the case of a compilation of a prospective
financial statement, the attestation report should
also include: (1) a statement that a compilation of
a projection is limited in scope, (2) a disclaimer
of responsibility to update the report for events
occurring after the reports date, and (3) a
separate paragraph that describes the limitations
on the usefulness of the presentation (e.g., the
prospective statements fail to provide footnotes).
See Figure 21-12 for an example of a
compilation report for a forecast.
In the case of agreed-upon procedures to
prospective financial statements, three conditions
for accepting such an engagement are: (1) the
specific users have participated in determining its
nature and scope, and they take responsibility for
the adequacy of the procedures; (2) report
distribution is restricted to those users, and (3) the
statements include a summary of significant
assumptions.
See Figure 21-13 for an example of an agreedupon procedures report for a forecast.
595
596
Key Feature and

Type of
Procedure
Type of
Assurance
/Opinion
For
public
companies,
the
engagement is performed in accordance
with PCAOBs Auditing Standard AS 5 An
Audit of Internal Control Over Financial
Reporting That Is Integrated with An Audit
of Financial Statements.
10. Attestation of Websites (also known as

WebTrust Service)
This engagement provides reasonable

assurance that a clients website complies
with Trust Services principles and criteria
for electronic commerce.
Form of Report
allows the auditor to attest on a timely basis as to
whether a client has eliminated the cause of a
previously issued adverse opinion regarding its
ICFR. However, the auditors engagement to
report on whether a previously reported material
weakness continues to exist in conformity with
AS4 is voluntary.
See Figure 8-10 and Figure 8-11 in Chapter 8
for examples of reports on ICFR of public
companies.
With an Audit of Its Financial Statements
Examination
Examining the website
for:
(1)
Adequacy
of
disclosure.
(2) Transaction integrity.
(3) Information integrity.
Positive
A WebTrust report is in the form of a clickable

WebTrust seal that states whether a clients
website meets the WebTrust principles developed
by a joint AICPA/CICA task force.
See Figure 21-15 for an example of a
WebTrust report.
Examination
Examining
the
information systems for:
(1)
Availability
for
operation.
(2) Security against
unauthorized access.
(3) Integrity of system
process.
(4) Maintainability of
system resources.
Positive
A SysTrust report is similar to the WebTrust

report shown in Figure 21-15. It states whether a
clients information systems meets the SysTrust
principles developed by a joint AICPA/CICA
task force, and includes managements assertions
about the effectiveness of the controls over the
information systems.
Examination
Review
Positive
Negative
An attestation report similar to an examination

report.
An attestation report similar to a review report.
The auditors report on MD&A is to provide
assurance on whether
(1) The presentation includes, in all material
respects, the required elements of the rules and
regulations adopted by the SEC.
(2) The historical financial amounts included in
the presentation have been accurately derived, in
all material respects, from the clients financial
statements.

accordance with Statements on Standards
for Attestation Engagements (SSAE) AT
101 Attestation Engagements.
At least once every 12 months, the

auditor tests a clients website to ensure
that its website continues to comply with
the Trust Services principles and criteria. If
the website does not comply, the WebTrust
seal can be revoked.
11. Attestation of Information Systems

(also known as SysTrust Service)
This engagement provides reasonable

assurance that a clients information
systems complies with Trust Services
principles and criteria for electronic
commerce.

101 Attestation Engagements.
The auditor tests a clients

information systems to determine whether
controls over the system were operating
effectively during a specified period. If the
system meets the requirements of the Trust
Services principles and criteria, an
unqualified attestation report is issued.
12. Attestation of Management Discussion

and Analysis (MD&A)
An auditor can examine or review

MD&A.

701 Managements Discussion and
Analysis.
To accept an engagement to examine

MD&A, the auditor must have audited the
Key Feature and

Type of
Procedure
Type of
Assurance
/Opinion
most recent financial statement period to

which the MD&A applies, and the other
financial statement periods also must have
been audited by the same or other auditors.
Form of Report
(3) The underlying information, determinations,
estimates, and assumptions of the client provide a
reasonable basis for the disclosures contained in
the presentation.
The auditor can accept an

engagement to review MD&A for an
annual or interim period.
13. Attestation of Service Organization

Control
AICPA AU 402 Audit Considerations

Relating to an Entity Using a Service
Organization requires an auditor (known as
an user auditor) of a company (known as
an user entity) that uses a service
organization to obtain an understanding of
how the user entity uses the service
organization, including the nature and
significance of the services and the effect
on internal control.
Examination
User Auditor
Service Auditor
See Table 21-8 for
details.
Positive
In
determining
the
sufficiency
and
appropriateness of the audit evidence provided by
the service auditors report, the user auditor
should consider the professional competence of
the service auditor and his/her independence with
respect to the service organization.
Many service organizations perform

similar processing services for numerous
user entities. If the auditor of each user
entity were to visit the service organization
for the purpose of reviewing controls, they
would ask similar questions and perform
similar tests. Thus, it is often advantageous
for the service organization to engage its
own auditor (known as a service auditor)
to examine its controls and issue a service
organization control report (known as a
SOC report) that is relevant to the user
entitys internal control over financial
reporting. The user auditor may then elect
to rely on this report as an alternative or in
addition to performing testing procedure at
the service organization.
14. Agreed-upon Procedures Engagements

This is an engagement when the
auditor and management or a third party
user agree that the audit will be limited to
certain specific audit procedures.

accordance to:
(1) AT 201 Agreed-Upon Procedures
Engagements for financial statement matters
such as agreed-upon audit procedures for
gross sales account for a lease agreement, and
(2) AT 201 Agreed-Upon Procedures
Engagements for non-financial statement
matters such as agreed-upon audit procedures
for testing compliance with federal
affirmative action laws.
This engagement is allowed when the

agreed-upon procedures are not sufficient
to express an opinion, provided that:
(1) The parties involved have a clear
understanding of the procedures to be
AICPA AT 801 Reporting on Controls at a

Service Organization describes two types of SOC
reports that a service auditor may issue:
(1) Type 1 report A report on a managements
description of a service organizations system and
the suitability of the design of controls.
(2) Type 2 report A report on a managements
description of a service organizations system and
the testing of the design and operating
effectiveness of controls.
If the user auditors control risk (CR) assessment

includes an expectation that controls at the
service organization operate effectively, the user
auditor should obtain a Type 2 report (if
available), or perform appropriate tests of
controls (TOC).
If the service auditors Type 2 report provides an
adequate basis for the user auditors assessment
of control risk, usually there is no need for the
user auditor to perform his/her own tests at the
service organization.
See Figure 21-16 for an example of a service
auditors Type 2 report.
Agreed-upon audit
procedures
The type of
assurance
varies with
the specific
procedures
agreed to and
performed.
The form of report varies with the specific

procedures agreed to and performed.
A report on an agreed-upon procedures
engagement should identify the specified users
and describe in detail the procedures the users
decided were necessary; state the work is not an
audit or review that results in an overall opinion
or assurance; and describe each of the agreedupon procedures and the specific findings related
to each procedure.
No overall positive or negative opinion is given
as a conclusion to the report. Instead, the report
provides the accountants findings based on the
procedures performed.
See Figure 21-17 for an example for an
agreed-upon procedures report.
597
598
Key Feature and

Type of
Procedure
Type of
Assurance
/Opinion
Form of Report
performed, and
(2) Use of the report is to be restricted to the
specified parties.
For this engagement, clearly worded

engagement letters specially delineating the
desired procedures to be performed are of
utmost important.
Future Other Audit Engagements

XBRL
XBRL, eXtensible Business Reporting Language, is an international information format designed specifically for
business information. It assigns all individual disclosure items within business reports unique electronically readable
tags that are mapped to taxonomies. XBRL offers major benefits in the preparation, analysis, and communication of
business information through its cost-effective and improved reliability as compared to other existing systems.
Audited financial statements are now being provided using XBRL. In 2009, the SEC issued rules requiring
public companies to provide financial information in a form that can be easily downloaded directly into interactive
spreadsheets to make it easier for investors to analyze and to assist in automating regulatory filings. The SEC
mandated that this form of financial information to be posted to a companys website. Under the current SEC rules
and professional auditing standards, auditors are not required to perform procedures or provide assurance on XBRLtagged data in the context of audited financial statements. Accordingly, the auditors report on the financial
statements does not cover the process by which XBRL-tagged data that results from this process, or any
representation of XBRL-tagged data. However, auditors may choose to engage in XBRL-related assurance
engagements (services) such as 1. Agree-upon procedures engagements on XBRL-tagged data to assist management
in its evaluation of the XBRL-tagged data and the audit committee in its oversight role. 2. Assurance engagements
on the controls related to the XBRL-tagging process and examinations of the accuracy of the XBRL-tagged data
itself. 3. Assurance engagements on financial information as presented in particular pre-defined instance documents.
Continuous Auditing
A demand exists for assurance beyond that provided on quarterly and annual financial statements. Continuous
auditing engagement provides assurance using a series of reports provided simultaneously or shortly after the related
information is released. Continuing auditing engagement is expected to grow significantly as companies provide
more and more up-to-date financial information on their Web sites.
Table 21-2 Procedures for Review Engagement
Procedures for Review Engagement
A review engagement consists primarily of inquiries of management and analytical procedures. It does not include obtaining an understanding of
internal control, TOC, TOB, or specific tests of balances such as confirmation of receivables or observation of physical inventory. AR 90
recommended the following procedures for a review engagement:
Obtain knowledge of the accounting principles and practices of the clients industry, such as, by using the AICPAs industry guides.
Obtain knowledge of the client, which includes the nature of business transactions, type of accounting records, and the form of financial
statements.
Make inquiries of management concerning: (1) The managements procedures for recording, classifying, and summarizing transactions,
and disclosing information in the statements. (2) The management actions taken at meetings of stockholders and board of directors. (3) The
managements preparation of the financial statements in conformity with GAAP.
Perform analytical procedures (Recall Chapter 7 on analytical procedures): (1) Develop expectations by identifying and using plausible
relationships that are reasonably expected to exist. (2) Compare recorded amounts or ratios developed from recorded amounts to expectations.
(3) Compare the consistency of managements responses in light of results of other review procedures and knowledge of business and industry.
Obtain a management representation letter (Recall Chapter 19 on management representation letter).
Based on these procedures, a CPA may become concerned that financial information is incorrect, incomplete, or otherwise unsatisfactory due to a
departure from GAAP. If so, additional procedures should be performed before the CPA issues either a standard negative opinion or a modified
standard negative opinion with the wordings With the exception of the matter described in the following paragraph, we are not aware of an
material modifications ... and add a paragraph in the report to describe the departure.
Figure 21-2 Example of a Review Report

We have reviewed the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the year then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the
American Institute of Certified Accountants. All information included in these financial statements is the representation of the management of
XYZ Company.
A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in
scope than an audit in accordance with the Standards of the Public Company Accounting Oversight Board, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order
for them to be in conformity with generally accepted accounting principles.
Table 21-3 Procedures for Compilation Engagement

Procedures for Compilation Engagement
A CPA is not required to be independent in the preparation of a clients financial statements. However, the CPA is required to exercise due care
in preparing the financial statements as follows:
Possess knowledge of the accounting principles and practices of the clients industry.
Know the client and the nature of its business transactions and records. The knowledge can be less than that for a review.
Make inquiries to determine whether the clients information is satisfactory.
Read the compiled financial statements and be alert for any obvious omissions or errors.
According to AR 80, a compilation engagement includes:

Preparation of financial statements either manually or through the use of computer software based on GAAP or on a comprehensive basis
of accounting other than GAAP.
Modification of client-prepared financial statements by materially changing account classifications, amounts, or disclosures directly on
the client-prepared financial statements.
According to AR 80, a compilation engagement does not include:

Typing or reproducing client-prepared financial statements without modification , as an accommodation to the client.
Preparing standard monthly journal entries such as depreciation and expiration of prepaid expenses.
Providing a financial statement format without dollar amounts to be used by the client in preparing financial statements.
Reading client-prepared financial statements.
Proposing/suggesting correcting journal entries or disclosure to be recorded by the client.
Advising a client about the selection of computer software to prepare financial statements.
Providing a client with the use of computer hardware or software to generate financial statements.
Figure 21-3 Example of a Compilation Report with Full Disclosure

We have compiled the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the year then ended, in accordance with the Statements on Standards for Accounting and Review Services issued by
the American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the representation of management. We have not
audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them.
Figure 21-4 Example of a Compilation Report that Omits Substantially All Disclosures
We have compiled the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the year then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the
American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the representation of management. We have not
audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them.
599
600
Management has elected to omit substantially all of the disclosures and the statement of cash flows required by generally accepted accounting
principles. If the omitted disclosures were included in the financial statements, they might influence the users conclusions about the companys
financial position, results of operations, and cash flows. Accordingly, these financial statements are not designed for those who are not informed
about such matters.
Figure 21-5 Example of a Review of Interim Financial Information Report

We have reviewed the accompanying balance sheet of XYZ Company as of March 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the three-month periods then ended, in accordance with the Public Company Accounting Oversight Board (United
States). All information included in these financial statements is the representation of the management of XYZ Company.
A review of interim financial information consists principally of inquiries of company personnel and analytical procedures applied to financial
data. It is substantially less in scope than an audit in accordance with the standards of the Public Company Accounting Oversight Board, the
objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an
opinion.
Table 21-4 Procedures for an Audit of Financial Statements Prepared in Accordance With a Special Purpose
Financial Reporting Framework
Procedures for an Audit of Financial Statements Prepared in Accordance With a Special Purpose Financial
Reporting Framework
AU 800 requires that auditors of special purpose framework statements:

Obtain an understanding of (1) the purpose for which the financial statements are prepared, (2) the intended users, and (3) the steps taken
by management to determine that the special purpose framework is acceptable in the circumstances.
Obtain the agreement of management that it acknowledges and understands its responsibility to include all informative disclosures that
are appropriate for the special purpose framework used to prepare the financial statements, including, but not limited to, additional disclosures
beyond those required by GAAP that may be necessary to achieve fair presentation. The auditor is required to evaluate whether such
disclosures are necessary.
In the case of special purpose financial statements prepared in accordance with a contractual basis of accounting, obtain an understanding
of any significant interpretations of the contract that management made in the preparation of those financial statements and to evaluate whether
the financial statements adequately describe such interpretations.
When management has a choice of financial reporting frameworks in the preparation of the financial statements, explain managements
responsibility for the financial statements in the auditors report and refer to managements responsibility for determining that the applicable
financial reporting framework is acceptable in the circumstances.
Figure 21-6 Example of a Report on Financial Statements Prepared in Accordance With an Income Tax Basis
A Special Purpose Financial Reporting Framework
We have audited the accompanying statements of assets, liabilities, and capital income tax basis of ABC Partnership as of December 31, 200x,
and the related statements of revenue and expenses income tax basis and of changes in partners capital accounts income tax basis for the year
then ended. These financial statements are the responsibility of the Partnerships management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board. Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As described in Note 3, these financial statements were prepared on the basis of accounting the Partnership uses for income tax purposes,
which is a comprehensive basis of accounting other than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities, and capital of ABC
Partnership as of December 31, 20xx, and its revenue and expenses and changes in partners capital accounts for the year then ended, on the basis
of accounting described in Note 3.
Table 21-5 Procedures for Auditing Specified Elements, Accounts, or Items of a Financial Statement
Procedures for Specified Elements, Accounts, or Items of a Financial Statement
The same audit procedures in an ordinary audit of full financial statements are used in an audit of specified elements, accounts, or items of a
financial statement. However, there are three key differences:
Materiality is defined in terms of the elements, accounts, or items involved rather than in relation to the overall financial statements. The
effect is that more evidence is required than if the same information were considered as part of an audit of the overall financial statements.
The first standard of reporting under PCAOBs GAAS does not apply because the presentation of elements, accounts, or items is not a
financial statement prepared in accordance with GAAP.
The audit must extend audit procedures to other elements, accounts, or items that are interrelated with those elements, accounts, or items
under consideration. For example, if the auditor were engaged to audit a clients accounts receivable, other accounts such as sales and
allowance for bad debts should also be considered.
Figure 21-7 Example of a Report of Specified Elements, Accounts or Items Gross Sales for the Purpose of
Computing Rent
We have audited the accompanying schedule of gross sales (as defined in the lease agreement dated March 31, 20xx, between ABC Company, as
lessor, and DEF Company, as lessee) of DEF Company at its 6th Street Store, San Francisco, for the year ended December 20xx. This schedule is
the responsibility of the DEF Companys management. Our responsibility is to express an opinion on this schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board. Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the schedule of gross sales is free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the schedule of gross sales. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall schedule presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the schedule of gross sales referred to above present fairly, in all material respects, the gross sales of DEF Company at its 6th
Street store, San Francisco, for the year ended December 31, 20xx, as defined in the lease agreement referred to in the first paragraph.
This report is intended solely for the information and use of the boards of directors and management of ABC Company and DEF Company
and should not be used by anyone other than these specified parties.
Figure 21-8 Example of a Report of Information Accompanying Basic Financial Statements

(When there is a positive opinion on the accompanying information)
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying
information on pages x through y is presented for purposes of additional analysis, and is not a required part of the basic financial statements.
Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly
stated in all material respects in relation to the basic financial statements taken as a whole.
(When there is a disclaimer of opinion on the accompanying information)
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying
information on pages x through y is presented for purposes of additional analysis, and is not a required part of the basic financial statements.
Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements and, accordingly we
express no opinion on it.
Figure 21-9 Example of a Debt Compliance Report

We have audited, in accordance with the standards of the Public Company Accounting Oversight Board, the balance sheet of ABC Company as
of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended, and have issued our
report thereon dated March 31, 20xx.
In connection with our audit, nothing came to our attention that caused us to believe that the Company failed to comply with the terms,
covenants, provisions, or conditions of sections xx to xx inclusive, of the indenture dated July 21, 20xx, with Bank of America insofar as they
relate to accounting matters. However, our audit was not directed primarily toward obtaining knowledge of such non-compliance.
This report is intended solely for the information and use of the boards of directors and managements of ABC Company and Bank of America
and should not be used for any other purpose.
601
602
Table 21-6 Procedures for Attestation of Prospective Financial Statements

Procedures for Prospective Financial Statements
In an examination of prospective financial statements, the auditor obtains satisfaction as to the completeness and reasonableness of all the
assumptions.
In a compilation of prospective financial statements, the auditor is primarily involved with the computational accuracy of the statements, and not
the reasonableness of the assumptions.
In agreed-upon procedures of prospective financial statements, the auditor and all users of the statements agree on specific, limited attestation
procedures.
AT 301 describes four elements in an examination of prospective financial statements:

Evaluating the preparation of the prospective financial statements.
Evaluating the support underlying (forecast) and hypothetical (projection) the assumptions.
Evaluating the presentation of the prospective financial statements for conformity with AICPA presentation guidelines.
Issuing an examination report.
These four elements are based primarily on accumulating evidence about the completeness and reasonableness of the underlying and hypothetical
assumptions as disclosed in the prospective financial statements. As such, the auditor is required to
Become familiar with the clients business and industry.

Identify the key factors on which the prospective results are expected to depend.
Determine that appropriate assumptions are included in determining prospective results.
The auditors report on an examination of prospective financial statements should include the following:
An identification of the prospective financial statements presented.
A statement that the examination of the prospective financial statements was made in accordance with AICPA standards and a brief
description of the nature of such an examination.
The CPAs opinion that the prospective financial statements are presented in conformity with AICPA presentation guidelines and that the
underlying assumptions (for forecast) and hypothetical assumptions (for projection) provide a reasonable basis for the prospective financial
statements.
A caveat that the prospective results may not be achieved.
A statement that the accountant assumes no responsibility to update the report for events and circumstances occurring after the date of the
report.
AT 301 describes the following requirements in an agreed-upon procedures for prospective financial statements:
The auditor is independent.
The auditor and the specified users agree upon the procedures performed or to be performed by the auditor.
The specified users take responsibility for the sufficiency of the agreed-upon procedures for their purposes.
The prospective financial statements include a summary of significant assumptions.
The prospective financial statements to which the procedures are to be applied are subject to reasonably consistent evaluation against
criteria that are suitable and available to the specified parties.
Criteria to be used to determine findings are agreed upon between the auditor and the specified users.
The procedures to be applied to the prospective financial statements are expected to result in reasonably consistent findings using the
criteria.
Relevant evidence is expected to exist to provide a reasonable basis for the auditors report.
The auditor and the specified users agree on materiality limits for reporting purposes, where applicable.
Use of the report is restricted to the parties who have agreed with the auditor on the procedures to be performed.
AT 301 describes a compilation of prospective financial statements that involves the followings:
Assembling, to the extent necessary, the prospective financial statements based on the responsible partys assumptions.
Performing the required compilation procedures, which include reading the prospective financial statements with their summaries of
significant assumptions and accounting policies and considering whether they appear to be (1) presented in conformity with the attestation
standards and (2) not obviously inappropriate.
Issuing a compilation report.
Figure 21-10 Example of an Examination Report on a Financial Projection

We have examined the accompanying projected balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of
December 31, 20xx, and for the year then ending. ABC Companys management is responsible for the projection, which was prepared for the
Bank of America for the purpose of negotiating a loan to expand ABC Companys plant. Our responsibility is to express an opinion on the
projection based on our examination.
Our examination was made in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of
Certified Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate the assumptions used by
management and the preparation and presentation of the projection.
In our opinion, the accompanying projection is presented in conformity with guidelines for presentation of a projection established by the
American Institute of Certified Public Accountants, and the underlying and hypothetical assumptions provided a reasonable basis for
managements projection, assuming the granting of the requested loan for the purpose of expanding ABC Companys plant as described in the
summary of significant assumptions. However, even if the loan is granted and the plant is expanded, there will likely be differences between the
projected and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We
have no responsibility to update this report for events and circumstances occurring after the date of this report.
The accompanying projection and this report are intended solely for the information and use of ABC Company and Bank of America and are
not intended to be and should not be used by anyone other than these parties.
Figure 21-11 Example of an Examination Report on a Financial Forecast

We have examined the accompanying forecasted balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of
December 31, 20xx, and for the year then ending. ABC Company is responsible for the forecast. Our responsibility is to express an opinion on
the forecast based on our examination.
Certified Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate both the assumptions used by
management and the preparation and presentation of the forecast. We believe that our examination provides a reasonable basis for our opinion.
In our opinion, the accompanying forecast is presented in conformity with guidelines for presentation of a forecast established by the
American Institute of Certified Public Accountants, and the underlying assumptions provided a reasonable basis for managements forecast.
However, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as
expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the
date of this report.
Figure 21-12 Example of a Compilation Report for a Forecast

We have compiled the accompanying forecasted balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of
December 31, 20xx, and for the year then ending, in accordance with the Statements on Standards for Attestation Engagements issued by the
American Institute of Certified Public Accountants.
A compilation is limited to presenting, in the form of a forecast, information that is the representation of management and does not include
evaluation of the support for the assumptions underlying the forecast. We have not examined the forecast and, accordingly, do not express an
opinion or any other form of assurance on the accompanying statements or assumptions. Furthermore, there will usually be differences between
the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material.
We have no responsibility to update this report for events and circumstances occurring after the date of this report.
This report is intended solely for the use of the boards of directors of ABC Company and XYZ Company and is not intended to be and should
not be used by anyone other than these parties.
Figure 21-13 Example of an Agreed-upon Procedures Report for a Forecast

Board of Directors ABC Company
Board of Directors XYZ Company
At your request, we have performed certain agreed-upon procedures, as enumerated below, with respect to the forecasted balance sheet, and the
related forecasted statements of income, retained earnings, and cash flows of ABC Company, a subsidiary of XYZ Company, as of December 31,
20xx, and for the year then ending. These procedures, which were agreed to by the boards of directors of ABC Company and XYZ Company,
were performed solely to assist you in evaluating the forecast in connection with the sale of ABC Company to XYZ Company.
This agreed-upon procedures engagement was conducted in accordance with the Statements on Standards for Attestation Engagements issued
by the American Institute of Certified Public Accountants. The sufficiency of these procedures is solely the responsibility of the specified users
of the report. Consequently, we make no representation regarding the sufficiency of the procedures described below either for the purpose for
which this report has been requested or for any other purpose.
The procedures and associated findings are as follows:
(1) With respect to forecasted rental income, we compared the assumptions about expected demand for rental of the housing units to demand for
603
604
similar housing units at similar rental prices in the city area in which ABC Companys housing units are located.
No exceptions were found as a result of this comparison.
(2) We tested the forecast for mathematical accuracy.
The forecast was mathematically accurate.
We were not engage to and did not conduct an examination, the objective of which would be the expression of an opinion on the accompanying
prospective financial statements. Accordingly, we do not express an opinion on whether the prospective financial statements are presented in
conformity with AICPA presentation guidelines or on whether the underlying assumptions provide a reasonable basis for the presentation. Had
we performed additional procedures, other matters might have come to our attention that would have been reported to you. Furthermore, there
will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and
those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this
report.
Table 21-7 Procedures for Attestation of Internal Control over Financial Reporting that Is Integrated with an
Audit of Its Financial Statements of Private Companies
Procedures for Attestation of Internal Control over Financial Reporting
that Is Integrated with an Audit of Its Financial Statements of Private Companies
The procedures in AT 501 for attestation of internal control over financial reporting that is integrated with an audit of its financial statements of
private companies are similar to that in AS 5 for an audit of internal control over financial reporting that is integrated with an audit of its financial
statements of public companies. They include the following steps:
Plan the engagement.

The auditor, client, and others involved first agree on the areas to be covered and the timing of the attestation. The auditor then obtains
information about the clients business, industry and regulatory requirements, and the nature of accounting transactions and the record-keeping
system.
Obtain an understanding of internal control.

The auditor obtains detailed information about the transactions, their flow through the system, transaction-related audit objectives, and control
activities used to achieve control.
Evaluate the design effectiveness of controls.

The auditor should evaluate whether the controls are suitably designed to prevent or detect misstatements in specific financial statement
assertions.
Test and evaluate the operating effectiveness of the controls.

These tests are concerned with how the controls are applied and their consistency of application. The methodology for these procedures is similar
to the procedures for performing TOC in an audit.
Form an opinion about managements assertion regarding the effectiveness of internal control.
A material weakness in internal control generally precludes management from asserting that the client has effective internal control.
In addition, AT 501 requires the following conditions to be met before the auditor can conduct an examination of internal control over financial
reporting that is integrated with an audit of its financial statements:
Management accepts responsibility for the effectiveness of its internal control.
Managements evaluation of control is based on suitable and available criteria (e.g., the Committee of Sponsoring Organizations (COSO)
Report).
Managements evaluation of control is supported by sufficient evidence.

Management presents its assertion about the effectiveness of its internal control in a written report that accompanies the auditors report.
Figure 21-14 Example of an Examination Report on Internal Control over Financial Reporting that Is
Integrated with an Audit of Its Financial Statements of Private Companies
We have examined managements assertion that ABC Company maintained effective internal control over financial reporting as of December 31,
20xx, included in the accompanying management report.
Certified Accountants. Those standards require that we plan and perform the examination to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material respects. Our examination of internal control over financial reporting
included obtaining an understanding of internal control over financial reporting, testing, and evaluating the design and operating effectiveness of
internal control, and such other procedures as we considered necessary in the circumstances. We believe that out examination provides a
reasonable basis for our opinion.
Because of inherent limitations in any internal control, errors or fraud may occur and not be detected. Also, projection of any evaluation of the
internal control over financial reporting to future periods is subject to the risk that internal control may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, managements assertion that ABC Company maintained effective internal control over financial reporting as of December 31,
20xx, is fairly stated, in all material respects, based upon the criteria established in Internal Control Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission.
Figure 21-15 Example of a WebTrust Report

We have examined the assertion [<hot link to managements assertion>] by ABC Company regarding the disclosure of its electronic commerce
business practices on its web site and the effectiveness of its controls over transaction integrity and information protection for electronic
commerce at [<web site address>] during the period August 1, 20xx, through October 31, 20xx.
These electronic disclosures and controls are the responsibility of ABC Companys management. Our responsibility is to express an opinion
on managements assertions with regards to the AICPA/CICA WebTrust Criteria [<hot link>] based on our examination.
Our examination was conducted in accordance with the Statements on Standards for Attestation Engagements issued by the American
Institute of Certified Public Accountants and, accordingly, included (1) obtaining an understanding of ABC Companys electronic commerce
business practices and its controls over the processing of electronic commerce transactions and the protection of related private customer
information, (2) selectively testing transactions executed in accordance with disclosed business practices, (3) testing and evaluation the operating
effectiveness of controls, and (4) performing such other procedures as we considered necessary in the circumstances. We believe that out
examination provides a reasonable basis for our opinion.
Because of inherent limitations in controls, errors or fraud may occur and not be detected. Furthermore, the projection of any conclusions,
based on our findings, to future periods is subject to the risk that (1) changes made to the system or controls, (2) changes in processing
requirements, or (3) changes required because of the passage of time may alter the validity of such conclusions.
In our opinion, during the period August 1, 20xx, through October 31, 20xx, ABC Company, in all material respects, based on the
AICPA/CICA WebTrust Criteria:
disclosed its business practices for electronic commerce transactions and executed transactions in accordance with its disclosed business
practices,
maintained effective controls to provide reasonable assurance that customers orders placed using electronic commerce were completed
and billed as agreed, and,
maintained effective controls to provide reasonable assurance that private customer information obtained as a result of electronic
commerce was protected from uses not related to ABCs business.
The CPA WebTrust seal of assurance on ABCs web site for electronic commerce constitutes a symbolic representation of the contents of this
report and it is not intended, nor should it be construed, to update this report or provide an additional assurance.
This report does not include any representation as to the quality of ABCs goods or services nor their suitability for any customers intended
purpose.
Table 21-8 Procedures for Attestation of Service Organizations

Procedures for Attestation of Service Organizations
Service organizations provide processing services to companies who decide to outsource their processing of data. Examples of services that are
typically outsourced include cloud computing services, payroll processing services, information security services, and information system
services.
User Auditor
AICPA AU 402 Audit Considerations Relating to an Entity Using a Service Organization requires an auditor (known as an user auditor)
of a company (known as an user entity) that uses a service organization to obtain an understanding of how the user entity uses the service
organization, including the nature and significance of the services and the effect on internal control. If the user auditor is unable to obtain a
sufficient understanding from the user entity, s/he should obtain that understanding through performing one or more of the following
procedures:
(1) Contact the service organization, through the user entity, to obtain specific information.
(2) Visit the service organization and perform necessary procedures about the relevant controls at the service organization.
(3) Obtain and consider the report of a service auditor (auditor of the service organization).
When there is a low degree of interaction between the user entitys controls and those at the service organization, the user auditor may
find that controls applied by the user entity are adequate to endure that material errors or fraud in transactions are detected. For example, the
user entitys computer personnel may develop input control totals and compare them to the service organizations output. When such controls
are adequate, the auditor needs test only the user entitys controls to obtain appropriate evidence; there is no need to perform tests of controls at
the service organization.
When there is a high degree of interaction between the user entitys controls and those at the service organization, the user auditor may
contact the service organization and, if necessary, perform procedures to obtain the required understanding of the service organization. In
addition, if the user auditors plan includes a presumption that certain controls operate effectively, the user auditor should obtain evidence of
their operating effectiveness regardless of whether those controls are applied by the user entity or by the service organization.
Many service organizations perform similar processing services for numerous user entities. If the auditor of each user entity were to visit
the service organization for the purpose of reviewing controls, they would ask similar questions and perform similar tests. Thus, it is often
advantageous for the service organization to engage its own auditor (i.e., a service auditor) to examine its controls and to issue a service
organization control report (known as a SOC report) that is relevant to the user entitys internal control over financial reporting. The user
auditor may then elect to rely on this report as an alternative or in addition to performing testing procedure at the service organization.
605
606
Procedures for Attestation of Service Organizations
AICPA AT 801 Reporting on Controls at a Service Organization describes two types of SOC reports that a service auditor may issue:
(1) Type 1 report A report on a managements description of a service organizations system and the suitability of the design of controls.
(2) Type 2 report A report on a managements description of a service organizations system and the testing of the design and operating
In determining the sufficiency and appropriateness of the audit evidence provided by the service auditors report, the user auditor should
consider the professional competence of the service auditor and his/her independence with respect to the service organization.
If the user auditors control risk (CR) assessment includes an expectation that controls at the service organization operate effectively, the
user auditor should obtain a Type 2 report (if available), or perform appropriate tests of controls (TOC).
If the service auditors Type 2 report provides an adequate basis for the user auditors assessment of control risk, usually there is no need
for the user auditor to perform his/her own tests at the service organization.
Service Auditor
Many service organizations perform similar processing services for numerous user entities. If the auditor of each user entity were to visit
the service organization for the purpose of reviewing controls, they would ask similar questions and perform similar tests. Thus, it is often
advantageous for the service organization to engage its own auditor (i.e., a service auditor) to examine its controls and to issue a service
organization control report (known as a SOC report) that is relevant to the user entitys internal control over financial reporting. The user
auditor may then elect to rely on this report as an alternative or in addition to performing testing procedure at the service organization.
The service auditors examination of a service organizations system and the suitability of the design and operating effectiveness of the
service organizations controls to achieve the related control objectives involves preforming procedures to obtain sufficient and appropriate
evidence about the fairness of the presentation of the service organizations system and the suitability of the design and operating effectiveness
of those controls to achieve the related control objectives. The examination procedures include assessing the risks that the service
organizations system is not fairly presented and that the controls were not suitably designed or operating effectively to achieve the related
control objectives. The examination procedures also include testing the operating effectiveness of those controls that the service auditor
considers necessary to provide reasonable assurance that the related control objectives were achieved.
AICPA AT 801 Reporting on Controls at a Service Organization describes two types of SOC reports that a service auditor may issue:
(1) Type 1 report A report on a managements description of a service organizations system and the suitability of the design of controls.
(2) Type 2 report A report on a managements description of a service organizations system and the testing of the design and operating
Specifically, a service auditor may issue the following three SOC Reports:
SOC 1 Reports (either Type 1 or Type 2 report) SOC 1 reports are issued under AICAP AT 801, which report on service organization
controls over financial reporting, particularly on those controls likely to be relevant to user entities financial statements. These are restricteduse report primarily for user auditors.
SOC 2 Reports (either Type 1 or Type 2 report) SOC 2 reports are issued under AT 101 Attest Engagements and relate to the Trust Services
principles of security, availability, processing integrity, confidentiality, and/or privacy. SOC 2 Reports are designed to provide (1)
Organizations that outsource tasks and functions a mechanism for improving governance and oversight of service providers. (2) Service
organizations the ability to communicate the suitability of the design and operating effectiveness of their controls. These are restricted-use
reports primarily for service organization and user entitys stakeholders such as customers, regulators, business partners, suppliers, and
directors. The report contents are similar to SOC 1 Report.
SOC 3 Reports (Neither Type 1 nor Type 2 report) SOC 3 reports are issued under AT 101 and AICPA Technical Practice Aid Trust
Services Principles, Criteria and Illustrations . These reports provide a short description of the service organizations system and report on
whether the service organization maintained effective controls based on the Trust Services Criteria of security, availability, processing
integrity, confidentiality, and/or privacy. They are general-use (for use by everyone) reports such as WebTrust and SysTrust reports (see other
audit engagements No. 10 and No. 11).
See Figure 21-16 Example of a Service Auditors Type 2 Report

We have examined ABC Service Organizations description of its Computer Center system for processing user entities transactions throughout
the year ended December 31, 20xx, and the suitability of the design and operating effectiveness of controls to achieve the related control
objectives stated in the description.
On page 01 of the description, ABC Service Organization has provided an assertion about the fairness of the presentation of the description
and suitability of the design and operating effectiveness of the controls to achieve the related control objectives stated in the description. ABC
Service Organization is responsible for preparing the description and for the assertion, including the completeness, accuracy, and method of
presentation of the description and the assertion, providing the services covered by the description, specifying the control objectives and stating
them in the description, identifying the risks that threaten the achievement of the control objectives, selecting the criteria, and designing,
implementing, and documenting controls to achieve the related control objectives stated in the description.
Our responsibility is to express an opinion on the fairness of the presentation of the description and on the suitability of the design and
operating effectiveness of the controls to achieve the related control objectives stated in the description based on our examination. We conducted
our examination in accordance with attestation standards established by the American Institute of Certified Public Accountants. Those standards
require that we plan and perform our examination to obtain reasonable assurance about whether, in all material respects, the description is fairly
presented and the controls were suitably designed and operating effectively to achieve the related control objectives stated in the description
throughout the year ended December 31, 20xx.
An examination of a description of a service organizations system and the suitability of the design and operating effectiveness of the service
organizations controls to achieve the related control objectives stated in the description involves preforming procedures to obtain evidence about
the fairness of the presentation of the description and the suitability of the design and operating effectiveness of those controls to achieve the
related control objectives stated in the description. Our procedures included assessing the risks that the description is not fairly presented and that
the controls were not suitably designed or operating effectively to achieve the related control objectives stated in the description. Our procedures
also included testing the operating effectiveness of those controls that we consider necessary to provide reasonable assurance that the related
control objectives stated in the description were achieved. An examination engagement of this type also includes evaluating the overall
presentation of the description and the suitability of the control objectives stated therein, and the suitability of the criteria specified by the service
organization and described at page 01. We believe that the evidence we obtained is sufficient and appropriate to provide a reasonable basis for
our opinion.
Because of their nature, controls at a service organization may not prevent, or detect and correct, all errors or omissions in processing or
reporting transactions. Also, the projection to the future of any evaluation of the fairness of the presentation of the description, or conclusions
about the suitability of the design or operating effectiveness of the controls to achieve the related control objectives is subject to the risk that
controls at a service organization may become inadequate or fail.
In our opinion, in all material respects, based on the criteria described in ABC Service Organizations assertion on page 01
(1) the description fairly presents the system that was designed and implemented throughout the year ended December 31, 20xx.
(2) the controls related to the control objectives stated in the description were suitably designed to provide reasonable assurance that the control
objectives would be achieved if the controls operated effectively throughout the year ended December 31, 20xx.
(3) the controls tested, which were those necessary to provide reasonable assurance that the control objectives stated in the description were
achieved, operated effectively throughout the year ended December 31, 20xx.
The specific controls tested and the nature, timing, and results of those tests are listed in pages 10-20.
This report, including the description of tests of controls and results thereof on pages 10-20 is intended solely for the information and use of
ABC Service Organization, user entities of ABC Service Organizations system during some or all of the year ended December 31, 20xx, and the
independent auditors of such user entities, who have a sufficient understanding to consider it, along with other information including information
about controls implemented by user entities themselves when assessing the risks of material misstatements of user entities financial statements.
This report is not intended to be and should not be used by any other than these specified parties.
Figure 21-17 Example of an Agreed-Upon Procedures Report

We have performed the procedures enumerated below, which were agreed to by the Board of Directors and management of ABC Company,
solely to assist you in determining the amount of gross sales as defined in the lease agreement dated September 1, 20xx, between MNO
Company, lessor, and ABC Company, lessee, for the year ended December 31, 20xx. This agreement to apply agreed-upon procedures was
performed in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public
Accountants. The sufficiency of these procedures is solely the responsibility of the Board of Directors and management of ABC Company.
Consequently, we make no representation regarding the sufficiency of the procedures described below either for the purpose for which this report
has been requested or for any other purpose.
The procedures we performed are summarized as follows:
1. We obtained a schedule prepared by management, which reflected gross sales, as defined above, for the year ended December 31,
20xx, of $800,000,000.
2. We obtained the weekly cash reports submitted by the store manager for the year. These reports show information on gross sales, cash
register readings, sales taxes, returns, and allowances for discounts and other information.
3. We compared monthly summarizations of these reports with the schedule of gross sales and compared approximately 5 percent of the
daily cash net receipts shown in the weekly cash reports with the bank statements.
Based solely on the foregoing procedures, we found:
1. The daily cash net receipts shown in the weekly cash reports that we compared with the bank statements to be in agreement.
2. The monthly summarizations to be in agreement with the schedule of gross sales we obtained from management.
These agreed-upon procedures do not constitute an audit or review of financial statements of any part thereof, the objective of which is the
expression of an opinion or limited assurance on the financial statements or a part thereof; accordingly, we do not express such an opinion. Had
we performed additional procedures, other matters might have come to our attention that would have been reported to you.
This report is intended solely for the use of the specified users listed and should not be used by those who have not agreed to the procedures
and taken responsibility for the sufficiency of the procedures for their purposes.
607
608
Multi-Choice Questions
21-1
A CPA has been engaged to perform review services for a client. Identify which of the following is a correct statement.
a. The CPA must perform the basic audit procedures necessary to determine that the statements are in conformity with
GAAP.
b. The financial statements are primarily representations of the CPA.
c. The CPA may prepare the statements from the books but may not assist in adjusting and closing the books.
d. The CPA is performing an accounting service rather than an audit of the financial statements.
21-2
It is acceptable for a CPA to be associated with financial statements when he or she is not independent with respect to the
client and still issue a substantially unmodified report for which of the following:
a. Audits of companies following GAAP.
b. Audits of financial statements that use a financial reporting framework other than GAAP.
c. Compilation of financial statements following GAAP.
d. Review of financial statements following GAAP.
21-3
Which of the following best describes the responsibility of the CPA in performing compilation services for a company?
a. The CPA must understand the clients business and accounting methods and read the financial statements for
reasonableness
b. The CPA has to satisfy only himself or herself that the financial statements were prepared in conformity with GAAP.
c. The CPA should obtain an understanding of internal control and perform tests of controls.
d. The CPA is relieved of any responsibility to third parties.
21-4
An auditor is reporting on cash basis financial statements. These statements are best referred to in his or her opinion by
which of the following descriptions?
a. Cash receipts and disbursements and the assets and liabilities arising from cash transactions.
b. Financial position and results of operations arising from cash transactions.
c. Balance sheet and income statements resulting from cash transactions.
d. Cash balance sheet and the source and application of funds.
21-5
Which of the following statements with respect to an auditors report expressing an opinion on a specific item on a
financial statement is correct?
a. Materiality must be related to the specified item rather than to the financial statements taken as a whole.
b. Such a report can be expressed only if the auditor is also engaged to audit the entire set of financial statements.
c. The attention devoted to the specified item is usually less than it would be if the financial statements taken as a whole
were being audited.
d. The auditor who has issued an adverse opinion on the financial statements taken as a whole can never express an opinion
on a specified item in these financial statements.
21-6
When asked to perform an audit to express an opinion on one or more specified elements, accounts, or items of a financial
statement, the auditor
a. may not describe auditing procedures applied.
b. should advise the client that the opinion can be issued only if the financial statements have been audited and found to be
fairly presented.
c. may assume that the first standard of reporting with respect to GAAP does not apply.
d. should comply with the request only if they constitute a major portion of the financial statements on which an auditor
has disclaimed an opinion based on an audit.
21-7
Which of the following best describes the auditors reporting responsibility concerning information accompanying the
basic financial statements?
a. The auditor has no reporting responsibility concerning information accompanying the basic financial statements.
b. The auditor should report on the information accompanying the basic financial statements only if he or she participated
in its preparation.
c. The auditor should report on the information accompanying the basic financial statements only if he or she did not
participate in its preparation.
d. The auditor should report on all the information accompanying the basic financial statements.
21-8
Information accompanying basic financial statements should not include

a. exceptions or reservations to the standard auditors report.
b. details of items in basic financial statements.
c. statistical data.
d. explanatory comments.
21-9
Which of the following professional services would be considered an attestation engagement?

a. A management consulting engagement to provide IT advice to a client.
b. An engagement to report on compliance with statutory requirements.
c. An income tax engagement to prepare federal and state tax returns.
d. A compilation of financial statements from a clients accounting records.
21-10
Which of the following statements concerning prospective financial statements is correct?

a. Only a financial forecast would normally be appropriate for limited use.
b. Only a financial projection would normally be appropriate for general use.
c. Any type of prospective financial statement would normally be appropriate for limited use.
d. Any type of prospective financial statement would normally be appropriate for general use.
21-11
Which of the following best describes a CPAs engagement to report on an entitys internal control (ICFR)?
a. An attestation engagement to examine and report on managements written assertions about the effectiveness of its
internal control (ICFR).
b. An audit engagement to render an opinion on the entitys internal control (ICFR).
c. A prospective engagement to project, for a period not to exceed 1 year, and report on the expected benefits of the entitys
internal control (ICFR).
d. A consulting engagement to provide constructive advice to the entity on its internal control (ICFR).
21-12
When reporting on financial statements prepared on the basis of accounting used for income tax purposes, the auditor
should include in the report a paragraph that
a. Emphasizes that the financial statements are not intended to have been examined in accordance with generally accepted
auditing standards.
b. Refers to the authoritative pronouncements that explain the income tax basis of accounting being used.
c. States that the income tax basis of accounting is a comprehensive basis of accounting other than generally accepted
d. Justifies the use of the income tax basis of accounting
21-13
The SEC requires a footnote in the annual audited financial statements disclosing quarterly information for sales, gross
profit, income, and earnings per share for the past two years. The footnote is labeled un-audited, but the CPA firm must
perform review procedures of the footnote information. Regarding the CPA firms review procedure, which of the
following statements is correct?
a. The review are required to be performed on a quarterly basis.
b. The review are required to be performed on an annual basis.
c. The review are required to be performed on a semi-annual basis.
d. The review can be performed as part of the annual audit.
21-14
Which of the following type of procedures on prospective financial statements is prohibited by AT 301?
a. A compilation.
b. A review.
c. An examination.
d. An agreed-upon procedure.
21-15
When an auditor reports on financial statements prepared on a clients income tax basis, the auditors report should
a. disclaim an opinion on whether the statements were examined in accordance with GAAP.
b. not express an opinion on whether the statements are presented in conformity with the comprehensive basis of
accounting used.
c. include an explanation of how the results of operations differ from the cash receipts and disbursements basis of
accounting.
d. state that the financial statements use a financial reporting framework other than GAAP.
609
610
21-16
An auditors report on financial statements prepared in conformity with the cash basis of accounting should include a
separate explanatory paragraph before the opinion paragraph that
a. justifies the reasons for departing from GAAP.
b. states whether the financial statements are fairly presented in conformity with another comprehensive basis of
accounting.
c. refers to the note to the financial statements that describes the basis of accounting.
d. explains how the results of operations differ from financial statements prepared in conformity with GAAP.
21-17
An auditors report on financial statements prepared in conformity with the cash basis of accounting should include all of
the following except
a. a reference to the note to the financial statements that describes the cash basis of accounting.
b. a statement that the cash basis of accounting is not using a financial reporting framework other than GAAP.
c. a positive opinion as to whether the financial statements are presented fairly in conformity with the cash basis of
accounting.
d. a statement that the audit was conducted in accordance with GAAS, specifically, AU 806.
21-18
A client, an insurance company, prepares its financial statements on a financial reporting framework insurance companies use
pursuant to the rules of a state insurance commission. If the clients financial statements are not suitably titled, the auditor should
a. disclose any reservations in an explanatory paragraph and qualify the opinion.
b. apply to the state insurance commission for an advisory opinion.
c. issue a special statutory basis report that clearly disclaims any opinion.
d. explain in the notes to the financial statements the terminology used.
21-19
An auditor is permitted to accept a separate engagement to audit (i.e., not in conjunction with an audit of financial
statements) and to issue a special report on a clients
a.
b.
c.
d.
21-20
Schedule of Accounts
Yes
Yes
No
No
Receivable Schedule of Royalties

Yes
No
Yes
No
When an auditor is requested to express an opinion on the rental and royalty income of a client. The auditor may
a. not accept the engagement because to do so would be tantamount to agreeing to express a piecemeal opinion.
b. not accept the engagement because unless also engaged to audit the full financial statements of the client.
c. accept the engagement provided the auditors opinion is expressed in a special report as per AU 800.
d. accept the engagement provided a paragraph is added that restricts the distribution of the report as per AU 905.
21-21
E is an employee of F Company. A, a CPA, is asked to express an opinion on Es profit participation in F Companys profit
net income. A, the CPA, may accept this engagement only if
a. A, the CPA, also audits F Companys complete financial statements.
b. F Companys financial statements are prepared in conformity with GAAP.
c. A, the CPAs report is available for use by F Companys other employees.
d. E, the employee, owns a controlling interest in F Company.
21-22
An auditor may express an opinion on an entitys accounts receivable balance even if the auditor has disclaimed an opinion
on the financial statement taken as a whole provided that the
a. report on the accounts receivable discloses the reason for the disclaimer of opinion on the financial statements.
b. use of the report on the accounts receivable is restricted as per AU 905.
c. auditor also reports on the current asset portion of the clients balance sheet.
d. auditor reports the accounts receivable balance in a special report that is separated from the disclaimer of opinion on the
financial statement taken as a whole.
21-23
An auditors report is issued in connection with which of the following is generally not considered to be a special report?
a. Compliance with aspects of contractual agreements or regulatory requirements unrelated to audited financial statements.
b. Compliance with aspects of contractual agreements or regulatory requirements related to audited financial statements.
c. Specified elements, accounts, or items of a financial statement presented in a document.
d. Financial statements prepared in accordance with an entitys income tax basis.
21-24
A CPA may accept an engagement to apply agreed-upon procedures that are not sufficient to express an opinion on one or
more specified accounts or items of a financial statement provided that
a. the CPAs report does not enumerate the procedures performed.
b. the financial statements are prepared in accordance with a financial reporting framework other than GAAP. .
c. use of the CPAs report is restricted to specified parties.
d. the CPA is also the entitys continuing auditor.
21-25
An objective of a review of interim financial information of a public company is to provide a CPA with a basis for
reporting whether
a. a reasonable basis exists for expressing an updated opinion regarding the financial statements that were previously
audited.
b. material modification should be made for the interim financial information to conform with GAAP.
c. the financial statements are presented fairly in accordance with standards of interim reporting.
d. the financial statements are presented fairly in accordance with GAAP.
21-26
Which of the following procedures ordinarily should be applied when an auditor conducts a review of interim financial
information of a public company?
a. Verify changes in key account balances.
b. Read the minutes of the board of directors meetings.
c. Inspect the open purchase order file.
d. Perform cutoff tests for cash receipts and disbursements.
21-27
Which of the following circumstances requires modification of the auditors report on a review of interim financial
information of a public company?
a.
b.
c.
d.
21-28
An Uncertainty
Yes
No
Yes
No
Departure from GAAP

Yes
No
No
Yes
What is an auditors responsibility for supplementary information which is outside the basic financial statements, but
required by the FASB?
a. The auditor has no responsibility for required supplementary information as long as it is outside the basic financial
information.
b. The auditor is responsible for testing of, but not for reporting on, the required supplementary information.
c. The auditor is responsible to apply limited audit procedures and report deficiencies in, or omissions of, the required
supplementary information.
d. The auditor should apply TOB procedures to the required supplementary information and report any material
misstatements in such information.
21-29
If information accompanying the basic financial statements has been subjected to limited auditing procedures, the auditor
may express an opinion that the accompanying information is fairly stated in
a. conformity with GAAP.
b. all material respects in relation to the basic financial statements taken as a whole.
c. conformity with standards established by the AICPA.
d. accordance with GAAS.
21-30
When investment and property schedules are presented as information accompanying the basic financial statements, the
auditors measurement of materiality on such information is the
a. lesser of the individual schedule of investments or schedule of property taken by itself.
b. greater of the individual schedule of investments or schedule of property taken by itself.
c. combined total of both the individual schedules of investments and property taken as a whole.
d. same as that used in forming an opinion on the basic financial statements taken as a whole.
21-31
According to SSARS, which of the following is a compilation engagement?

a. Typed client-prepared financial statements, without modification, as an accommodation to the client.
b. Provided a client with a financial statement format without dollar amounts, to be used by the client.
c. Suggest correcting journal entries to be recorded by the client.
d. Generate, through the use of computer software, financial statements for the client on a financial reporting framework other than
GAAP.
611
612
21-32
A CPA is engaged in a compilation service in conformity with SSARS when

I. Reproducing client-prepared financial statements, without modification, as an accommodation to a client.
II. Preparing standard monthly journal entries for depreciation and expiration of prepaid expenses.
a. I only.
b. II only.
c. Both I and II.
21-33
When a CPA performs more than one level of service (i.e., different scope of service) such as a compilation and a review,
or a compilation and an audit, concerning the financial statements of a nonpublic entity, the CPA ordinarily should issue
the report that is appropriate for
a. The lowest level of service rendered - the compilation engagement.
b. The highest level of service rendered the audit engagement.
c. The mid-level service rendered the review engagement.
d. All level of service rendered.
21-34
When compiling the financial statements of a client, a CPA should

a. review agreements with financial institutions for restrictions on cash balances.
b. understand the accounting principles and practices of the clients industry.
c. inquire of key personnel concerning related parties and subsequent events.
d. perform ratio analyses of the financial data of comparable prior periods.
21-35
When compiling the financial statements of a client, a CPA would be least likely to
a. perform analytical procedures designed to identify relationships that appear to be unusual.
b. read the compiled financial statements and consider whether they are free from obvious material errors.
c. omit substantially all of the disclosures required by GAAP.
d. issue a compilation report on one or more, but not all, of the basic financial statements.
21-36
Which of the following should not be included in a CPAs standard report based upon the compilation of a clients
a. A statement that a compilation is limited to presenting in the form of financial statements information that is the
representation of the management.
b. A statement that the compilation was performed in accordance with the SSARS issued by the AICPA.
c. A statement that the accountant has not audited or reviewed the statements.
d. A statement that the accountant does not express an opinion but provides only negative assurance on the statements.
21-37
How does a CPA make the following representation when issuing a compilation report of a clients financial statements?
a.
b.
c.
d.
21-38
The Financial Statements have Not been Audited

Implicitly
Explicitly
Implicitly
Explicitly
The CPA has Compiled the Financial Statements

Implicitly
Explicitly
Explicitly
Implicitly
Compiled financial statements should be accompanied by a report stating that

a. a compilation is limited to presenting in the form of financial statements information that is the representation of
management.
b. the CPA has compiled the financial statements in accordance with the AUs established by the Auditing Standard Board.
c. a compilation is substantially less in scope than a review or an audit in accordance with GAAP.
d. the CPA does not express an opinion but expresses only limited assurance on the compiled financial statements.
21-39
Financial statements of a client compiled without audit or review by a CPA should be accompanied by a report stating that
a. the scope of the CPAs procedures has not been restricted in testing the financial information.
b. the CPA has assessed the accounting principles and significant estimates made by management.
c. the CPA does not express an opinion or any form of assurance on the financial statements.
d. the CPA has made inquiry of clients personnel and applied analytical procedures to the financial data.
21-40
When a compilation engagement omits substantially all disclosures required by GAAP, the CPA should indicate in the
compilation report that the financial statements are
a. not designed for those who are uninformed about the omitted disclosures.
b. prepared in conformity with a comprehensive basis of accounting other than GAAP.
c. not compiled in accordance with SSARS.
d. special-purpose financial statement that are not comparable to those of prior periods.
21-41
A CPA may compile a clients financial statements that omits substantially all of the disclosures required by GAAP only if
the omission is
I. Clearly indicated in the accountants report.
II. Not undertaken with the intention of misleading the financial statement users.
a. I only.
b. II only.
c. Both I and II.
d. Either I or II.
21-42
Which of the following representations does a CPA make implicitly when issuing a standard compilation report of a
clients financial statements?
a. The CPA is independent with respect to the client.
b. The financial statement has not been audited.
c. A compilation consists of primarily inquires and analytical procedures.
d. The CPA does not express an assurance on the financial statements.
21-43
In a review engagement, a CPA should

a. understand the accounting principles of the industry in which the client operates.
b. develop audit programs to determine whether the clients financial statements are fairly presented.
c. assess the risk that a material misstatement could occur in a financial statement assertion.
d. confirm with the clients lawyer that material loss contingencies are disclosed.
21-44
Which of the following procedures most likely would not be included in a review engagement of a nonpublic company?
a. Obtaining a management representation letter.
b. Considering whether the financial statements conform with GAAP.
c. Assessing control risk.
d. Performing analytical procedures.
21-45
Which of the following procedures should a CPA perform for a review engagement of a nonpublic company?
a. Communicating material weaknesses discovered during the assessment of control risk.
b. Obtaining a client representation letter from members of management.
c. Sending bank confirmation letters to the clients financial institutions.
d. Examining cash disbursements in the subsequent period for unrecorded liabilities.
21-46
Which of the following procedures is usually performed by a CPA in a review engagement of a nonpublic company?
a. Sending a letter of inquiry to the clients lawyer.
b. Confirm a significant percentage of accounts receivable by sending positive confirmation requests.
c. Communicating material weaknesses discovered during the consideration of internal control.
d. Comparing the financial statements with comparable statements of prior periods.
21-47
Performing inquiry and analytical procedures is the primary basis for a CPA to issue a
a. report on compliance with requirements governing major federal assistance programs in accordance with the Single
Audit Act.
b. report on prospective financial statements that present a clients expected financial position, given one or more
assumptions.
c. management advisory report prepared at the request of a clients audit committee.
d. review report on comparative financial statements for a nonpublic entity in its second year of operations.
21-48
Which of the following statements is true concerning both an engagement to compile and an engagement to review a
nonpublic companys financial statements?
a. The CPA neither obtains an understanding of internal control nor assesses control risk.
b. The CPA must be independent in fact and in appearance.
c. The CPA expresses no assurance on the financial statements.
d. The CPA should obtain a written management representation letter.
613
614
21-49
Which of the following inquiry or analytical procedures ordinarily are performed in an engagement to review a nonpublic
companys financial statements?
a. Analytical procedures designed to test the accounting records and to gather evidential matter.
b. Inquiries concerning the companys procedures for recording and summarizing transactions.
c. Analytical procedures designed to test managements assertions regarding continue existence.
d. Inquiries of the companys attorney concerning contingent liabilities.
21-50
A CPA who reviews the financial statements of a nonpublic company should issue a report stating that a review
a. provides only limited assurance that the financial statements are fairly presented.
b. includes examining, on a test basis, information that is the representation of management.
c. consist principally of inquiries of company personnel and analytical procedures applied to financial data.
d. does not obtain evidential matter or apply procedures ordinarily performed during an audit.
21-51
A CPA who reviews the financial statements of a nonpublic company should issue a report stating that a review
a. is substantially less in scope than an audit.
b. provides negative assurance that internal control is functioning as designed.
c. provides only limited assurance that the financial statements are fairly presented.
d. is substantially more in scope than compilation.
21-52
A CPA who reviews the financial statements of a nonpublic company should issue a report stating that
a. the scope of the inquiry and analytical procedures performed by the CPA has not been restricted.
b. all information included in the financial statements is the representation of management of the nonpublic company.
c. a review includes examining, on a test basic, evidence supporting the amounts and disclosures in the financial
statements.
d. a review is greater in scope than a compilation, the objective of which is to present financial statements that are free of
material misstatements.
21-53
A CPA who reviews the financial statements of a nonpublic company should issue a report stating that the CPA
a. does not express an opinion or any form of limited assurance on the financial statements.
b. is not aware of any material modifications that should be made to the financial statements for them to conform with
GAAP.
c. obtained reasonable assurance about whether the financial statements are free of material misstatements.
d. examined evidence, on a test basis, supporting the amounts and disclosures in the financial statements
21-54
During an engagement to review the financial statements of a nonpublic entity, a CPA becomes aware that several leases
that should be capitalized are not capitalized. The CPA considers these leases to be material to the financial statements.
The CPA decides to modify the standard review report because management will not capitalize the leases. Under these
circumstances, the CPA should
a. issue an adverse opinion because of the departure from GAAP.
b. express no assurance of any kind on the entitys financial statements.
c. emphasize that the financial statements are for limited use only.
d. disclose the departure from GAAP in a separate paragraph of the accountants report.
21-55
A CPA , without auditing an entitys financial statements, may accept an engagement to examine managements assertion
about the effectiveness of the entitys internal control over financial reporting in effect
a.
b.
c.
d.
21-56
As of a Specified Date
Yes
Yes
No
No
During a Specified Period of Time

Yes
No
Yes
No
Which of the following conditions is necessary for a CPA to accept an attest engagement to examine an entitys internal
control over financial reporting?
a. The CPA anticipates relying on the entitys internal control in a financial statement audit.
b. Management provides to the CPA its written assertion about the effectiveness of internal control.
c. The CPA is a continuing auditor who previously has audited the entitys financial statements.
d. Management agrees not to include the CPAs report in a general-use documents.
21-57
When engaged to express an opinion on an examination of managements assertion about the effectiveness of an entitys
internal control (ICFR), the CPA should
a. obtain managements written representations acknowledging responsibility for establishing and maintaining internal
control (ICFR).
b. not directly express an opinion on the effectiveness of internal control (ICFR).
c. keep informed of events subsequent to the date of the report that might have affected the opinion.
d. accept responsibility for the establishment of the control procedures tested.
21-58
A CPA has been engaged to report on an examination of managements assertion about an entitys internal control (ICFR) without
performing an audit of the financial statements. The managements assertion is contained in a separate report that will accompany the
CPAs report on the entitys internal control (ICFR). What restrictions, if any, should the CPA place on the use of this report (i.e.,
report on the entitys ICFR)?
a. This report should be restricted for use by management.
b. This report should be restricted for use by the audit committee.
c. This report should be restricted for use by a specified regulatory agency.
d. The CPA does not need to place any restriction on the use of this report.
21-59
A, a CPA was engaged to examine managements written assertion about the effectiveness of internal control over
financial reporting of Company C. As report should state that
a. because of inherent limitations of internal control, errors or fraud may occur and not be detected.
b. managements assertion is based on criteria established by the AICPA.
c. the results of As tests will form the basis for As opinion on the fairness of Cs financial statement presentation.
d. the purpose of the engagement is to plan an audit and determine the nature, timing, and extent of tests to be performed.
21-60
When a CPA expresses an unqualified opinion on managements assertion that internal control over financial reporting is
sufficient to meet the entitys stated objectives, it is implied that the
a. entity has not violated provisions of the Sarbanes-Oxley Act of 2002.
b. likelihood of management fraud is minimal.
c. CPA has engaged in an improper form of reporting because the assertion is too subjective.
d. CPA believes that managements assertion about the effectiveness of internal control over financial reporting is fairly stated.
21-61
Company C engaged A, a CPA, to examine managements written assertion about the effectiveness of its internal control
over financial reporting. As report described several material weaknesses and potential errors and fraudulent activities that could
occur. Subsequently, Company Cs management included As report in its annual report to the board of directors with a statement that
the cost of correcting the weaknesses would exceed the benefits. A should
a. disclaim an opinion as to managements cost-benefit statement.
b. advise the board that A either agrees or disagree with managements statement.
c. express an adverse opinion as to managements cost-benefit statement.
d. advise both management and the board that A was withdrawing the opinion.
21-62
A CPAs consideration of internal control (ICFR) in a financial statement audit (Hint: Consider audit versus examination)
a. is usually more limited than that made in connection with an engagement to examine managements written assertion
about the effectiveness of internal control (ICFR).
b. is usually more extensive than that made in connection with an engagement to examine managements written assertion
c. will usually be identical to that made in connection with an engagement to examine managements written assertion
d. will usually result in a report on whether managements written assertion about the effectiveness of internal control (ICFR) is
fairly stated.
21-63
How do the scope, procedures, and purpose of an engagement to examine managements written assertion about the
effectiveness of an entitys internal control compare with those for the consideration of internal control in a financial statement audit?
a.
b.
c.
d.
Scope
Similar
Different
Different
Different
Procedures
Different
Similar
Different
Similar
Purpose
Similar
Similar
Different
Different
615
616
21-64
Which of the following accounting engagements may a CPA perform without being required to issue a compilation or
review report as per the Statements on Standards for Accounting and Review Services (SSARS)?
I. Preparing a working trial balance.
II. Preparing standard monthly journal entries.
a. I only.
b. II only.
c. Both I and II.
21-65
C, a privately held company, asked its tax accountant A, a CPA, to generate Cs interim financial statements on As
computer when A prepared Cs quarterly tax return. A should not submit these interim financial statements to C unless, as a minimum,
A complies with the provisions of (Hint: Read the key word generate as compile)
a. Statements on Standards for Accounting and Review Services (SSARS).
b. Statements on Standards for Un-audited Financial Services.
c. Statements on Standards for Consulting Services.
d. Statements on Standards for Attestation Engagements (SSAE)
21-66
C, a privately held company, asked its tax accountant A, a CPA, to reproduce Cs interim financial statements on As
computer when A prepared Cs quarterly tax return. A should not submit these interim financial statements to C unless, as a minimum,
A complies with the provisions of (Hint: Read the key word reproduce as process)
a. Statements on Responsibilities in Tax Practice (SRTP)
b. Statements on Standards for Accounting and Review services (SSARS).
c. Statements on Standards for Attestation Engagements (SSAE).
d. None of the answers are correct.
21-67
A CPA is required to comply with the provisions of Statements on Standards for Accounting and Review Services
(SSARS) when
a.
b.
c.
d.
21-68
Consulting on Accounting Matters

Yes
No
Yes
No
May a CPA accept an engagement to compile or review the financial statements of a not-for-profit client if the CPA is
unfamiliar with the specialized industry accounting principles but plans to obtain the required level of knowledge before compiling or
reviewing the financial statements?
a.
b.
c.
d.
21-69
Processing Financial Data for Clients of other CPA Firms

Yes
Yes
No
No
Compilation
No
Yes
No
Yes
Review
No
No
Yes
Yes
If requested to perform a review engagement for a nonpublic entity in which a CPA has an immaterial direct financial
interest, the CPA is
a. not independent and, therefore, may not be associated with the financial statements.
b. not independent and, therefore, may not issue a review report.
c. not independent and, therefore, may issue a review report, but may not express an auditors opinion.
d. independent because the financial interest is immaterial and, therefore, issue a review report.
21-70
The party responsible for assumptions identified in the preparation of prospective financial statements is usually
a. a third-party lending institution .
b. the clients management.
c. the reporting accountant.
d. the clients independent auditor.
21-71
An examination of a financial forecast is a professional service that involves

a. compiling or assembling a financial forecast that is based on managements assumptions.
b. restricting the use of the accountants report to management and the board of directors.
c. assuming responsibility to update management on key events for one year after the reports date.
d. evaluating the preparation of a financial forecast and the support underlying managements assumptions.
21-72
A CPAs compilation report on a financial forecast should include a statement that

a. the forecast should be read only in conjunction with the audited historical financial statements.
b. the CPA expresses only limited assurance on the forecasted statements and their assumptions.
c. there will usually be differences between the forecasted and actual results.
d. the hypothetical assumptions used in the forecast are reasonable in the circumstances.
21-73
When a CPA examines a financial forecast that fails to disclose several significant assumptions used to prepare the
forecast, the CPA should describe the assumptions in the CPAs report and express
a. an unqualified opinion.
b. an unqualified opinion with an additional explanatory paragraph.
c. a positive opinion about the reasonableness of the assumptions.
d. no opinion.
21-74
When a CPA examines a compilation of a projected financial statements, the CPAs report should include a separate
paragraph that
a. describes the limitations on the usefulness of the presentation.
b. provides an explanation of the differences between an examination and an audit.
c. states that the CPA is responsible for events and circumstances up to 1 year after the reports date.
d. disclaims an opinion on whether the assumptions provide a reasonable basis for the projection.
21-75
A CPA may accept an engagement to apply agreed-upon procedures to prospective financial statements provide that
a. distribution of the report is restricted to the specified users.
b. the prospective financial statements are also examined.
c. responsibility for the adequacy of the procedures performed is taken by the CPA.
d. negative assurance is expressed on the prospective financial statements taken as whole.
21-76
A CPA s standard report on a compilation of a projection should not include (Hint: Consider the key word compile)
a. statement that a compilation of a projection is limited in scope.
b. disclaimer of responsibility to update the report for events occurring after the reports date.
c. statement that the accountant expresses only limited assurance that the results may be achieved.
d. separate paragraph that describes the limitations on the presentations usefulness.
21-77
With regard to a clients Managements Discussion and Analysis (MD&A), a CPA may ordinarily perform which of the
following other audit engagements?
I. Review of interim financial information.
II. Audit of specified elements, accounts or items.
III. Attestation of websites.
IV. Audit of compliance with debt agreement.
a. Type I engagement only.
b. Type I and type II engagements.
c. Type I and type III engagements.
d. Type I and type IV engagement
21-78
What type of assurance may an auditor ordinarily provide on a clients Managements Discussion and Analysis (MD&A)?
a. Either a negative or a positive opinion depending on the type of other audit engagements.
b. Either a positive or a material weakness opinion depending on the type of other audit engagements.
c. Either a negative or a disclaimer opinion depending on the type of other audit engagements.
d. Express no opinion at all time.
21-79
Which of the following is not a principle of Trust Services?

a. Security.
b. Authentication.
c. privacy.
d. Confidentiality.
617
618
21-80
Which of the following is not an objective of an auditors examination of a clients MD&A?

a. The presentation includes, in all material respects, the required elements of the rules and regulations adopted by the Securities and
Exchange Commission.
b. The historical amounts included in the presentation have been accurately derived, in all material respects, from the entitys financial
statements.
c. The presentation is in conformity with rules and regulations adopted by the AICPA.
d. The underlying information, determinations, estimates, and assumptions provide a reasonable basis for the disclosures contained in
the presentation.
21-81
An auditors report relating to a SysTrust engagement is most likely to express

a. an opinion on whether the information system is electronically secure.
b. an opinion on managements assertion that the information system meets one or more of the SysTrust principles.
c. negative opinion on whether the controls of the information system are adequate.
d. no opinion or other assurance, but a summary of findings relating to the information system.
21-82
Which of the following distribution of service organization control (SOC) reports is appropriate?
I.
II.
III.
IV.
SOC 1
Restricted-use report
General-use report
SOC 2
General-use report
SOC 3
General-use report
Restricted-used report
Restricted-used report
a. I
b. II
c. III
d. IV
21-83
An auditors service organization control (SOC) report that reports on managements description and design of its controls and control
operating effectiveness is a
a. Type 1 SOC report.
b. Type 2 SOC report.
c. Type 1 or Type 2 SOC report.
d. Neither Type 1 nor Type 2 report.
21-84
An auditors service organization control (SOC) report that reports on service organization controls over financial reporting,
particularly on those controls likely to be relevant to user entities financial statements is a
a. SOC1 report.
b. SOC 1 and SOC 2 reports.
c. SOC 1, SOC2, and SOC3 reports.
d. SOC 2 and SCO3 reports
21-85
A service organization control (SOC) report is usually issued by the

a. user auditor.
b. user auditor and service auditor.
c. service auditor.
d. internal auditor.
Key to Multi-Choice Questions

21-1 d. 21-2 c. 21-3 a. 21-4 a. 21-5 a. 21-6 c. 21-7 d. 21-8 a. 21-9 b. 21-10 c. 21-11 a.
21-12 c. 21-13 d. 21-14 b. 21-15 d. 21-16 c. 21-17 b. 21-18 a. 21-19 a. 21-20 c. 21-21 a.
21-22 d. 21-23 a. 21-24 c. 21-25 b. 21-26 b. 21-27 d. 21-28 c. 21-29 b. 21-30 d. 21-31 d.
21-32 d. 21-33 b. 21-34 b. 21-35 a. 21-36 d. 21-37 d. 21-38 a. 21-39 c. 21-40 a. 21-41 c.
21-42 a. 21-43 a. 21-44 c. 21-45 b. 21-46 d. 21-47 d. 21-48 a. 21-49 b. 21-50 c. 21-51 a.
21-52 b. 21-53 b. 21-54 d. 21-55 a. 21-56 b. 21-57 a. 21-58 d. 21-59 a. 21-60 d. 21-61 a.
21-62 a. 21-63 d. 21-64 c. 21-65 a. 21-66 d. 21-67 d. 21-68 d. 21-69 b. 21-70 b. 21-71 d.
21-72 c. 21-73 d. 21-74 a. 21-75 a. 21-76 c. 21-77 b. 21-78 a. 21-79 b. 21-80 c. 21-81 b.
21-82 a. 21-83 b. 21-84 a. 21-85 c.
619
620

Simulation Question 21-1 is an adaptation with permission from a case by Ivancevich, S. H., and G.W. Joseph in the Issues in Accounting
Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts;
Zacha Technology Center, Inc.
Your CPA firm
ZTCs Request
ZTCs Documentation on IC System
Useful Information Relating to ZTCs Requests
Zacha Technology Center Incorporated (hereafter, ZTC) is a privately held wholesale/retail computer hardware and software store.
ZTC also performs computer repair services for its retail customers. ZTC is a for-profit entity that operates in an unregulated industry. William
Zacha, founder and Chief Executive Officer, currently holds all of its shares. Since ZTC is privately held, none of its activities are a matter of
public record. ZTC has never been audited, nor has the internal control (IC) system ever been evaluated by a CPA firm.
Business-to-consumer (B2C) sales occur over-the-counter in the store, and by mail, fax, email, and on the corporate web site.
Business-to-business (B2B) transactions are conducted via a network hub, which is operated by the store. The hub enables electronic data
interchange (EDI) trading partners to connect via commercial telephone lines directly to the store or via value added networks (VANs) that
provide connectivity for EDI customers. The network hub is used for placing wholesale customer purchase orders and for initiating supplier sales
invoices.
Members of ZTCs Board of Directors serve mostly in unpaid, advisory role, sharing their business expertise with the business sole
owner. Over the past several years, the business has expanded significantly. William Zacha expects this trend to continue and foresees the need to
raise additional capital and possibly sell common stock via an initial public offering (IPO). If ZTC goes public, the firm will seek to raise
approximately $9 million.
You are a CPA and an audit partner in the CPA firm of Hayes, Talus, Armstrong and Yee. The firm audits several small companies
registered with the SEC, and has periodically provided consulting services to both audit and non-audit clients seeking to initiate a public offering.
The CPA firm has never been, and will not be, engaged as ZTCs financial statement auditor.
You were solicited by ZTC because of your professional reputation for thoroughly evaluating IC systems and your experience in
advising on the ISO-9000 (International Organization for Standardization) certification process. You meet the appropriate professional guidelines
for independence regarding an audit and/or attestation relationship with ZTC. You are not an accredited ISO-9000 registrar possessing the ability
to certify that the client is ISO-9000 qualified. However, you are qualified to advise clients on their readiness to pursue certification.
William Zacha wants you to evaluate ZTCs IC system and to report on the completeness and strength of the ICs. He would also
like you to provide some guidance on what steps might be required and what forms would be necessary to prepare for an IPO. With respect to the
ICs, Zacha would like one auditors report that could be used for multiple purposes.
You should access Data File 21-1 in iLearn for Table 1, which summarizes ZTCs requests.
ZTCs documentation is consistent with that of many technology companies of similar age and size. There is no central, complete set
of documentation regarding the total IC system. Individual departments (e.g., purchasing, cash disbursements, etc.) have written procedures
defining how transactions should be processed, who may authorize actions, how to handle contingency/unusual situations, and other matters of
importance. The documentation provides adequate information to enable the practitioner to visualize internal control strengths and weaknesses
with respect to segregation of duties. This documentation does not provide any assurance that the procedures that are supposed to be in place are
actually operable.
The company has taken steps to protect itself in the event of a disaster. A contract exists with a disaster-recovery service provider that
provides an alternate hot site should ZTCs computer fail. The hot site1 is the disaster recovery service providers location, where a computer
system is ready to resume data processing in the event that ZTCs computer is disabled. The service provider contract stipulates the maximum
acceptable down times, speeds of recovery for specific applications, and other agreed-upon procedures. As part of the contract, the service
provider reconfigures its own equipment to mimic ZTCs system. In other words, the vendor builds a duplicate hardware system sufficient to
handle all of ZTCs software applications and processing. ZTC periodically updates data files stored the hot site, as well as copies of software
when new releases or versions are made operational. Annually, as required by the contract, ZTC exercises the procedures by relocating to the
service providers as if experiencing a disaster. Lessons learned during these trial runs are recorded and any procedural changes are adequately
documented.
International Organization for Standardization (ISO) 9000. ISO-9000 is a set of international quality standards produced by the ISO.
The overall objective of ISO is to promote the development of standardized requirements to ease the international exchange of goods and
services. Many nations and economic blocks have adopted ISO-9000 certification as a prerequisite to selling goods and services within their
jurisdictions.
Foreign Corrupt Practices Act (FCPA 1977). The purpose of the FCPA is to control questionable or illegal foreign payments by U.S.
companies. All companies in the U.S. are prohibited from bribing a foreign governmental official, foreign political, foreign political party,
foreign party official, or candidate for a foreign political office for the purpose of promoting business interests. The FCPA subjects companies
and their employees to civil liability and criminal prosecution under federal securities laws (as incorporated into Section 30A of the Securities
Exchange Act of 1934).
WebTrust and Other Web Site Certification Seals. A number of different organizations and commercial firms provide certification
seals that provide Internet customers with a greater sense of confidence that e-commerce transactions will be conducted properly and
1
A hot site (or recovery operations center) is a ready-to-use location with computer equipment in place that may be used to resume computer
processing in the event of a disaster. Alternatively, a cold site (or empty shell) is a location lacking computer hardware that can be equipped and
used as the data processing site in the event of a disaster.
confidentially, Some of the more common seals are BBBOnline Reliability, TRUSTe, VeriSignTM, BizRate, ICSA, and WebTrust.
WebTrust was jointly developed and is administered by the American Institute of Certified Public Accountants (AICPA) and the Canadian
Institute of Chartered Accountants (CICA) to evaluate and test e-commerce web sites to reduce customer concerns about transaction integrity,
control, authorization, confidentiality, and anonymity. Any of the web site seals can be displayed in an attempt to provide greater assurance to
potential customers that the web sites business practices have appropriate internal controls and that these controls have been evaluated.
SystTrust. The AICPA and the CICA have also jointly developed an assurance service to evaluate and test whether a business system
is reliable when measured against four essential principles: availability, security, integrity, and maintainability. Under the SysTrust guidance, a
business system is organized to transform data inputs into information outputs using infrastructure, software, people, procedures, and data
(http://www.aicpa.org, AICPA/CICA 2001a).
Service Organization IC Evaluations. A service organization provides services to user organizations by processing certain accounting
transactions. The service organization executes transactions and maintains the related accountability and/or records transactions and processes
related data. The service organization performs, for the using organization, some ICs related to the transactions processed, and also takes
responsibility for one or more of the five management assertions that auditors test for during a financial statement audit. A service organization
can have its ICs evaluated by its own independent service auditor and report to the auditors of using organizations on the strength of its ICs. AU
402, Audit Considerations Relating to an Entity Using a Service Organization, governs the responsibility of both the service auditor and the user
auditors.
Required
1. In order for you to provide the appropriate assurance services to ZTC:
(a) Research and summarize the important characteristics of ISO-9000. You should research (i) ISO at http://www.iso.ch for information on the
requirements for ISO-9000 certification, (ii) American National Standards Institution (ANSI) at http://www.ansi.org for information on ISO-9000
certification, and (iii) Registrar Accreditation Board (ANSI-RAB) for its role and rules on ISO-9000.
(b) Research and summarize the important characteristics of service organizations IC. You should research AU 402, Audit Considerations
Relating to an Entity Using a Service Organization at http://www.aicpa.org for information on service organizations IC evaluations.
(c) Research and summarize the important characteristics of IPO filing. You should research SEC at http://www.ansi.org for information on IPO
filing requirements for small businesses, and (ii) Foreign Corrupt Practices Act of 1977 on IC compliance for purposes of an IPO.
2. Review and evaluate the following Web Site Certification Seals to recommend a certification seals that is of greatest value to ZTC:
BBBOnline Reliability seal program at http://www.bbbonline.org
TRUSTe seal program at http://www.truste.org
VeriSign seal program at http://www.verisign.com
BizRate seal program at http://www.bizrate.com
ICSA seal program at http://www.trusecure.com
WebTrust seal program at http://www.cpawebtrust.org
3. Review the following AICPAs Professional Standards to determine which one(s) is(are) applicable to providing assurance services to ZTC.
Fill out each column of the table below. An entry is made in the first row as an example.
Professional
Standard
Attestation:
AT 101
Attestation:
AT 401
Attestation:
AT 501
Attestation:
AT 601
Attestation:
AT 701
Auditing:
AU 402
Auditing:
AU 265
Auditing:
Engagement
Requirements
Written management assertions,
with criteria established by a
recognized body or regulatory
agencies and other bodies
composed of experts. Criteria
from a body designed by the
AICPA
are
considered
reasonable criteria.
Type of Investigation
Can perform any of
three types:
1. Examination
2. Review
3.
Agreed
Upon
Procedures
Type of
Report
1. Examination, express
positive opinion about
assertions conforming to
criteria.
2. Review, state scope was
less than an examination,
and
express
negative
assurances only.
3.
Agreed
Upon
Procedures, report only
procedures and findings.
Distribution of
Report
For Examination and
Review, can distribute
generally.
For Agreed Upon
Procedures, restrict to
specified users.
621
622
AU 260
Auditing:
AU 920,
AU 925
Accounting &
Review services:
AR 110
4. Based on your work in 1, 2 and 3 above, fill out each column of the table below to address the ZTCs requests (Access Data File 21-1 in
iLearn for Table 1, which summarizes ZTCs requests). An entry is made in the first row as an example.
ZTCs Requests
1. To assure B2B trading partners and their
independent auditors
2. To assure e-commerce (B2C) retail web customers
3. To assure general creditors
4. To assure bank credit line providers
5. To assure the ZTC Board of Directors oversight
committees
6. To support an ISO-9000 certification
7. To assure ZTCs independent financial statement
auditors
8. To improve the internal control system
9. To comply with the 1977 FCPA for purpose of an
IPO.
Professional Standard that Applies

Type of Engagement Needed
Service auditor examination
AU 402

Simulation Question 21-2 is an adaptation with permission from a case by Swain, M. R., R. D. Allen, D. M. Cottrell, and K. Pexton in the Issues
in Accounting Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based on
fictional data.
Other Audit Engagement involving an E-Commerce Company
Monday Morning
It had been a long weekend for Sheri Brinker. She had joined TechMall.com, Inc. (hereafter, TMC) seven months ago, following its
acquisition by Wahoo.com. She had never worked harder than now in her position as TMCs first Vice President of Finance. IT had required a
Herculean effort to build her new finance team and to help TMC meet its new public reporting responsibility that accompanied its acquisition by
Wahoo.com. TMCs amazingly fast growth since beginning operations just three years ago had fostered an environment where financial reporting
and internal controls were quite loose. TMC had (until the acquisition by Wahoo) been financed by a small group of private investors who were
much more focused on technology and marketing than on accounting systems and financial reports. Because TMC had never required any debt
financing, the company never even had to respond to the reporting requirements of a bank or loan officer. As a result, Sheri often found herself to
be the bearer of bad news as she and her newly hired finance team worked through one accounting issue after another.
Early in December, with the end of TMCs fiscal year (and its first audit) approaching at the end of the month, Sheri turned her
attention to the issue of revenue recognition. Her previous public accounting work caused her to be reasonably familiar with SAB No. 101 the
Securities and Exchange Commission (SEC) Staff Accounting Bulletin on revenue recognition as well as EITF (Emerging Issues Task Force)
No. 99-19, Recording Revenue Gross as a Principal versus Net as an Agent , which was released by the Financial Accounting Standards Board
(FASB). However, prior to her employment as TMC, Sheri had little previous experience with Internet companies and their typically aggressive
approach to revenue recognition. As a result, Sheris long weekend had been spent carefully rereading all the material she had collected on SAB
No. 101 and EITF No. 99-19. She wanted to be ready at Tuesdays weekly Executive Committee meeting to outline all possible revenue
recognition problems TMC might be facing as it headed into its first audit.
As Sheri sat reviewing her notes on Monday for the next days Executive Committee meeting, Steve Tambasco, TMCs VP for
Marketing, burst into her office and proudly announced, Ive solved the revenue problem. Were going to make the end-of-year bonus for sure!
Sheri didnt say a word, but simply waited for the details.
Steven rushed on:
Ive spent the entire morning on the phone with PlayBall.com. You know how hard Ive been working these past two months on a
partnership with them to combine our inventory fulfillment system with their merchant base and roll out a new channel for sports equipment
merchants in the Wahoo portal. The big problem with closing this deal has been getting an agreement on how were going to split the revenues in
the partnership. I think I may have been pushing their president a little hard today on that issue because he was getting frustrated and said
something about how he wished he could just buy our technology and roll out the new channel himself. I think he is right. Why not sell them our
technology? I know thats never been part of our business model before. However, if we put into the contract all kinds of non-compete
agreements and guarantees that they wont resell our technology to anyone else, this could solve the problem Ive been having getting PlayBall to
agree to the kinds of splits on merchant revenue we normally have in our partnerships with other merchant aggregators.
How does this sale help with the revenue splits, Steve? responded Sheri.
I figure the price on this deal should be worth at least what wed expect to get out of a typical revenue split arrangement with PlayBall
over the next two years. Your accounting staff will have to run the numbers, but Ill be surprised if they come up with a number less than
$600,000. And if I cant get PlayBall to agree to at least $400,000, then youd better fire me! Sheri, Im convinced that PlayBall is not interested
in having us control the relationship with and pricing of their merchants; so this is probably the only way were going to be able to do business
with them. Now the only important thing is that if we can get this sale made before the end of the year, well easily have enough revenue and
income to make our quarterly performance goal.
This was startling news for Sheri. At last weeks executive team meeting, she reported that, by her estimates, the company would be
just short of its quarterly revenue target and would miss the quarterly operating profit target by somewhere between $150,000 and $200,000.
Obviously, the executive team was not happy with the report. Steves idea had the potential to bring in $400.000 in revenue and very little
incremental cost over a short time period. A deal like this would certainly put TMC over the top in terms of both its revenue and profit goals,
resulting in significant bonus money for the executive team, as well as a number of managers and key engineers. Sheri wanted to ask some
questions, but Steve was already headed out her office door.
I have got to run, Sheri. I need to get over to Engineering and talk to Kristie [TMCs VP of Technology] about what we need to do in
order to deliver the technology to PlayBall. Then I need to get back on the phone with PlayBall to start working out some of the details. Ive
already briefed Doug (TMC president] on the deal, and hes pretty excited! I cant wait to tell everyone else at the executive meeting tomorrow
to plan on the bonus!
With a slam of the door, Steve was gone. If he had stayed, though, he might have been surprised to see that Sheri was not starting her
own private celebration as she returned to her outline of concerns with some of TMCs revenue recognition practices. Sheri found it almost ironic
that Steves idea to sell technology also had potential revenue recognition problems. Her weekend with SAB No.101 had also included some
research of Statement of Position (SOP) No. 97-2, the American Institute of Certified Public Accountants (AICPA) statement on software
revenue recognition. The AICPA had taken a pretty firm stand on the criteria required to immediately recognize revenue on a software sale. Sheri
was afraid that this new deal of Steves might have difficulty passing the tests laid out by this statement. Great, she thought as she looked over
notes from her weekend reading. Steves going to come to tomorrows team meeting like a knight in shining armor, and Ill likely end up again
looking like a bean counter getter in the way of business.
The TMC Company
TMC is a class Internet startup company based in Madison, Wisconsin. IT was initially formed by Doug Liddle,Steve Tambasco, and
Kristi Smith-Meyers. Doug and Steve has originally been heavily involved in sales and distribution of consumer electronics and related
equipment. It was clear to these two individuals that many merchants of consumer electronic goods (e.g., computers, digital cameras, audit
equipment, cell phones and pagers, etc.) were focusing on the Internet, but these merchants were not sure how to integrate the Internet with their
businesses. Certain that the potential of the Internet could somehow be merged with their excellent understanding of, and connections within, the
electronics distribution industry, Dough and Steve recruited Kristi, a project manager working for a large local networking company, to help them
create an Internet channel that was essentially a virtual mall of cyber stores for electronics merchants.
Kristi immediately began assembling a team of engineers and programmers to build web-based technology that eventually became a
complete e-commerce solution for the targeted merchants. The technology was designed to include hosting, web site development, registration in
a key search engine, inventory management and fulfillment/shipping, and the ability to process customer payments. One important challenge
faced and overcome by Kristis team was the creation of an inventory system that allow merchants to build and maintain a unique mix of products
and prices while seamlessly providing receiving and shipping capabilities from the merchants own physical warehouse as well as direct
shipments on behalf of merchants from key electronics parts distributors. Perhaps most importantly, it was relatively inexpensive and easy to set
up merchants in the technology Kristi and her engineering team designed, and the technology was a stable and straightforward platform for the
merchants themselves to use.
With Dough designated as TMCs President and Kristi working as the VP of Technology, Steve took on the role of VP of Marketing.
IN order for TMC to be successful in the very competitive and fast-moving e-commerce world, it was critical that Steve identify and quickly
bring large blocks of electronics merchants into the TMC virtual mall. The process he followed was one of creating partnerships with merchant
aggregators, defined as organizations that have business relationships already established with numerous retailers of electronics parts and
products. These merchant aggregators for TMC included manufacturers, wholesalers/distributors, and industry organizations and associations.
Even magazines and other consumer electronics trade publications were possible partners in the effort to market the TMC virtual mall to the
thousands of potential Internet merchants of electronic goods and services in North America. Hence, rather than try to sell space in the TMC
virtual mall directly to individual merchants, the strategy was instead to form a partnership with a potential merchant aggregator and have that
partner market TM space to o its own merchant base.
TMCs revenue streams from an individual merchant are based on the following schedule:
Nonrefundable Setup Fee
Monthly Statement Fee
Transaction Fee
Revenue Split
Standard Pricing Schedule

$750
$50 (no charge for initial setup month)
2 percent of total sales dollars ($200 maximum fee per sale transaction)
70:30 (i.e., 30 percent of all merchant fees collected by TMC are remitted to
the merchant aggregator partner.
The standard pricing schedule shows the standard prices that the merchant aggregator is to use when marketing TMC services to potential
merchant clients. While it is possible that the merchant aggregator can negotiate with TMC form more favorable pricing for its own merchants,
TMC has yet to concede any price reductions to any merchant aggregators.
Exhibit 1 depicts the structure of TMCs relationships with its merchant clients and its merchant aggregators. You should access Data
File 21-2 in iLearn for Exhibit 1, which shows the structure of TMC. In this relationship, the merchant aggregator establishes a partnership
with TMC to market space in the TMC virtual mall to its own collection of merchants. Once set up in the TMC channel, the merchant client sells
electronic goods and services to its own customers within the TMC channel. Although there is no termination date for the merchant, one of
Kristis engineers determined that the average length of time that a merchant is actively registered to use the TMC system is eight quarters (two
623
624
years). TMC s virtual mall technology facilitates delivery to the customer; and in a manner similar to the function of a traditional credit card
processor, collects the sales price and remits the sales price (less all transaction fees) back to the merchant client. In addition to the initial setup
fee collected from the merchant, TMC also collects a fixed monthly maintenance fee (called a Statement Fee) and a fee on each sales transaction
(which is variable based on the dollar volume of the merchants transactions). All three types of fees are remitted directly to TMC, which then
splits these revenue with the appropriate merchant aggregator using a predetermined revenue split ratio.
It was clear to the founders early on that the key to securing the enthusiasm and commitment of a prospective merchant aggregator
partners was the ongoing revenue splits from the virtual mall. TMC partners could make a lot of money in this arrangement, depending on how
many merchants they arranged to have TMC set up in the virtual mall, as well as on the dollar volume of retail sales subsequently generated by
these merchants. An additional appeal for the merchant aggregators is that they bear very little business risk in this arrangement.
All the merchant aggregator needs to do is contact and inform its set of potential e-commerce merchants, obtain a list of applicants,
and deliver to TMC the name and contact information for the merchant applicant. TMC then becomes entirely responsible to set up the merchant,
collect the setup fee, and handle any customer support issues that come from the merchant client. At the beginning of each subsequent month,
TMC is then responsible for electronically invoicing the merchant and collecting the monthly statement fee. Each day, TMC is responsible for
settling the merchants sales transactions, retaining 2 percent of the transaction amount, and electronically remitting the rest of the money back to
the merchant. At the end of each month, TMC determines the amount of setup fees, statement fees, and transaction fees that were actually
collected, and remits 30 percent of the collected fees back to the appropriate partner. TMC is responsible to pay the merchant aggregator only as
it is able to actually collect the setup fee, statement fee, or transaction fee. Hence, TMC and its partners share the credit risk of nonpayment
merchants. While TMC is not liable to the merchants customer for goods and services sold by the merchant, TMC is solely liable to the merchant
for transaction problems due to technology breakdowns in the virtual mall system. Conversely, the merchant aggregator does not have any
liability to the merchant for problems in the TCM system.
Both Steve and Doug felt that the strength of this reasonably simple business model was the potential to create revenue and cash in
both the early stages and the mature stages of TMCs life cycle. As merchant aggregators work to bring retail merchants into the TMC system,
large setup fees are immediately generated. Later, as these merchants new Internet businesses grow and become successful, TMC and its
partners are positioned to grow and become successful by sharing in the total sales value of each customer transaction. One important aspect of
this revenue model is that it motivates TMC to help merchant clients grow their Internet business. Further, even if a merchants virtual store
within the portal struggles to grow as a viable e-commerce business, TMC still expects to realize an ongoing revenue stream via the monthly
statement fee.
The initial financial results of this revenue model were impressive. TMC was generating significant operating profits and positive cash
flows by the end of its first year of operations. Revenues continued to grow an average of nearly 20 percent a month through the second year and
into the third year with operating margins of approximately 50 percent. TMCs success soon began drawing attention from large companies and
investors in the e-commerce industry. Late in the third year of operations, as Dough and the other founders began discussing with attorneys the
possibility of an IPO (initial public offering), inquiries began surfacing that indicated a merger or acquisition of TMC could be on the horizon.
Early in its fourth year, two large Internet portal companies contacted Doug within days of one another to invite him to consider selling or
merging his company with theirs. Within 60 days of that first call, after surprising little due diligence on the part of the buying company, TMC
was acquired by Wahoo.com Company, a multifaceted Internet company out of Austin Texas. At that time, TMC had 52 employees, partnership
contracts with 32 merchant aggregators, and nearly 8,000 merchants in its virtual mall. At the close of its third year, TMC reported revenues of
$2.59 million and net income of $1.35 million. The total acquisition price was $55.5 million, cash and stock.
The Finance Team
Before its acquisition, TMCs employees consisted of engineers, technical support staff, marketing, and office administration
personnel. Other than an accounts payable clerk and two individuals in charge of account collections, little management attention was paid to
financial reporting and control. When it became obvious that TMC would soon have significant financial reporting responsibilities as a result of
the acquisition, Sheri Brinker was hired. An aggressive and extremely competent CPA from a local firm, Sheri was hired as TMCs first VP of
Finance. She was immediately consumed by the intense acquisition process initiated by Wahoo.com Company, a well-managed public company
trading on the NASDAQ with a market cap of close to $4 billion. Sheri immediately hired a controller to handle the general ledger system and
began expanding the finance staff. Not unexpectedly, Sheri continued to make necessary changes to TMCs accounting system. As a result,
TMCs growth in reported operation income was declining rather than increasing for the first time in its rather short history. One example of
TMCs poor financial discipline prior to the acquisition was the companys management of receivables. The analysis of bad debts performed in
the three years of TMCs existence was severely inadequate. With a lot of effort, Sheri determined that Wahoos initial estimates during the due
diligence period of the acquisition gravely underestimated the actual bad debts on TMCs balance sheet. A little more than 30 percent of the
current receivables balance was determined to be uncollectible. The subsequent charges to the next quarters income statement in order to catch
up on underestimations of past receivables were both sizable and painful.
Dough, Steve, and Kristi were quite concerned about the impact of Sheris work on the monthly income statements,. Their concern
was due in large part to the bonus plan that had been negotiated into the acquisition deal with Wahoo.com. As a first-year incentive to the TMC
executive team, Wahoo had been persuaded to commit an additional 5 percent of the acquisition deal price to a series of quarterly bonuses to be
shared across most of the TMC management- and engineering-level employees. The bonus plan was based on achieving certain revenue and
operating profit goals in its first four quarters as a wholly owned subsidiary of Wahoo. Naturally, as each quarter was drawing to a close, the
bonus plan became a major discussion topic in executive team meetings. At last weeks executive meeting, Sheris financial projections showed
that revenue and operating income were going to be just short of the fourth quarters bonus targets. You should access Data File 21-2 in iLearn
for Exhibit 2, which presents TMCs Income Statement. Some of the comments made in the ensuing discussion strongly implied that a large
share of the responsibility for missing the quarterly bonus belonged to Sheri and her draconian accounting policies.
Back to Monday
As Sheri sat in her office musing over her experience at TMC and her analysis of the companys revenue recognition practices, she
could clearly see that a serious confrontation was likely at the next days executive team meeting. Sheris draconian accounting policies were
now shifting focus to the revenue line of the income statement. Basically, there were two revenue issues at stake in TMCs current business
model. First, TMC had always recognized all fees invoiced to the merchant client as gross revenue, then immediately booked a commission
expense to the appropriate reseller (the merchant aggregator partner). SAB No. 101 indicates that the SEC staff takes a hard look at the need for
some companies (e-commerce related or otherwise) to book net revenues instead of gross revenues, though operating income is unaffected in
either case. Nevertheless, there was specific pressure on TMCs revenues due to the bonus plan. Sheri also wondered about the timing of her
companys revenue recognition. In addition to the gross vs. net revenues issue, she wondered if TMC needed to defer the setup fee over the
average life of a merchant rather than follow the current practice of recognizing the full merchant setup fee in the original invoice month. Next
month, Wahoo.coms auditors, Price Firehouse, LLP, were scheduled to begin work on TMCs first audit, and Sheri was sure that they would be
asking a lot of hard questions. She did not want to be making significant changes to her financial statements as a result of that audit. Sheri decided
that the best start would be to take the projected quarterly results that she had originally presented at last weeks executive committee meeting
and alter the projected results as needed in light of SAB No. 101 and EITF No. 99-19.
Of even larger concern was Steves proposed technology sale to PlayBall. Steve clearly saw this deal as the panacea to their problem
of meeting the current bonus plan targets. However, SOP No. 97-2 outlined specific software revenue recognition criteria, the same basic criteria
contained in SAB No.101, which could make it difficult for Sheri to immediately recognize revenue from Steves proposed sale. Further, SOP
No. 97-2 expanded the revenue recognition criteria in the case of software sales to include such important elements as:
1. Objective Evidence of Vendor-Specific Fair Value.
2. Post-Contract Customer Support.
3. Licenses with the Right of Upgrade.
SOP No. 97-2 is based on the concept that revenue must be deferred and recognized ratably over the period of time for which any services are
rendered to the customer. As a result, software revenue recognition was becoming controlled by increasingly conservative guidelines. It appeared
to Sheri that key to the decision to defer the contract revenue was the notion of objective evidence of vendor-specific fair value. The one positive
aspect to this deal was that it was still in its infancy. If there was a way to structure the contract appropriately, Sheri wondered if she might be
able to recognize most or all of the entire proposed contract sales price before the year ended. In fact, she seemed to recall that the AICPA had
issued a Technical Practice Aid that addressed implementation issues surrounding SOP No. 97-2. She wondered if this publication might help her
analyze the impact of SOP No. 97-2 on TMCs accounting for the proposed sale of TMC technology.
As Monday afternoon moved on, it became evident that Sheri would have a long evening at the office. Her career transition from
auditor to business manager during the last seven months had been both an exciting and challenging personal evolution. Yet she knew from past
experience at TMC that, unlike her previous life, she couldnt walk into the executive team meeting tomorrow and simply lay out the accounting
facts according to Generally Accepted Accounting Principles (GAAP). The team expected her to present proposed solutions that were
technically correct, yet as good for the company as possible. Sheri always prided herself on being true to the standards of her CPA profession, but
that was an easier personal standard to uphold when she was with her CPA firm working with client companies. Now that she was actually part of
a corporate team and working to build a career as inside the business, she was feeling emotionally conflicted. She still winced as she recalled an
executive meeting about four months earlier when after presenting a difficult analysis involving expense projections on the accounts receivable
project, Doug had looked her coldly in the eye and in front of the rest of the team said, Sheri, I appreciate your work here, but you need to drop
tour auditor mindset. Dont tell me what I cant do. What I need from you are solutions. Tell me what I can do and how to do it!
Required
Sheri, the VP of finance, wants to be ready at Tuesdays weekly Executive Committee meeting to outline all possible revenue recognition
problems TMC might be facing as it heads into its first audit. She engages you for a WebTrust service (other audit engagement). Specifically, she
wants you to draft her a heads up memo to be read by Doug Liddle, Tuesday morning, before the start of the executive team meeting. Your
memo should address the following three separate issues in light of SAB No.101, EITF No. 99-19, SOP No. 97-2, and any relevant Technical
Practice Aid(s) issued by the AICPA.
1. Gross vs. Net Fees
Analyze whether TMC should recognize revenues from merchant fees net of commissions paid to merchant aggregator partners (net method), or
whether TMC should continue to recognize the entire fee amount as revenue with the commissions paid recognized as an expense (gross method).
Note that the question of gross vs. net fees applies to all three types of merchant fees. In the case of the transaction fee, the revenue in question is
the 2 percent transaction fee for service provided to the TMC merchant, not the total sales price collected by TMC for electronic goods sold by
the TMC merchant to its customer (refer to Exhibit 1 in iLearn).
For the analyses, you should research the following two authoritative literatures:
i. SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (Questions 5 and 10): http://www.sec.gov
ii. EITF No. 99-19, Recording Revenue Gross as a Principal versus Net as an Agent (Paragraphs 9-19): http://www.fasb.org
2. Deferral of Setup Fees
TMC charges its new vendor clients a $750 setup fee that TMC recognizes a s revenue in the original invoice month when the vendor establishes
an account. Analyze whether this treatment and revenue recognition practice is acceptable under current authoritative pronouncements, or
whether some portion of this revenue should be deferred and recognized ratably in subsequent months. If some revenue should be deferred,
analyze the potential impact of this deferral on Year 4 revenues. Remember that after being set up, the merchant can do business with the TMC
portal as long as the merchant continues paying the monthly statement fee.
Again, for the analyses, you should research the following two authoritative literatures:
i. SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (Questions 5 and 10): http://www.sec.gov
ii. EITF No. 99-19, Recording Revenue Gross as a Principal versus Net as an Agent (Paragraphs 9-19): http://www.fasb.org
iii. Any authoritative literature on prior period adjustment and materiality.
3a. Sale of Technology
Analyze the potential impact of TMCs proposed sale of technology to PlayBall.com. In performing this analysis of when and how much revenue
can be recognized, assume that TMC charges a price of $400,000, which includes all work necessary to install the software on PlayBalls server
and provide unlimited technical support and maintenance for the next two years. Also, assume that the contract could be signed and the software
installed before the end of the year. The term is generally used in professional accounting to describe the two years of unlimited technical support
and maintenance that is to be bundled with the sale of the TMC software is post-contract customer support or PCS.
625
626
For the analyses, you should research the following two authoritative literature:
i. AICPA Statement of Position No. 97-2, Software Revenue Recognition (Paragraph 10, 12, 57, 59): http://www.aicpa.org
ii. Technical Information Service (TIS) Section 5100 Revenue Recognition, TPA 5100.39 Software Revenue Recognition for Multiple-Element
Arrangements and TPA 5100.54 Fair Value of PCS in a Multi-Year Time-Based License and Software Revenue Recognition :
http://www.aicpa.org
3b. Restructure the Technology Sale Contract
Given that the deal for selling TMCs technology to PlayBall is still in the proposal stage (no contracts have yet been signed), are there any
options for Sheri to structure the deal so that TMC can Recognize more revenue in Year 4 from this proposed sale? For example, what if the twoyear proposed contract described in 3a. above was rewritten as a one-year contract at a somewhat lower price that covered software, installation,
and one year of PCS? Note that subsequent year or years of PCS would then be handled with a separate contract. Also, keep in mind that Sheri
must carefully consider such adjustments in light of the expectations of her executive colleagues, the goals and strategies of the company, the
expectations of the customer receiving the technology, and the standards of her profession as a CPA.
Again, for the analyses, you should research the following two authoritative literatures:
i. AICPA Statement of Position No. 97-2, Software Revenue Recognition (Paragraph 10, 12, 57, 59): http://www.aicpa.org
ii. Technical Information Service (TIS) Section 5100 Revenue Recognition, TPA 5100.39 Software Revenue Recognition for Multiple-Element
Arrangements and TPA 5100.54 Fair Value of PCS in a Multi-Year Time-Based License and Software Revenue Recognition :
http://www.aicpa.org

California.
Review and Approval of Other Audit Engagement Reports
You are the partner-in-charge of other audit engagements in your CPA firm. Auditors in your CPA firm submit their reports on other
audit engagements to you for review and approval.
Required
For each of the following six other audit engagement reports submitted to you for review and approval:
1. Identify the specific type of attestation report.
2. Identify any mistake in the written wording/paragraph.
3. Identify any mistake in the citing of authoritative guideline.
3. Identify any mistake in the description of the procedure performed.
4. Identify any mistake in the assurance/opinion issued.
5. Identify any omission of the required wording/paragraph.
6. Identify any inclusion of the non-required wording/paragraph.
1. Report Submitted by Auditor A
We have reviewed ABC Service Organizations description of its Computer Center system for processing user entities transactions throughout
the year ended December 31, 20xx, and the suitability of the design and operating effectiveness of controls to achieve the related control
objectives stated in the description.
On page 01 of the description, ABC Service Organization has provided an assertion about the fairness of the presentation of the description
and suitability of the design and operating effectiveness of the controls to achieve the related control objectives stated in the description. ABC
Service Organization is responsible for preparing the description and for the assertion, including the completeness, accuracy, and method of
presentation of the description and the assertion, providing the services covered by the description, specifying the control objectives and stating
them in the description, identifying the risks that threaten the achievement of the control objectives, selecting the criteria, and designing,
implementing, and documenting controls to achieve the related control objectives stated in the description.
Our responsibility is to express an opinion on the fairness of the presentation of the description and on the suitability of the design and
operating effectiveness of the controls to achieve the related control objectives stated in the description based on our examination. We conducted
our review in accordance with attestation standards established by the Public Company Accounting Oversight Board. Those standards require
that we plan and perform our examination to obtain reasonable assurance about whether, in all material respects, the description is fairly
presented and the controls were suitably designed and operating effectively to achieve the related control objectives stated in the description
throughout the year ended December 31, 20xx.
Because of their nature, controls at a service organization may not prevent, or detect and correct, all errors or omissions in processing or
reporting transactions. Also, the projection to the future of any evaluation of the fairness of the presentation of the description, or conclusions
about the suitability of the design or operating effectiveness of the controls to achieve the related control objectives is subject to the risk that
controls at a service organization may become inadequate or fail.
In our opinion, in all material respects, based on the criteria described in ABC Service Organizations assertion on page 01
(1) the description fairly presents the system that was designed and implemented throughout the year ended December 31, 20xx.
(2) the controls related to the control objectives stated in the description were suitably designed to provide reasonable assurance that the control
objectives would be achieved if the controls operated effectively throughout the year ended December 31, 20xx.
(3) the controls tested, which were those necessary to provide reasonable assurance that the control objectives stated in the description were
achieved, operated effectively throughout the year ended December 31, 20xx.
The specific controls tested and the nature, timing, and results of those tests are listed in pages 10-20.
2. Report Submitted by Auditor B
We have reviewed managements assertion that ABC Company maintained effective internal control over financial reporting as of December 31,
20xx, included in the accompanying management report.
Our review was made in accordance with the Statements on Standards for Accounting and Review Services issued by the American Institute
of Certified Accountants. Those standards require that we plan and perform the review to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material respects. Our examination of internal control over financial reporting
included obtaining an understanding of internal control over financial reporting. We believe that out examination provides a reasonable basis for
our opinion.
Because of inherent limitations in any internal control, errors or fraud may occur and not be detected. Also, projection of any evaluation of the
internal control over financial reporting to future periods is subject to the risk that internal control may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
3. Report Submitted by Auditor C
We have examined the accompanying projected balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of
December 31, 20xx, and for the year then ending. ABC Companys management is responsible for the projection, which was prepared for the
Bank of America for the purpose of negotiating a loan to expand ABC Companys plant.
Our examination was made in accordance with the Auditing Standards AU 800 issued by the American Institute of Certified Public
Accountants and, accordingly, included such procedures as we considered necessary to evaluate the assumptions used by management and the
preparation and presentation of the projection.
In our opinion, the accompanying projection is presented in conformity with guidelines for presentation of a projection established by the
American Institute of Certified Public Accountants, and the underlying assumptions provided a reasonable basis for managements projection,
assuming the granting of the requested loan for the purpose of expanding ABC Companys plant as described in the summary of significant
assumptions. However, even if the loan is granted and the plant is expanded, there will likely be differences between the projected and actual
results, because events and circumstances frequently do not occur as expected, and those differences may be material.
4. Report Submitted by Auditor D
We have reviewed the accompanying schedule of gross sales (as defined in the lease agreement dated March 31, 20xx, between ABC Company,
as lessor, and DEF Company, as lessee) of DEF Company at its 6th Street Store, San Francisco, for the year ended December 20xx. This schedule
is the responsibility of the DEF Companys management. Our responsibility is to express an opinion on this schedule based on our reviews.
Current review standards require that we plan and perform the review to obtain reasonable assurance about whether the schedule of gross sales
is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the schedule of
gross sales. A review also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating
the overall schedule presentation. We believe that our audits provide a reasonable basis for our opinion.
The schedule of gross sales referred to above present fairly, in all material respects, the gross sales of DEF Company at its 6th Street store, San
Francisco, for the year ended December 31, 20xx, as defined in the lease agreement referred to in the first paragraph.
This report is intended solely for the information and use of the boards of directors and management of ABC Company and DEF Company
and should not be used by anyone other than these specified parties.
5. Report Submitted by Auditor E
We have audited the accompanying statements of assets, liabilities, and capital income tax basis of ABC Partnership as of December 31, 200x,
and the related statements of revenue and expenses income tax basis and of changes in partners capital accounts income tax basis for the year
then ended. These financial statements are the responsibility of the Partnerships management. Our responsibility is to express an opinion on
these financial statements based on our audits.
Our audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As described in Note 3, these financial statements were prepared on the basis of accounting the Partnership uses for income tax purposes,
which is a comprehensive basis of accounting other than generally accepted accounting principles.
This report is intended solely for the information and use of the boards of directors and management of ABC Partnership.
627
628
6. Report Submitted by Auditor F
We have reviewed the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained
earnings, and cash flows for the year then ended, in accordance with Statements on Standards for Attestation Engagement issued by the
American Institute of Certified Accountants. All information included in these financial statements is the representation of the management of
XYZ Company.
A review includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A review also
includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Based on our review, the accompanying financial statements are presented fairly.
This report is intended solely for the information and use of the boards of directors and management of XYZ and should not be used by
anyone other than these specified parties.
629
630
Appendix A
Appendix A
AICPA Clarified Statements on Auditing Standards
AU 200
200
210
220
230
240
250
260
265
AU 300-499
300
315
320
330
402
450
AU 500
500
501
505
510
520
530
540
550
560
570
580
585
AU 600
600
610
620
AU 700
700
705
706
708
720
725
730
AU 800
800
805
806
810
AU 900
905
910
915
920
925
930
935
General Principles and Responsibilities

Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing
Standards
Terms of Engagement
Quality Control for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards
Audit Documentation
Consideration of Fraud in a Financial Statement Audit
Consideration of Laws and Regulations in an Audit of Financial Statements
The auditors Communication With Those Charged With Governance
Communicating Internal Control Related Matters Identified in an Audit
Risk Assessment and Response to Assessed Risks
Planning an Audit
Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement
Materiality in Planning and Performing an Audit
Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained
Audit Considerations Relating to an Entity Using a Service Organization
Evaluation of Misstatements Identified During the Audit
Audit Evidence
Audit Evidence
Audit Evidence-Specific Consideration for Selected Items
External Confirmations
Opening Balances-Initial Audit Engagements, Including Reaudit Engagements
Analytic Procedures
Audit Sampling
Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures
Related Parties
Subsequent Events and Subsequently Discovered Facts
Going Concern
Written Representations
Consideration of Omitted Procedures After the Report Release Date
Using the Work of Others
Special Considerations- Audits of Group Financial Statements (including the Work of Component Auditors)
Using the Work of Internal Auditors
Using the Work of an Auditors Specialist
Audit Conclusions and Reporting
Forming an Opinion and Reporting on Financial Statements
Modifications to the Opinion in the Independent Auditors Report
Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditors Report
Consistency of Financial Statements
Other Information in Documents Containing Audited Financial Statements
Supplementary information in Relation to the Financial Statements as a Whole
Required Supplementary Information
Special Considerations
Special Considerations-Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks
Special Considerations-Audits of Single Financial Statements and Specific Elements, Accounts, or Items of a Financial
Statement
Reporting on Compliance With Aspects of Contractual Agreements or Regulatory Requirements in Connection With Audited
Engagements to Report on Summary Financial Statements
Special Considerations in the United States
Alerts as to the Intended Use or Purpose of the Auditors Written Communication
Financial Statements Prepared in Accordance With a Financial Reporting Framework Generally Accepted in Another Country
Reports on Application of Requirements of an Applicable Financial Reporting Framework
Letters for Underwriters and Certain Other Requesting Parties
Filings With the U.S. Securities and Exchange Commission Under the Securities Act of 1933
Interim Financial Information
Compliance Audits
Appendix B
PCAOB Audit Standards
AS No.
AS 1
AS 3
AS 4
AS 5
AS 6
AS 7
AS 8
AS 9
AS 10
AS 11
AS 12
AS 13
AS 14
AS 15
AS 16
Title
References in Auditors Reports to the Standards of the Public Company Accounting Oversight Board
Audit Documentation
Reporting on Whether a Previously Reported Material Weakness Continues to Exist
An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements
Evaluating Consistency of Financial Statements
Engagement Quality Review
Audit Risk
Audit Planning
Supervision of the Audit Engagement
Consideration of Materiality in Planning and Performing an Audit
Identifying and Assessing Risks of Material Misstatement
The Auditors Responses to the Risks of Material Misstatement
Evaluating Audit Results
Audit Evidence
Communications with Audit Committees
PCAOB Rules
Section 1
Section 2
Section 3
Section 4
Section 5
Section 6
Section 7
General Provisions
Registration and Reporting, which include
Rule 2100 Registration Requirements for Public Accounting Firms
Rule 2103 Registration Fee
Professional Standards, which include:
Rule 3520 Auditor Independence
Rule 3521 Contingent Fees
Rule 3523 Tax Services for Persons in Financial Reporting Oversight Roles
Rule 3524 Audit Committee Pre-approval of Certain Tax Services
Rule 3525 Audit Committee Pre-approval of Non-audit Services Related to Internal Control Over Financial Reporting
Rule 3526 Communication with Audit Committees Concerning Independence
Inspections, which include
Rule 4003 Frequency of Inspections
Rule 4009 Firm Response to Quality Control Defects
Rule 4010 Board Public Reports
Investigations and Adjudications, which include:
Rule 5200 Disciplinary Proceedings
Rule 5300 Disciplinary Sanctions
International, which include:
Rule 6001 Assisting Non-U.S. Authorities in Inspections
Rule 6002 Assisting Non-U.S. Authorities in Investigations
Funding
631
632
Appendixes C D E
Appendix C
AICPA Statements on Standards for Attestation Engagements (SSAE)
AT
20
50
101
201
301
401
501
601
701
801
Title
Defining Professional Requirements in Statements on Standards for Attestation Engagements
Statements on Standards for Attestation Engagement Hierarchy
Attest Engagements
Agreed-Upon Procedures Engagements
Financial Forecasts and Projections
Reporting on Pro Forma Financial Information
An Examination of an Entitys Internal Control Over Financial Reporting that is Integrated with an Audit of Its Financial
Statements
Compliance Attestation
Managements Discussion and Analysis
Reporting on Controls at a Service Organization
Appendix D
AICPA Statements on Standards for Accounting and Review Services (SSARS)
AR
20
50
60
80
90
110
120
200
300
400
600
Title
Defining Professional Requirements in Statements on Standards for Accounting and Review Services
Standards for Accounting and Review Services
Framework for Performing and Reporting on Compilation and Review Engagements
Compilation of Financial Statements
Review of Financial Statements
Compilation of Specified Elements, Accounts, or Items of a Financial Statement
Compilation of Pro Forma Financial Information
Reporting on Comparative Financial Statements
Compilation Reports on Financial Statements Included in Certain Prescribed Forms
Communications Between Predecessor and Successor Accountants
Reporting on Personal Financial Statements included in Written Personal Financial Plans
Appendix E
AICPA Code of Professional Conduct (CPC)
ET
50
90
100
200
300
400
500
Title
Rules: Applicability and Definitions
Independence, Integrity, and Objectivity
General Standards - Accounting Principles
Responsibilities to Clients
Responsibilities to Colleagues
Other Responsibilities and Practices
Appendix F
Key Terms
Absence of causal connection: An auditors legal defense under which the auditor contends that the damages claimed by the client
were not brought about by any act of the auditor.
Acceptable risk of incorrect acceptance (ARIA): The risk that the auditor is willing to take of accepting a balance as correct when
the true misstatement in the balance is equal to or greater than tolerable misstatement.
Acceptable risk of incorrect rejection (ARIR): The risk that the auditor is willing to take of rejecting a balance as incorrect when it
is not misstated by a material amount.
Acceptable risk of over-reliance (ARO): The risk that the auditor is willing to take of accepting a control as effective or a rate of
monetary misstatements as tolerable when the true population exception rate is greater than the tolerable exception rate.
Acceptable risk of under-reliance (ARU): The risk that the auditor is willing to take of accepting a control as effective or a rate of
monetary misstatements as tolerable when the true population exception rate is smaller than the tolerable exception rate.
Accounting estimate: A transaction involving managements judgments or assumptions, such as determining the allowance for
doubtful accounts, establishing warranty reserves, and assessing assets for impairment.
Accounting records: The records of initial entries and supporting records, such as checks and records of electronic fund transfers;
involves; contracts; the general and subsidiary ledgers, journal entries, and other adjustments to the financial statements that are not
reflected in formal journal entries; and records such as work sheets and spreadsheets supporting cost allocations, computations,
reconciliations, and disclosures.
Accrued liabilities (accrued expenses): Short-term obligations for services of a continuing nature that accumulate over time.
Examples include interest, taxes, rent, salaries, and pensions. They generally are not evidenced by invoices or statements.
Accrued payroll expenses: The liability accounts associated with payroll; these include accounts for accrued salaries and wages,
accrued commissions, accrued bonuses, accrued benefits, and accrued benefits, and accrued payroll taxes.
Accuracy specific audit objective: the specific audit objective of verifying that amounts and other data relating to recorded
transactions and events have been recorded appropriately and that financial and other information are disclosed fairly.
Adjusting journal entries (AJEs): Journal entries designed to correct misstatements found in a clients records.
Adverse opinion (report): A report issued when the auditor believes the financial statements, taken as a whole, are so materially
misstated that they do not present fairly the clients financial position or the results of its operations and cash flows in conformity with
GAAP.
Adverse opinion (report) on internal controls: A report in which the auditor communicates to shareholders that the company has
not maintained effective internal control over financial reporting.
Agreed-upon procedures engagement: An engagement in which the procedures to be performed are agreed upon by the CPA, the
responsible party making the assertions, and the intended users of the CPAs report.
Allocation of the preliminary judgment about materiality: The process of assigning to each balance sheet account the misstatement
amount to be considered material for that account based o the auditors preliminary judgment.
Allowance for sampling risk (ASR): Also referred to as precision, an interval around the sample results in which the true population
characteristic is expected to lie.
Alternative procedure (in Accounts receivable confirmation): Procedures used to obtain evidence about the existence and
valuation of accounts receivable when a positive confirmation is not returned. These procedures include examining cash collected after
the confirmation date and vouching unpaid invoices to customers orders, sales, orders, shipping documents, and sales invoices.
Altman Z-score (model): A combination of weighted financial ratios to produce a score that predicts whether a company has a high
potential for bankruptcy (non-going concern).
American Institute of Certified Public Accountants (AICPA): A voluntary organization of CPAs that sets professional
requirements, conducts research, and publishes materials relevant to accounting, auditing, management consulting services, and taxes.
An examination of an entitys internal control over financial reporting that is integrated with an audit of its financial
statements: This engagement is usually done for a clients management or audit committee, or for meeting the requirements of a
regulatory agency. For private companies, the engagement is performed in accordance with AICPAs AT 501. For public companies,
the engagement is performed in accordance with PCAOBs Auditing Standard AS 5.
Analytical procedure: Use of comparisons and relationships to assess whether account balances or other data appears reasonable.
Analytical procedure risk: The risk that analytical procedures will fail to detect material misstatements.
Application controls: Controls related to a specific use of information technology, such as the inputting, processing, and outputting of
sales or cash receipts.
Application programs: Computer programs written to accomplish specific data processing tasks such as processing sales and
accounts receivable, updating inventory, computing payroll, or developing special management reports.
Appropriateness of evidence: A measure of the quality of evidence; appropriate evidence is relevant and reliable for classes of
transactions, account balances, and related disclosures.
As of date (in ICFR): A concept applied to internal control over financial reporting (ICFR) by the Sarbanes-Oxley Act of 2002 and
PCAOB Standard No.5. The internal control reports of both management and the auditors are for a particular point in time, the as of
date, as oppose to the entire period under audit. This date is ordinarily the last day of the clients fiscal period.
Asset impairment: A term used to describe managements recognition that a significant portion of fixed assets is no longer as
productive as had originally been expected. When assets are so impaired, the assets should be written down to their expected
economic value.
Asset misappropriation: A fraud that involves the theft or misuse of a clients assets. Common examples include skimming cash,
stealing inventory, and payroll fraud. It is one type of defalcation.
Assertion: A representation or declaration made by the responsible party, typically management of the audit client.
Assessment of control risk: A measure of the auditors expectation that internal controls will neither prevent material misstatements
from occurring nor detect and correct them if they have occurred; control risk is assessed for each transaction-related objective in a
cycle or class of transactions.
Assurance service: An independent professional service that improves the quality of information for decision makers. An assurance
633
634
Appendix F
Key Terms
service differs from a consulting service in that the former focuses on optimizing a clients decision making whereas the later focuses
on improving a clients outcomes or conditions.
Attestation of prospective (forecast or projection) financial statements: Prospective financial statements are financial information
representing the financial position, results of operations, and cash flows for some period of time in the future. This engagement is
performed in accordance with the Statements on Standards for Attestation Engagements (SSAE) AT 301.
Attestation of Service Organization Control: AICPA AU 402 requires an auditor (known as an user auditor) of a company (known
as an user entity) that uses a service organization to obtain an understanding of how the user entity uses the service organization,
including the nature and significance of the services and the effect on internal control.
Attestation of information systems (also known as SysTrust Service): This engagement provides reasonable assurance that a
clients information systems complies with Trust Services principles and criteria for electronic commerce. The engagement is
performed in accordance with Statements on Standards for Attestation Engagements (SSAE) AT 101.
Attestation of websites (also known as WebTrust Service): This engagement provides reasonable assurance that a clients website
complies with Trust Services principles and criteria for electronic commerce. The engagement is performed in accordance with
Statements on Standards for Attestation Engagements (SSAE) AT 101.
Attestation service: A type of assurance service in which a CPA firm issues a report about the reliability of an assertion that is the
responsibility of another party. Audit is a subset of attestation service, which in turn is a subset of assurance service.
Attestation standards: (See Appendix C) A general set of standards intended to guide attestation work in areas other than audits of
financial statements. The Auditing Standards Board issued 11 Attestation Standards that parallel the previously 10 GAAS. Following
the same framework used for auditing standards, detailed interpretations of the 11 Attestation Standards are provided in more than 10
Statements on Standards for Attestation Engagements (ATs).
Attribute: The characteristic being tested for in the population.
Attribute estimation sampling (AES) technique: A statistical sampling technique for tests of controls (TOC) that evaluates a sample
of items that result in an estimate of the proportion of the items in a population containing a control attribute (characteristic) of
interest.
Audit assurance: A complement to audit risk; an audit risk of 5 percent is the same as audit assurance of 95 percent.
Audit committee: Selected members of a clients board of directors whose responsibilities include ensuring auditors to remain
independent of management. Members of the audit committee must be independent directors, that is, members of the board of
directors who do not also serve as corporate officers or have other relationships that might impair independence.
Audit documentation: Records of auditing procedures applied, evidence obtained, and conclusions reached by the auditor in the
engagement.
Audit evidence: Any information that corroborates or refutes the auditors premise that the financial statements present fairly the
clients financial position and operating results.
Audit failure: A situation in which the auditor issues an incorrect audit opinion as the result of an underlying failure to comply with
the requirements of auditing standards.
Audit of compliance with debt agreement: This engagement is to report whether an audit client that enters into loan agreements
complies with certain debt agreements or regulatory requirements related to audited financial statements. The engagement is
performed in accordance with the AU 806.
Audit of financial statements that use a financial reporting framework other than GAAP: Financial statements that use a
financial reporting framework other than a GAAP financial reporting framework is referred to as a special-purpose financial reporting
frameworks. Audit of financial statements that use a special-purpose financial reporting framework is performed in accordance with
the AICPA AU 800.
Audit of information accompanying the basic financial statements: Information accompanying the basic financial statements
includes comparative statements supporting the control totals, supplementary information required by FASB or SEC, statistical data, a
schedule of insurance coverage, and specific comments on changes in the financial statements. This engagement is performed in
accordance with the AU 725.
Audit of specified elements, accounts or items: Examples of this engagement include a report on rentals, royalties, and profit
participation. It may be performed as a separate engagement or as part of an audit of a clients complete financial statements. This
engagement is performed in accordance with the AICPAAU 805
Auditing: A systematic process of a. objectively obtaining and evaluating evidence regarding assertions about economic actions and
events to ascertain the degree of correspondence between those assertions and established criteria and b. communicating the results to
interested users.
Auditing Standard Board (ASB): An important arm of the Auditing Standards Division is the Auditing Standards Board (ASB),
which promulgates the 10 generally accepted auditing standards (GAAS) that guide the quality of audit services. Compliance with the
10 GAAS is mandatory for members of AICPA who perform auditing and other related professional services. The ASB replaced the
10 GAAS with 4 fundamental principles underlying an audit that are grouped into four categories: (1) the purpose and premise of an
audit, (2) personal responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting.
Auditing Standards (AU): Detailed guidance to the 10 GAAS are provided by more than 100 Statements of Auditing Standards
(AUs) issued by the ASB. The AUs are labeled by their AU numbers #, which are based on the topical content with which they are
issued. as part of improving clarity and converging with international auditing standards, the more than 100 AUs are reorganized into
six groups in a new AU codification scheme: (1) AU 200 General Principles and Responsibilities, (2) AU 300-499 Risk Assessment
and Response to Assessed Risks, (3) AU 500 Audit Evidence, (4) AU 600 Using the Work of Others, (5) AU 700 Audit Conclusions
and Reporting, and (6) AU 800-999 Special Considerations.
Audit plan: A description of the nature, timing, and extent of the audit procedures to be performed. Ordinarily, it is documented with
an audit program.
Audit Practice and Quality Center (CAQ): The AICPA has established audit practice and quality centers as resource centers to
improve audit practice quality. In addition to these resource centers for CPA firms, the AICPA has established audit quality centers for
governmental audits and employee benefit plan audits.
Audit procedure: Detailed instruction for the collection of audit evidence.
Audit program: Audit procedures for an entire audit consisting of a set of tests of controls procedures, a set of tests of balances
Key Terms
procedures, and a set of completing the audit procedures.

Audit report: The end product of the auditors work, indicating the auditing standards followed, and expressing an opinion as to
whether an entitys financial statements are fairly presented in accordance with established criteria such as the GAAP.
Audit report date: The date on which the auditor has obtained sufficient appropriate audit evidence to support the opinion on the
financial statements or other financial information being reported upon. Typically, this is the date on which the auditor has completed
the field work, and the audit report is ordinarily dated as of this date.
Audit report issue date: the date on which the auditors report and the clients financial statements are issued (mailed) to the
stockholders in the form of an annual financial report.
Audit risk (AR): The risk that the auditor will conclude after conducting an audit that the financial statements are fairly stated and an
unqualified opinion can therefore be issued when, in fact, they are materially misstated.
Audit risk model: A model reflecting the relationships between audit risk (AR), inherent risk (IR), control risk (CR), and detection
risk (DR); AR=IR x CR x DR.
Audit sampling: Testing less than 100 percent of a population for the purpose of making inferences about that population.
Audit trail: Term used to describe the documents and records that allow an auditor to trace a transaction from its origination through
to its final disposition, or vice versa. It may be electronic or paper based.
Auditing service: A type of attestation service in which an auditor issues an audit report about the reliability of the financial
statements that are the responsibility of the clients management.
Balance-related information assertions/objectives: Assertions (objectives) about account balances at period end.
Bank cutoff statement: A bank statement for a period of time determined by the auditor that is shorter than the regular month-end
bank statements. The bank sent it directly to the auditor, who uses it to verify reconciling items on the clients year-end bank
reconciliation.
Batch processing: A system in which like transactions are processed periodically as a group.
Bill and hold (transactions): Transactions in which sales of merchandise are billed to customers prior to delivery, with the goods
being held by the seller. These transactions may overstate revenues and net income if they do not meet specific requirements for
recognition as sales. In addition, these transactions may overstate inventory if they were included in the total inventory on hand.
Bill of lading: A shipping document issued by a common carrier acknowledging the receipt of goods and setting forth the provisions
of the transportation agreement.
Blank confirmation request: A request addressed to the debtor, requesting the recipient to fill in the amount of the accounts
receivable balance.
Board of directors: Persons elected by the stockholders of a corporation to oversee management and to direct the affairs of the
corporation.
Brainstorming (in audit plan): A required part of every financial statement audit. Conducted at the planning phase of the audit
whereby the audit team considers changes in account balances, deficiencies in controls, and motivations to commit fraud to identify
areas where fraud is more likely to occur and how it will occur.
Breach of contract: Failure to perform a contractual obligation that has not been excused. For CPA firms, the parties to a contact
usually involve the audit clients and designated third-party beneficiaries.
Business performance measurement (in assurance service): An assurance service that help a client to track performance using a
variety of financial and nonfinancial measures.
Business risks: Risks that threaten managements ability to achieve the organizations objectives.
Bylaws: The rules and procedures adopted by a corporations stockholders, including the corporations fiscal year and the duties and
powers of its officers.
Call privilege for preferred stock: A preferred stock may carry a call privilege option in which case the issuing company will have
the right to redeem (call) the preferred stock at a later date for a predetermined price. This call price would be in excess of the original
issue price, such as 105 percent of par value.
Cash basis framework: A special purpose accounting framework that includes no accruals.
Cash equivalent: Excess cash invested in short-term, highly liquid investments such as time deposits, certificates of deposit, and
money market funds.
Capital expenditure: An expenditure for property, plants, and equipment that is properly charged to an asset account.
Capital (finance) lease: A capital (finance) lease is a lease that meets one or more of the following criteria: the lease term is greater
than 75% of the property's estimated economic life; the lease contains an option to purchase the property for less than fair market
value; ownership of the property is transferred to the lessee at the end of the lease term; or the present value of the lease payments
exceeds 90% of the fair market value of the property. A capital lease (finance) lease is recorded and amortized as a purchased asset in
the balance sheet by the lessee. The determination of whether a lease is a capital (finance) lease or an operating lease is defined in the
United States by Statement of Financial Accounting Standards SFAS No. 13.
Capital stock certificate record: A record of the issuance and repurchase of capital stock for the life of the corporation. See also
Shareholders capital stock master file.
Certified public accountant: A person licensed by the state to practice public accounting as a profession, based on having passed the
Uniform CPA Examination and having met certain educational and experience requirements.
Chart of accounts: A listing of all the entitys accounts, which classifies transactions into individual balance sheet and income
statement accounts.
Circumstance-imposed scope limitation: A restriction on auditors from gathering sufficient appropriate evidence because of a
situation beyond control of both the auditors and client, such as late appointment of the auditors.
Class action suits: Law suits brought on behalf of a large group of plaintiffs to promote consistent judgments and minimize litigation
costs.
Classes of transactions in the revenue cycle: The categories of transactions for the revenue cycle in a typical company: sales, cash
receipts, sales returns and allowances.
Classification specific audit objective: The specific objective of verifying that financial items have been properly classified in the
635
636
Appendix F
Key Terms
Client advisory comment letter (Management letter): A letter written by the auditor to a clients management containing the
auditors recommendations for improving any aspect of the clients control/business.
Client-imposed scope limitation: A restriction on auditors from gathering sufficient appropriate evidence because of the clients
deliberate refusal to provide them access to documents or to otherwise limit the auditors application of auditing procedures.
Clients inquiry of lawyer letter: A letter sent by auditors to a clients lawyer requesting a description and evaluation of pending or
threatened litigation, unasserted claims, and other loss contingencies. The returned letter from the clients lawyer is referred to as the
lawyer representation letter.
Close family relative: AICPA defines as a parent, sibling, and non-dependent child. PCAOB defines as a parent (including adoptive
parent and step-parent), dependent (i.e., person who received half or more support), non-dependent child (including step-child), and
brother and sister (excluding grandchild, grand-parent, parent-in-law, and the spouse of each of these).
Cloud computing: A model for enabling on-demand user network access to a shared pool of computing resources (e.g., networks,
servers, storage, applications, or services), often through an Internet browser.
Code of Professional Conduct (CPC): A code of conduct designed by the AICPA to provide a framework for providing professional
services and responding to other ethical issues in the profession.
Cold (concurrent) review: A review of the audit conducted by a partner not otherwise involved in the audit to help assure that the
evidence in the documentation adequately supports the audit report.
Collateral: An asset or a claim on an asset usually held by a borrower or an issuer of a debt instrument to serve as a guarantee for the
value of a loan or security. If the borrower fails to pay interest or principal, the collateral is available to the lender as a basis to recover
the principal amount of the loan or debt instrument.
Collusion: A fraudulent cooperative effort among employees to steal assets or misstate records.
Comfort letter: A letter issued by the independent auditor to the underwriters of securities registered with the SEC under the
Securities Act of 1933. Comfort letter deal with such matters as the auditors independence and the compliance of unaudited data with
requirements of the SEC.
Commercial paper: Note issued by major corporations, usually for short periods of time and at rates approximating prime lending
rates, usually with high credit rating. Its quality may change if the financial strength of the issuer declines.
Common law: Law developed through court decisions, custom, and usage without written legislation. It operates on court precedence
and it may differ from state to state or by jurisdiction.
Committee of Sponsoring Organizations of the Treadway Commission (COSO): In the 1970s, the major accounting organizations
(including AICPA) sponsored the National Commission on Fraudulent Financial Reporting (the Treadway Commission) to study and
establish a comprehensive framework of internal control for the auditor to assess the quality of internal control over financial
reporting.
Commission (in ethics): The payment of a fee for selling an item or as a percentage of the fees generated for performing a service to
attestation clients, which is prohibited by the Code of Professional Conduct (CPC). However, commission is allowed for performing a
non-attestation client, which the auditor must disclose its nature to the user affected by the auditors service.
Common-size financial statements: Financial statements that present each amount as percentage of some financial statement base.
As an example, a common-size income statement presents all revenues and expenses as a percentage of net sales.
Compensating (compensatory) control: A control elsewhere in the system that offsets the absence of a key control.
Compilation procedure (inventory cycle): A test of balances procedure performed by the auditor to test for the specific audit
objective of mathematic accuracy of inventories.
Compilation service (financial statements): A nonaudit engagement in which the accountant under-takes to present, in the form of
financial statements, information that is the representation of management, without undertaking to express any assurance on the
statements.
Completeness assertion: Implicit or explicit assertion made by the management that all accounting transactions and balances that
should have been recorded in the financial statements have been recorded. For example, management asserts that there are no
unrecorded inventories and that all sales occurred are included in the income statement.
Completeness specific audit objective: The specific objective of verifying that the financial items that should be included in the
financial statements have actually been included.
Compliance audit: (a) A review of an organizations financial records performed to determine whether the organization is following
specific procedures, rules, or regulations set by some higher authority; (b) An audit performed to determine whether an entity that
receives financial assistance from the federal government has complied with specific laws and regulations.
Compliance supplement: A publication of the U.S. Office of Management and Budget that specifies audit procedures for federal
financial assistance programs.
Computed upper exception rate (CUER): The upper limit of exception (the maximum except rate) in the population at a given
acceptable risk of overreliance (ARO).
Computed upper misstatement rate (CUMR): A statistical estimation of the maximum population misstatement rate. It is the sum
of the projected population misstatement (PPM) and the allowance for sampling risk (ASR).
Computer-assisted audit techniques (CAATs): Computer programs that allow auditors to test computer files and databases.
Confidential information (in ethics): Information obtained during the conduct of an audit related to the clients business or business
plans; the auditor is prohibited from communicating confidential information except in specific instances allowed by the Code of
Professional Conduct (CPC) or with the clients permission.
Confirmation: The auditors receipt of a written or oral response from an independent third party verifying the accuracy of
information requested.
Consignment (in or out): A transfer of goods from the owner to another person who acts as the sales agent of the owner.
Contingent fee (in ethics): A fee established for the performance of any service pursuant to an arrangement in which no fee will be
charged unless a specified finding or result is attained (or achieved), or in which the amount of the fee otherwise depends on the
finding or results of such services. For example, an auditor is prohibited from receiving audit fee that is contingent upon issuing an
unqualified opinion to the client.
Contingent liability (loss contingency): A potential future obligation to an outside party for an unknown amount resulting from
activities that have already taken place.
Key Terms
Continuous auditing: To provide assurance using a series of reports provided simultaneously or shortly after the related information
is released.
Contract law: Law stems from case law, the Uniform Commercial Code, and other state statutes. It establishes the rights and
responsibilities of parties to consensual private agreements.
Contributory negligence: An auditors legal defense under which the auditor claims that the client failed to perform certain
obligations and that it is the clients failure to perform those obligations that brought about the claimed damages.
Control activities: Policies and procedures that help ensure that necessary actions are taken to address risks in the achievement of the
entitys objectives. Typically, they include the following five specific control activities: (1) adequate separation of duties, (2) proper
authorization of transactions and activities, (3) adequate documentations and records, (4) physical control over assets and records, and
(5) independent checks on performance.
Control environment: The tone of an organization, which reflects the overall attitude, awareness, and actions of the board of
directors, management, and owners influencing the control consciousness of its people.
Control deficiency: A deficiency in the design or operation of controls that does not prevent or detect misstatements on a timely
basis. A deficiency in design exists when either a control necessary to meet a control objective is missing or the existing control is not
designed to operate effectively. A deficiency in operation exists when a properly designed control does not operate as designed, or
when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively.
Control environment: The actions, policies, and procedures that reflect the overall attitudes of top management and directors about
internal control and its importance to the audit client.
Control risk: The risk that a material misstatement that could occur in an account will not be prevented or detected on a timely basis
by internal control.
Convertible bonds: A corporate bond, usually a junior debenture that can be exchanged, at the option of the holder, for a specific
number of shares of the company's preferred stock or common stock. Convertibility affects the performance of the bond in certain
ways. First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as
the price of the underlying stock rises. In this way, convertible bonds offer some of the benefits of both stocks and bonds. Convertibles
earn interest even when the stock is trading down or sideways, but when the stock prices rise, the value of the convertible increases.
Therefore, convertibles can offer protection against a decline in stock price.
Corporate charter: A legal document granted by the state in which a company is incorporated that recognizes a corporation as a
separate entity; it includes the name of the corporation, the date of incorporation, capital stock the corporation is authorized to issue,
and the types of business activities the corporation is authorized to conduct.
Corporate governance: The oversight mechanisms in place to help ensure the proper stewardship over an entitys assets.
Management, the board of directors, and the audit committee play primary roles, and the independent auditor plays a key facilitating
role.
Corroborating documents: Documents and memoranda included in the working papers that substantiate representations contained in
the clients financial statements, lawyers letters, copies of contracts, copies of minutes of directors and stockholders meetings, and
representation letters from the clients management.
Cost Accounting standards Board: A five-member board established by Congress to narrow the options in cost accounting that are
available under GAAP. Audit clients that have significant supply contracts with the U.S. government agencies are subject to the cost
accounting standard established by the board.
Covered member (in ethics): An individual on the attestation engagement team, an individual in a position to influence the
attestation engagement, or a partner in the office in which the lead attestation engagement partner primarily practices in connection
with the attestation engagement.
Cross-sectional analysis: A technique that involves comparing the clients ratios for the current year with those of similar firms in the
same industry.
Cruising (in depletion): The inspection of a tract of forestland for the purpose of estimating the total lumber yield.
Current files: All audit files applicable to the year under audit.
Cutoff: The process of determining that transactions occurring near the balance sheet date are assigned to the proper accounting
period.
Cutoff period: The few days just before and after the balance sheet date; the number of days is determined by the auditor, depending
on the assessment of potential errors made in recording items in the incorrect period.
Cutoff specific audit objective: The specific objective of verifying that transactions occurring near the balance sheet date have been
recorded in the proper accounting period.
Cutoff tests: Audit testing procedures applied to transactions selected from those recorded during the cutoff period to provide
evidence as to whether the transactions have recorded in the proper accounting period.
Cutoff bank statement: A partial-period bank statement and the related cancelled checks, duplicate deposit slips, and other
documents included in bank statements, mailed by the bank directly to the auditor; the auditor uses it to verify reconciling items on the
clients year-end bank reconciliation.
Cutoff misstatements: Misstatement that take place as a result of current period transactions being recorded in a subsequent period or
subsequent period transactions being recorded in the current period.
Cycle inventory count: Periodic testing of the accuracy of the perpetual inventory recorded by counting all inventory on a cyclical
basis.
Database management systems: Hardware and software systems that allow audit clients to establish and maintain data bases shared
by multiple applications.
Date of the auditors report: The date on which auditors have obtained sufficient appropriate evidence to support their opinion.
Debenture (bond): An unsecured bond, dependent upon the general credit of the issuer.
Debit memo: A document indicating a reduction in the amount owed to a vendor because of returned goods or an allowance granted.
Debit covenant: An agreement between an entity and its lender that places limitations on the entity; usually associated with
debentures or large credit lines. Common limitations include restrictions on dividend payments, requirements for a specified working
capital or debt/equity ratio, and annual audits of the entitys financial statements to be furnished to the lender. Failure to satisfy the
637
638
Appendix F
Key Terms
agreement may result in loans or bonds becoming immediately due and payable or redeemable.
Decision support systems: IT information systems that combine models and data in an attempt to solve non-structured problems with
extensive user involvement.
Defalcation: The theft or embezzlement of funds or other assets from a client. The theft is usually covered up through factitious
accounting entries. Asset misappropriation is one type of defalcation.
Deficiency in control: A deficiency in the design or operation of a control that does not prevent or detect misstatements on a timely
basis. A deficiency in design exists when either a control necessary to meet a control objective is missing or the existing control is not
designed to operate effectively. A deficiency in operation exists when a properly designed control does not operate as designed, or
when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively.
Depletion: Expense associated with the extraction of natural resources. The units of production method are normally used. Unlike
depreciation (for tangible assets) and amortization (for intangible assets), which describe the deduction of expenses of tangible assets
and the reduction in carrying value of intangible assets, depletion is the actual physical reduction of natural resources by companies.
Derivatives: Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else
(known as the underlying). The underlying value on which a derivative is based can be an asset (e.g., commodities, equities (stocks),
residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices,
consumer price index (CPI), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit.
The main types of derivatives are forwards, futures, options, and swaps.
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is
known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying
moves in the direction they expect. This activity is known as speculation.
Detailed supporting schedule: Detailed schedules prepared by the client or the auditor in support of specific amounts on the financial
statements.
Detection risk (DR): The risk that the auditors procedures will lead them to conclude that a financial statement assertion is not
materially misstated when in fact such misstatement does exist.
Difference estimation: An audit sampling technique that uses the difference between the audited (correct) values and book values of
items in a sample to calculate the estimated total audited value of the population. Difference estimation is used in lieu ratio estimation
when the differences are not nearly proportional to book values.
Digital signatures: Electronic certificates that are used to authenticate the validity of individuals and companies conducting business
electronically.
Direct financial interest: A personal investment under the direct control of the investor. Investments made by a CPAs spouse or
dependents also are regarded as direct financial interests of the CPA.
Disclaimer opinion (report): A report issued when the auditor is not able to express an opinion on whether the overall financial
statements are fairly presented or the auditor is not independent.
Discovery sampling: An audit sampling technique for locating at least one deviation (exception), providing that the deviation
(exception) occurs in the population with a specified frequency.
Distributed data processing: An IT system that uses communication links to share data and programs among various users in remote
locations throughout the organization. The users may process the data in their own departments.
Dual-dated audit report: The use of one audit report date for formal subsequent events and a later date for new subsequent
events that come to the auditors attention between the field work completion date and the audit report issue date.
Dual purpose test (procedure): A concurrent audit procedure that serves as a test of controls and a test of balances of the transactions
that occurred during the year. For example, a test of controls over equipment acquisitions (tests the control activity of authorization) is
combined with a test of balance of whether the dollar amounts of equipment acquisitions are properly recorded (tests the specific audit
objective of completeness).
Due (professional) care: A legal standard requiring that the auditor performs his/her professional services with the same degree of
skill, knowledge, and judgment possessed by other members of the profession.
Due diligence: A CPA firms contention that its audit work was adequate to support its opinion on financial statements included in a
registration statement filed with the SEC under the Securities Act of 1933.
Earnings management: A deliberate action taken by management to meet earnings objectives.
Earn-out: Earn-out clauses are often included in the business acquisition agreement if the buyer and seller disagree significantly over
what the business should be worth. This is especially so if the business financial performance is expected to improve substantially at
some future time, after the purchase. In such cases, the acquisition agreement may set an additional amount that the seller will receive
in the future if this financial performance expectation is realized. One way to specify the earn-out is as a percentage of revenues in
excess of an agreed-upon amount, payable over a certain time period, and limited to some maximum.
Effective date (of SEC): The date the SEC indicates to the client that it may begin selling the new securities described in a
registration statement that it has filed (filing date) with the SEC.
Electronic commerce (e-commerce): An IT system that involves the electronic processing and transmission of business transactions
between customer and client. A variety of activities may be included, including electronic trading of goods and services, online
delivery of digital products, and electronic funds transfer.
Electronic data interchange (EDI): An IT system in which data are exchanged electronically between the computes of different
companies. In an EDI system, source documents are replaced with electronic transactions created in a standard format.
Electronic funds transfer (EFT) system: An IT system that transmits and processes funds-related cash disbursement and receipt
transactions.
Elements of Quality Control (AICPA): The Quality Control Standards Committee of the AICPA replaced the previously established
five elements of quality control with six elements of quality control in Statement on Quality Control Standards (SQCS No.8), A Firms
System of Quality Control. A CPA firms system of quality control should be designed to provide the firm with reasonable assurance
that the firm and its personnel comply with professional, legal, and regulatory requirements and that the partners issue appropriate
reports.
Elements of Quality Control (PCAOB): The Quality Control Standards Committee previously established five elements of quality
Key Terms
control that CPA firms should consider in setting up their policies and procedures in order to conform to professional standards. The
PCAOB adopted and retained the five elements of quality control as part of its interim auditing standards.
Embedded audit module: A method of auditing transactions whereby the auditor embeds a module in the clients application
software to identify transactions with characteristics that are of interest to the auditor, which the auditor is then able to analyze them
on a real-time, continuous basis as the client transactions are processed.
Engagement letter: An agreement between the CPA firm and the client as to the terms of the engagement for the conduct of the audit
and related services.
Engagement risk: The risk of loss or injury to the auditors reputation by association with a client that goes bankrupt or one whose
management lacks integrity.
Entity-level controls (in ICFR): Controls that have a pervasive effect on the audit clients system of internal control such as controls
related to the control environment; controls over management override; the managements risk assessment process; and controls over
the period-end financial reporting process.
Error: An unintentional mistake of the financial statements.
Estimation transaction: A transaction involving managements judgments or assumptions, such as determining the allowance for
doubtful accounts, establishing warranty reserves, and assessing assets for impairment.
Ethics: A system or code of conduct based on moral duties and obligations that indicates how an individual should behave.
Ethics Rulings: A set of questions and answers issued by the AICPA that explains the application of Rules and Interpretations of the
Code of Professional Conduct to specific ethical situations.
Examination: An attestation engagement that results in positive assurance as to whether or not the assertions under examination
conform with the applicable criteria.
Exception rate: The percent of items in a population that have exceptions in prescribed controls or monetary correctness. Also
referred to as occurrence rate or deviation rate.
Existence or occurrence assertion: Implicit or explicit assertion made by the management that asset and liability balances stated in
the balance sheet actually exist at the balance sheet date and that revenue and expense transactions stated in the income statement
actually occurred during the accounting period. For example, management asserts that inventories in the balance sheet actually exist at
balance date and that sales in the income statement actually occurred during the accounting period.
Existence or occurrence specific audit objective: The specific objective of verifying that the financial items included in the financial
statements should actually be included.
Expected population exception (deviation) rate (EPER): Exception rate that the auditor expects (estimates) to find in the population
before audit testing begins.
Explanatory paragraph: A paragraph inserted in an auditors report to explain a matter or to describe the reasons for giving an
opinion that is other than unqualified.
External document: A document, such as a vendors invoice, that has been generated by an outside party to the clients organization.
Fidelity bonds: A form of insurance in which a bonding company agrees to reimburse an employer for losses attributable to theft or
embezzlement by bonded employees.
Fieldwork standards: One of three categories of the GAAS that deals with the actual conduct of an audit.
Financial Accounting Standards Board: The Financial Accounting Standards Board is an independent private body that develops
generally accepted accounting principles (GAAP). The board consists of seven members who are assisted by a large research staff and
an advisory council. It issues Statements of Financial Accounting Standards (SFASs) that are officially recognized by the AICPA.
Financial audit: An audit of the financial statements of an organization or segment of the organization. This type of service involves
obtaining and evaluating evidence about a clients financial statements. The AICPAs GAAP and Auditing Standard Boards Auditing
Standard AU 700 require that auditors of private companies in the United States to provide an opinion on the companys financial
statements.
Financial forecasts: Prospective financial statements that present an entitys expected financial positions, results of operations, and
cash flows for future periods, to the best of the responsible partys knowledge and belief, and given one or more underlying
assumptions.
Financial instruments: A broad category of instruments, usually debt securities but also equity or hedges that represents financial
agreements between a party (usually an issuer) and counter-party (usually an investor) based on either underlying assets or agreements
to incur financial obligations or make payments. These instruments range in complexity from a simple bond to complicated
agreements containing put or options.
Financial interest: An ownership interest in equity or a debt security issued by an entity, including rights and obligations to acquire
such an interest and derivatives directly related to such interest. A direct financial interest is a financial interest that is owned directly
by an auditor, or is under the control of the auditor. An indirect financial interest is a financial interest that is owned by an auditor
through an investment vehicle, mutual funds, estate, trust, or other intermediary when the auditor does not control the intermediary nor
has authority to supervise or participate in the intermediarys investment decisions.
Financial projections: Prospective financial statements that present an entitys expected financial positions, results of operations, and
cash flows for future periods, to the best of the responsible partys knowledge and belief, and given one or more underlying and
hypothetical assumptions.
Financial reporting framework: A set of criteria used to determine the measurement, recognition, presentation, and disclosure of
material items in the financial statements.
Financial statement assertions: Expressed or implied representations by management about information that is reflected in the
financial statements. The tree sets of assertions relate to ending account balances, transactions, and presentation and disclosure.
Flowchart: A diagrammatic representation of the clients documents and records and the sequence in which they are processed.
FOB destination: Shipping contract in which title to the goods passes to the buyer when the goods are received.
FOB origin: Shipping contract in which title to the goods passes to the buyer at the time that the goods are shipped.
Foreign Corrupt Practices Act of 1977: A federal statute that makes it illegal to offer a bribe to an official of a foreign country for
the purpose of exerting influence and obtaining or retaining business and that requires U.S. companies to maintain reasonably
complete and accurate records and an adequate system of internal control.
639
640
Appendix F
Key Terms
Forecasts (in prospective financial statements): Prospective financial statements that present an entitys expected financial
positions, results of operations, and cash flows for future periods, to the best of the responsible partys knowledge and belief, and
given one or more underlying assumptions.
Foreseeable third parties: An unlimited class of users that the auditor should have reasonable been able to foresee as being likely
users of financial statements.
Foreseen third parties: Members of a limited class of users whom the auditor is aware will rely on the financial statements.
Forward contract: A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the
future. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. The forward price
of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date.
The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of
a profit, or loss, by the purchasing party. This process is used in financial operations to hedge risk, as a means of speculation, or to
allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
Fundamental principles underlying an audit in accordance GAAS: The ASB replaced the ten GAAS with four fundamental
principles underlying an audit that are grouped into four categories: (1) the purpose and premise of an audit, (2) personal
responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting.
Futures contract: a futures contract is a standardized contract, to buy or sell a specified commodity of standardized quality at a
certain date in the future, at a market determined price (the futures price). The price is determined by the instantaneous equilibrium
between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of
the contract. In many cases, the items may be such non-traditional "commodities" as foreign currencies, commercial or government
paper (e.g., bonds), or "baskets" of corporate equity ("stock indices") or other financial instruments. They are traded on a futures
exchange.
Fraud: An intentional misrepresentation of the financial statements by management (also known as fraudulent financial reporting), or
theft of assets by employees (also known as employee fraud). Fraud also is referred to as irregularities.
Fraud Triangle: A diagrammatic representation of the three factors of fraud: incentives/pressures, opportunities, and
attitudes/rationalization.
Fraudulent financial reporting (management fraud): Intentional misrepresentations or omissions of amounts or disclosures in
financial statements to deceive users.
Generally accepted accounting principles (GAAP): Accounting principles that are generally accepted for the preparation of
financial statements in the United States. GAAP standards are currently issued primarily by the FASB.
Generally accepted auditing standards (GAAS): 10 auditing standards, developed by the AICPA, consisting of general standards,
standards of field work, and standards of reporting, which are supported by a set of detailed Statements on Auditing Standards (AUs).
General cash account/balance (cash on hand): The primary bank account for most organizations; virtually all cash receipts and
disbursements flow through this account at some time.
General controls: Controls that surround all parts of the audit clients information technology function.
General standards: One of three categories of the GAAS that deals with the qualification of the auditor conducting an audit and the
standard of care expected of those conducting an audit.
Generalized audit software (GAS): Computer programs used by auditors that provide data retrieval, data manipulation, and
reporting capabilities specifically oriented to the audit process.
Goodwill: The excess of the net purchase price for an entity over the sum of the fair market values of specifically identifiable tangible
and intangible assets of that entity.
Goodwill impairment: The decrease in the value of goodwill. It is measured by comparing the fair value of the reporting entity with
the carrying value of that entity. If fair value is less than carrying value (including goodwill), the presumption is that goodwill has
been impaired. Goodwill should be written down to an amount that would cause fair value to be no more than carrying value.
Government Accountability Office (GAO): Government organization directly accountable to the Congress of the United States that
performs special investigations for the Congress and establishes broad standards for the conduct of governmental audits.
Government audits: Financial, performance, and attestation engagements of government agencies or government funded
institutions.
Government Auditing Standards (GAGAS) (or Yellow Book): A publication of the Government Accountability Office (GAO) that
is widely used as a reference by government auditors and CPAs who perform governmental audit work.
Gross negligence: Lack of even slight care, indicative of a reckless disregard for ones professional responsibilities.
Horizontal analysis: A technique that involves comparing financial statement amounts and ratios for a particular company from year
to year.
Hedge fund: A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a
wider range of investment and trading activities than other investment funds and pays a performance fee to its investment manager.
Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds, as
a class, invest in a broad range of investments including shares, debt, commodities and so forth. As the name implies, hedge funds
often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods,
most notably short selling. However, the term "hedge fund" has come to be applied to many funds that do not actually hedge their
investments, and in particular to funds using short selling and other "hedging" methods to increase rather than reduce risk, with the
expectation of increasing return. Hedge funds are typically open only to a limited range of professional or wealthy investors. This
provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee
structures and the liquidity of interests in the fund. A hedge fund will typically commit itself to a particular investment strategy,
investment types and leverage levels via statements in its offering documentation, thereby giving investors some indication of the
nature of the fund. The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by
leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed
debt.
Hedging: Hedging is a finance strategy designed to reduce investment risk using call options, put options, short-selling, or futures
contracts. A hedge can help lock in profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss.
Key Terms
Illegal acts: Violations of laws or governmental regulations.

Immediate family member: AICPA defines as a spouse, spousal equivalent, and dependent (whether or not related). PCAOB defines
as a spouse, spousal equivalent (including cohabitant), and dependent (i.e., person who received half or more support).
Imprest bank account: A bank account that normally carries a zero balance and is replenished by the company when checks are to be
written against the account. The imprest payroll account is one type of imprest bank account.
Imprest cash account (petty cash): A fund of cash maintained within the company for small cash acquisitions or to cash employees
checks; the funds fixed balance is comparatively small and is periodically reimbursed.
Imprest payroll account: A bank account to which the exact amount of payroll for the pay period is transferred by check or wires
transfer from the employers general cash account.
Income smoothing: A form of earnings management in which revenues and expenses are shifted between periods to reduce
fluctuations in earnings.
Independence (in auditing): Being objective and unbiased while performing auditing services. It requires being independent in fact
and in appearance.
Independent auditors: Certified public accountants or accounting firm that perform audits of commercial and non-commercial
financial entities.
Independent in appearance: The auditors ability to maintain an unbiased viewpoint in the eyes of others.
Independent in fact: The auditors ability to maintain an unbiased viewpoint in the performance of professional services.
Independent registrar: Outside agent engaged by a corporation to make sure that its stock is issued in accordance with capital stock
provisions in the corporate charter and authorizations by the board of directors; required by the SEC for publicly held corporations.
Indirect financial interest: An investment in which the specific investment decisions are not under the direct control of the investor,
for example, an investment in a professionally managed mutual fund.
Information and communication: The set of manual and/or computerized procedures that initiates, records, processes, and reports an
entitys transactions and maintains accountability for the related assets.
Inherent risk (IR): The risk of material misstatement of a financial statement assertion, assuming there were no related controls.
Inquiry (an audit procedure): Seeking information of knowledgeable persons, both financial and non-financial, throughout the
clients entity or outside the clients entity.
Inquiry of the audit clients attorney: A letter from the client requesting that legal counsel inform the auditor of pending litigation or
any other information involving legal counsel that is relevant to financial statement disclosure.
Inspection (an audit procedure): Examination of internal or external records or documents that are in paper form, electronic form, or
other media.
Inspection (by the PCAOB): A process that leads to an assessment of the degree of compliance of each registered public accounting
firm and associated persons of that firm with the Sarbanes-Oxley Act of 2002 and the boards requirements in connection with its
performance of audits, issuance of audit reports, and related matters.
Inter-bank transfers schedule: A audit working paper that lists all transfers between client bank accounts starting a short period
before year end and continuing for a short period after year end.
Interest rate swap: An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another
party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They
can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates.
Integrated audit (in ICFR): As required by the Sarbanes-Oxley Act of 2002 and AS 5 of the Public Company Accounting Oversight
Board, an audit that includes providing assurance on both the financial statements and internal control over financial reporting.
Integrated audits are required of publicly traded companies in the United States.
Integrated test facility: A set of dummy records and files included in an IT system enabling test data to be processed simultaneously
with live input.
Interim audit (work): Those audit procedures that are performed before the balance sheet date. The purpose is to facilitate earlier
issuance of the audit report and to spread the auditors work more uniformly over the year.
Interim financial information: Refers to financial information or statements covering a period less than a full year for a 12-month
period ending on a date other than the entitys fiscal year end.
Internal auditors: Auditors employed by a company to audit for the companys board of directors and management.
Internal control: A process designed to provide reasonable assurance regarding the achievement of managements objectives in the
following categories: (a) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with
applicable laws and regulations.
Internal control over financial reporting (ICFR): A process designed by, or under the supervision of, the audit clients principal
executive and principal financial officers, or persons performing similar functions, and effected by the audit clients board of directors,
management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with GAAP.
Internal control over financial reporting (ICFR) audit: An attestation engagement in which the auditor reports on the effectiveness
of internal control over financial reporting; such reports are required for public companies under Section 404 of the Sarbanes-Oxley
Act and PCAOB Standard No.5.
Internal control questionnaire: A series of questions about the controls in each audit area used as a means of indicating to the
auditor aspects of internal control that may be inadequate.
Internal document: A document, such as a sales invoice, that is generated within the clients organization.
International Federation of Accountants (IFAC): A worldwide organization of national accounting bodies (e.g., AICPA) that
fosters a coordinated worldwide accounting profession with harmonized standards.
International Auditing and Assurance Standards Board (IAASB): A committee of the International Federation of Accountants,
established to issue standards on auditing and reporting practices to improve the degree of uniformity of auditing practices and related
services throughout the world.
International Standards on Auditing (ISAs): Statements issued by the International Auditing and Assurance Standards Board
(IAASB) of the International Federation of Accountants (IFAC) to promote international acceptance of auditing standards.
Interpretations of Rules of Conduct: Guidelines issued by the AICPA for the scope and applicability of specific rules in the Rules of
641
642
Appendix F
Key Terms
J
K
L
Conduct.
Introductory paragraph: The paragraph of an auditors report in which the auditor indicates that s/he has audited the financial
statements, that the financial statements are the responsibility of management, and that the auditors responsibility is to form an
opinion.
Inventory compilation tests: Audit procedures used to verify whether physical counts of inventory are correctly summarized,
inventory quantities and prices are correctly extended, and extended inventory is correctly footed.
Inventory pricing tests: Audit procedures used to verify the costs used to value physical inventory.
Iron curtain method (approach): A method (approach) that quantifies the total likely material misstatements as of the current yearend based on the effects of reflecting all material misstatements (including projecting material misstatements where appropriate)
existing in the balance sheet at the end of the current year, irrespective of whether the material misstatements occurred in the current
year or previous years. For example, if expenses were materially misstated by $20,000 in the previous year and $30,000 during the
current year, the iron curtain method would quantify the misstatement as $50,000. Also see and compare with rollover method
(approach).
Issuer (Public or publicly traded company): A company that is permitted to offer its registered securities (stock, bonds, etc.) for sale
to the general public, typically through a stock exchange, or occasionally a company whose stock is traded over the counter (OTC) via
market makers.
Job cost system: System of cost accounting in which costs are accumulated by individual jobs when material is used and labor costs
are incurred.
Job time ticket (job card): A document designed to accumulate the labor and machine time devoted to a particular production order.
Joint and several liability: A legal concept that holds a class of defendants jointly responsible for losses attributed to the class as well
as liable for any share of losses that cannot be collected from those unable to pay their share. Thus, a financially responsible defendant
may be required to pay losses attributed to defendants that do not have the ability to pay.
Kiting: The transfer of money from one bank to another and improperly recording the transfer so that the amount is recorded as an
asset in both accounts; this practice is used by embezzlers to cover theft of cash.
Lack of duty to perform: An auditors legal defense under which the auditor claims that no contract existed with the client; therefore,
no duty existed to perform the disputed service.
Lapping (of accounts receivable): The postponement of accounting entries for the collection of receivables to conceal an existing
theft of cash.
Lawyer representation letter: The auditor sent a clients inquiry of lawyer letter to a clients lawyer requesting a description and
evaluation of pending or threatened litigation, unasserted claims, and other loss contingencies. The returned letter from the clients
lawyer is referred to as the lawyer representation letter.
Lead schedule: An audit schedule (working paper) with columnar headings similar to those in a clients working trial balance, set up
to combine similar ledger accounts, the total of which appears in the working trial balance as a single amount.
Letter of credit: A binding document that a buyer requests from his/her bank in order to guarantee that the payment for goods will be
transferred to the seller. Basically, a letter of credit gives the seller reassurance that s/he will receive the payment for the goods. In
order for the payment to occur, the seller has to present the bank with the necessary shipping documents confirming the shipment of
goods within a given time frame. It is often used in international trade to eliminate risks such as unfamiliarity with the foreign country,
customs, or political instability.
Leverage (Gearing): leverage is borrowing money to supplement existing funds for investment in such a way that the potential
positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to
increase the returns to equity.
Local area networks (LANs): Networks that connect computer equipment, data files, software, and peripheral equipment within a
local area, such as a single building or a cluster of buildings, for intra-company use.
Lockbox (system): A post office box controlled by an audit clients bank at which cash remittances from the clients customers are
received. The bank picks up the remittances, immediately credits the cash to the clients bank account, and forwards the remittance
advices to the company.
Major federal financial assistance program (award): A significant federal assistance program as determined by the auditors based
on a risk-based approach. In a single audit, the auditors must provide an opinion on compliance related to major programs.
Management assertions: Implicit or explicit representations made by management about classes of transactions, related account
balances, and presentation and disclosures in the financial statements.
Management integrity: The honesty and trustworthiness of management as exemplified by past and current actions. The auditor
assesses the extent to which they can trust management and its representations to be honest and forthright.
Management representation (in ICFR): A written representation from an audit clients management related to the audit of ICFR. It
includes statements such as management did not rely on work performed by the audit in forming its assessment of the effectiveness of
ICFR; management has disclosed to the auditor all deficiencies in the design or operation of ICFR, and so on.
Management representation letter: A single letter or separate letters prepared by officers of the client company at the auditors
request setting forth certain representations about the companys financial position or operations.
Managements discussion and analysis (MD&A): Managements discussion of a companys operating results, liquidity, and
financial position that is required in the regular financial statement filings with the SEC. An auditor may audit MD&A under an audit
of specified elements, accounts or items, or review MD&A under a review of interim financial information.
Material: Of substantial importance. Significant enough to affect evaluations or decisions by users of financial statements.
Information that should be disclosed so that financial statements constitute a fair presentation. Involves both qualitative and
quantitative considerations.
Material requisition (in inventory cycle): A document that authorizes the release of raw materials for production and updates the
raw materials perpetual inventory records.
Materiality: The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the
Key Terms
omission or misstatement. Alternatively, a common definition of materiality is that a misstatement in the financial statements can be
considered material if knowledge of the misstatement will affect a decision of a reasonable user of the financial statements.
Material misstatement: A misstatement in the financial statements, knowledge of which would affect a decision of a reasonable user
of the statements.
Material weakness (in ICFR): A control deficiency, or a combination of significant control deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material misstatement of the companys annual or interim financial
statements will not be prevented or detected on a timely basis.
Maximum population exception rate (MPER): The upper limit of exception (the highest except rate) in the population at a given
acceptable risk of overreliance (ARO).
Mean-per-unit estimation: A classical variables sampling plan enabling the auditors to estimate the average dollar value (or other
variable) of items in a population by determining the average value of items in a sample.
Minutes: A formal record of the issues discussed and actions taken in meetings of stockholders or the board of directors.
Misappropriation of assets (defalcations): A fraud involving the theft of an entitys assets.
Misstatement: An instance where a financial statement assertion s not n accordance with the criteria against which it is audited.
Misstatements may be classified as fraud (intentional), errors (unintentional), and other illegal acts such as noncompliance with laws
and regulations (intentional or unintentional).
Monetary unit sampling (MUS): A statistical sampling technique that provides upper and lower misstatement bounds expressed in
monetary amounts; also known as dollar unit sampling, cumulative monetary amount sampling, and sampling with probability
proportional to size.
Monitoring: Managements ongoing and periodic assessments of the quality of internal control performance to determine that
controls are operating as intended and are modified when needed.
Narrative description: A written description of a clients internal controls, including the origin, processing, and disposition of
documents and records, and the relevant control procedures.
Negative confirmation: A request addressed to the debtor/creditor, requesting a response only if the recipient disagrees with the
amount of the stated account balance.
Negative goodwill: In a business combination, negative goodwill is accounted for under the purchase accounting method when the
fair market value of the net assets of the acquired company exceeds the purchase price paid.
Negative (limited) assurance (opinion): A statement (opinion) of what the auditor does not know for sure as opposed to what the
auditor does know for sure (positive assurance). For example, a statement (opinion) that the auditor was "not aware of material
modifications that should be made to financial statements for them to conform with the U.S. generally accepted accounting principles"
is a negative assurance used in a review of financial statements service.
Negligence: Failure to exercise reasonable care, thereby causing harm to another person or to a property.
Non-issuer (Non-public company): A company other than one whose securities are traded on a public market or one that makes a
filing with a regulatory agency in preparation for the sale of securities on a public market.
Non-negligent performance: An auditors legal defense under which the auditor claims that the audit was performed in accordance
with auditing standards.
Non-public company (Non-issuer): A company other than one whose securities are traded on a public market or one that makes a
filing with a regulatory agency in preparation for the sale of securities on a public market.
Non-routine transaction: A transaction that occurs only periodically, such as counting and pricing inventory, calculating depreciation
expense, or determining prepaid expenses.
Non-sampling risk: The risk that the auditor fails to identify existing exceptions in the sample. It is caused by either the auditor fails
to recognize exception or fails to apply appropriate or effective audit testing procedures.
Non-statistical sampling: The auditor uses professional judgment to select the sample items, estimate the population attributes or
values, and estimate the sampling risk.
Note payable: A legal obligation to a creditor, which may be unsecured or secured by assets.
Observation (an audit procedure): The process of watching a process or procedure being performed by others.
Off balance sheet: Off balance sheet means an asset or debt or financing activity not on the company's balance sheet. It could involve
a lease or a separate subsidiary or a contingent liability such as a letter of credit. It also involves loan commitments, futures, forwards
and other derivatives. Financial institutions often offer asset management or brokerage services to their clients. The assets in question
(often securities) usually belong to the individual clients directly or in trust, while the company may provide management, depository
or other services to the client. The company itself has no direct claim to the assets, and usually has some basic fiduciary duties with
respect to the client. Financial institutions may report off-balance sheet items in their financial statements, and may also refer to
"assets under management," a figure that may include on and off-balance sheet items. The AICPAs accounting standard determines
that an item should appear on the company's balance sheet if it is an asset or liability formally owned by or legally responsible for;
uncertain assets or liabilities must also meet tests of being probable, measurable and meaningful. For example, a company that is
being sued for damages would not include the potential legal liability on its balance sheet until a legal judgment against it is likely and
the amount of the judgment can be estimated; if the amount at risk is small, it may not appear on the company's accounts until a
judgment is rendered.
Off-the-shelf software: Commercially available software created for a variety of users in the same industry or with the same
application.
Operating lease: An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an
aircraft, a ship etc.) being leased. An operating lease is commonly used to acquire equipment on a relatively short-term basis. Thus, for
example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease. An operating
lease is recorded as rent expense over the lease term in the income statement by the lessee. The determination of whether a lease is a
capital (finance) lease or an operating lease is defined in the United States by Statement of Financial Accounting Standards SFAS No.
13.
Operational audit: A review of any part of a clients operating procedures and methods for the purpose of evaluating efficiency and
effectiveness. The terms management audit, performance audit, operational audit, and efficiency and effectiveness audit are often
643
644
Appendix F
Key Terms
synonymous terms.
Opinion paragraph: The paragraph of an auditors report that communicated the degree of responsibility that the auditors are taking
for the financial statements.
Options: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock,
commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the
amount is usually 100 shares. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is
exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case
of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the
price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase
the option is lost. For the buyer, the upside is unlimited. Options, like stocks, are therefore said to have an asymmetrical payoff
pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security
underlying the option. Options are most frequently as either leverage or protection. As leverage, options allow the holder to control
equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is
exercised. As protection, options can guard against price fluctuations in the near term because they provide the right acquire the
underlying stock at a fixed price for a limited time.
Ordinary negligence: Violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under
similar circumstances.
Other comprehensive basis of accounting: Financial statements prepared under regulatory, tax, cash basis, or other definitive criteria
having substantial support.
Parallel simulation: An audit testing approach that involves the auditors use of audit software, either purchased or programmed by
the auditor, to replicate some pare of a clients application softwares.
Payroll master file: A computer file for recording each payroll transaction for each employee and maintaining total employee wages
paid and related data for the year to date.
Peer review: The review by CPAs of a CPA firms compliance with its quality control system.
Periodic inventory system: A system of accounting (usually a manual system) for inventories that does not require a day-to-day
record of inventory changes. Costs of materials used and costs of goods sold cannot be calculated until ending inventories, determined
by physical count, are subtracted from the sum of opening inventories and purchases (or costs of goods manufactured in the case of a
manufacturer). The ending inventories are determined solely by means of a physical inventory count at the end of the accounting
period.
Permanent files: Auditors files that contain data of a historical or continuing nature pertinent to the current audit such as copies of
articles of incorporation, bylaws, bond indentures, and contracts.
Perpetual inventory system: A system of accounting (usually a computer system) for inventories in which a perpetual inventory
master file is used to continuously update computerized record of inventory items purchase, used, sold, and on hand for merchandise,
raw materials, and finished goods. The accuracy of the ending inventories is determined periodically by physical count of inventories.
Perpetual inventory master file: A continuously updated computerized record of inventory items purchased, used, sold, and on hand
for merchandise, raw materials, and finished goods.
Persuasiveness of evidence: The degree to which the auditor is convinced that the evidence supports the audit opinion; the two
determinants of persuasiveness are the appropriateness and sufficiency of the evidence.
Phases of the audit process: The five aspects of a complete audit: (1) audit plan, (2) tests of controls (TOC), (3) tests of balances
(TOB), (4) Completing the audit (CTA), and (5) audit report.
Physical evidence: Evidence derived by the auditors from physical examination.
Plaintiff: The party claiming damages and bringing suit against the defendant.
Pledging (of receivables): To assign to a bank, factor, finance company, or other lender an exclusive claim against accounts
receivable as security (collateral) for a debt.
Positive confirmation: A request addressed to the debtor/creditor, requesting that the recipient indicate that the recipient indicates
directly on the request whether the stated account balance is correct or incorrect and, if incorrect, by what amount.
Precedent: A legal principle that evolves from a common law court decision and then serves as a standard for future decisions in
similar cases.
Predecessor auditors: A CPA firm that formerly served as auditor but has resigned from the engagement or has been notified that its
services have been terminated.
Preferred stock (Preference share): Capital stock which provides a specific dividend that is paid before any dividends are paid to
common stock holders, and which takes precedence over common stock in the event of a bankruptcy or liquidation. Like common
stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting
rights of common stockholders. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although
the company does not have to pay this dividend if it lacks the financial ability to do so. In general, there are four different types of
preferred stock: cumulative preferred, non-cumulative, participating, and convertible.
Preliminary judgment about materiality (PJAM): The maximum amount by which the auditor believes that the financial
statements, taken as whole, could be misstated and still not affect the decision of reasonable users of the financial statements.
Presentation and disclosure assertion: Implicit or explicit assertion made by the management that all components of the financial
statements are properly classified, described, and disclosed in conformity with GAAP. For example, management asserts that amounts
presented as extraordinary items in the income statement are properly classified and described.
Presentation-related information assertions/objectives: Assertions (objectives) about presentation and disclosure.
Primarily (third-party) beneficiary: A person who was not a party to a contract but is named in the contract as one to whom the
contracting parties intended that primary benefits be given.
Principal auditor: Auditor who uses the work and reports of other independent auditors who have audited the financial statements of
one or more subsidiaries, branches, or other segments of the principal auditors client. Ordinarily, the principal auditor audits at the
clients headquarter.
Principles (in CPC): The part of the AICPA Code of Professional Conduct that expresses that professions responsibilities to the
Key Terms
public, clients, and colleagues and provides a framework for the Rules of Conduct.
Private (privately held) company (non-issuer): A company whose shares are not traded on the open market as opposite to a public
(publicly traded) company.
Private Securities Litigation Reform Act of 1995: A federal law passed in 1995 that significantly reduced potential damages in
securities-related litigation.
Privileged information: Client information that the professional cannot be legally required to provide; information that an auditor
obtains from a client is confidential but not privileged.
Privity: A relation between parties that is held to be sufficiently close and direct to support a legal claim on behalf of or against
another person with whom this relation exists.
Privity of contract: Privity of contract is the relationship that exists between two or more parties to an agreement.
Process cost system: System of cost accounting in which costs are accumulated for a process, with unit costs for each process
assigned to the products passing through the process.
Professional Ethics Executive Committee (PEEC): The Professional Ethics Executive Committee (PEEC) enforces the Code of
Professional Conduct (CPC) and interprets Rules of Conduct.
Professional judgment: The application of relevant training, knowledge, and experience in making informed decisions about
appropriate course of action during an audit engagement.
Professional skepticism: an attitude of the auditor that includes a questioning mind and a critical assessment of audit evidence.
Program audit: A government audit to determine the extent to which the desired results or benefits established by the legislature or
other authorizing body are being achieved; the effectiveness of organizations, programs, activities, or functions; and whether the entity
has complied with laws and regulations applicable to the program.
Projected misstatement: An estimate of the most likely amount of monetary misstatement in a population.
Projections (in prospective financial statements): Prospective financial statements that present an entitys expected financial
positions, results of operations, and cash flows for future periods, to the best of the responsible partys knowledge and belief, and
given one or more underlying and hypothetical assumptions.
Proof of cash: A four-column audit schedule prepared by the auditor to reconcile the banks record of the audit clients beginning
balance, cash deposits, cleared checks, and ending balance for the period with the audit clients records.
Proof of cash receipts: An audit procedure to test whether all recorded cash receipts have been deposited in the bank account by
reconciling the total cash receipts recorded in the cash receipts journal for a given period with the actual deposits made to the bank.
Proportionate liability: A method of allocating damages to each group that is liable according to that groups pro rata share of any
damages recovered by the plaintiff.
Prospective financial statements: Financial statements that deal with expected future data rather than with historical data. Ordinarily,
it consists of either financial forecasts or projections.
Prospectus: The first part of a registration statement filed with the SEC, issued as part of a public offering of debt or equity and used
to solicit prospective investors in a new security issue containing, among other items, audited financial statements. The Securities Act
of 1933 imposes liability for misstatements in a prospectus.
Proximate cause: Damage to another is directly attributable to a wrongdoers act. The issue of proximate cause may be raised as a
defense by a CPA. For example, A CPA might have been negligent in rendering services, but s/he will not be liable for the plaintiffs
loss if his/her negligence was not the proximate cause of the loss.
Prudent person concept: The legal concept that a person has a duty to exercise reasonable care and diligence in the performance of
obligations to another person.
Public (publicly traded) company (Issuer): A company that is permitted to offer its registered securities (stock, bonds, etc.) for sale
to the general public, typically through a stock exchange, or occasionally a company whose stock is traded over the counter (OTC) via
market makers.
Public Company Accounting Oversight Board (PCAOB): Board created by the Sarbanes-Oxley Act to oversee auditors of public
companies, including establishing auditing and quality control standards and performing inspections of registered accounting firms.
PCAOB standards: Standards regarding the conduct of financial statements for public companies. Currently consist primarily of
standards and statements established by the AS, as these statements and standards were adopted by the PCAOB in 2003 on an interim
basis, though the PCAOB has added some significant standards.
Purchase order: A document prepared by the purchasing department indicating the description, quantity, and related information for
goods and services that the company intends to purchase.
Purchase requisition (in expenditure cycle): Request by an authorized employee to the purchasing department to place an order for
inventory and other items used by an entity. It may be documented on paper or in a computer system.
Qualified opinion (report): A report issued when the auditor believes that the overall financial statements are fairly stated but that
either the scope of the audit was limited or the financial data indicated a failure to follow GAAP.
Quality control: Methods and procedures used by a CPA firm to ensure that the firm meets its professional responsibilities to clients
and others.
Quality control standards: AICPA standards for establishing quality control policies and procedures that provide reasonable
assurance that all of a CPA firms engagements are conducted in accordance with applicable professional standards.
Quality Control Standards Committee: The Quality Control Standards Committee monitors a peer (or quality) review program
among the CPA firms. Every three years, members of the CPA Firms Division must subject their practice to a Peer (or Quality)
Review Program.
Questioned costs: Those costs paid with federal assistance that appears to be in violation of a law or regulation inadequately
documented, unnecessary, or unreasonable in amount.
Random number table: A listing of independent random digits conveniently arranged in tabular form to facilitate the selection of
random numbers with multiple digits.
Ratio estimation: A sampling plan that uses the ratio of audited (correct) values to book values of items in the sample to calculate the
estimated total audited value of the population. Ratio estimation is used in lieu of difference estimation when the differences are nearly
proportional to book values.
645
646
Appendix F
Key Terms
Reasonable assurance: The concept that an audit performed in accordance with auditing standards may fail to detect a material
misstatement in a clients financial statements.
Reasonable possibility (in ICFR): A reasonable possibility exists when the likelihood of a control deficiency is either reasonable
possible or probable as those terms are used in Financial Accounting Standards Board Statement No.5, Accounting for
Contingencies (FASB No.5).
Re-calculation (re-computation): An audit procedure that determines the mathematical accuracy of documents or records.
Receiving report: A document prepared by the receiving department at the time tangible goods are received, indicating the
description of the goods, the quantity received, the date received, and other relevant data; it is part of the documentation necessary for
payment to be made.
Recipient (in government audit): An organization receiving federal assistance directly from the federal agency administering the
program.
Reclassification journal entry (RJE): A working paper entry drafted by the auditors to assure fair presentation of the clients
financial statements, such as an entry to transfer accounts receivable credit balances to the current liabilities section of the clients
balance sheet. Since reclassification entries do not correct misstatements in the client companys accounting records, they are not
posted to the clients ledger accounts.
Referral fee (in ethics): Fees received or paid for referring business or service to an attestation client, which is allowed by the Code
of Professional Conduct, but the auditor must disclose such acceptance or payment to the client.
Registered public accounting firm: A public accounting firm registered with the PCAOB in accordance with the Sarbanes-Oxley
Act of 2002. Any CPA firm auditing SEC reporting companies must be registered.
Registration statement: A document including audited financial statements that must be filed with the SEC by any company in order
to sell its securities to the public through the mails or interstate commerce. The Securities Act of 1933 provides liability to security
purchasers for material misrepresentations in registration statements.
Related party: Affiliate company, principal owner of the client company, or any other party with which the client deals, where one of
the parties can influence the management or operating policies of the other.
Related party transaction: A transaction in which one party has the ability to influence significantly the management or operating
policies of the other party, to the extent that one of the transacting parties might be prevented from pursuing fully its own separate
interests.
Relevant assertions: Assertions that have a meaningful bearing on whether an account balance, class of transaction, or disclosure is
fairly stated. For example, valuation may not be relevant to the cash account unless currency translation is involved; however,
existence and completeness are always relevant.
Relevant assertions (in ICFR): A financial statement assertion that has a reasonable possibility of containing a misstatement or
misstatements that would cause the financial statements to be materially misstated.
Relevance of evidence: Whether evidence relates to assertions being tested.
Reliability of evidence: The diagnosticity of evidence; that is, whether the type of evidence can be relied on to signal the true state of
the assertion being tested.
Re-performance (an audit procedure): The auditors independent execution of procedures or controls that were originally
performed as part of the clients internal control, either manually or through the use of computer-assisted audit techniques.
Report on internal control over financial reporting (prepared by auditors): Report that expresses an opinion on the effectiveness
of the entitys internal control over financial reporting.
Report on internal control over financial reporting (prepared by management): Report that describes the process through which
management assesses its internal control over financial reporting and that provides managements conclusion with respect to the
effectiveness of its internal control over financial reporting.
Reporting standards: One of three categories of the GAAS that deals with the nature of the audits report and required
communication.
Reporting unit (for goodwill impairment): A reporting unit is an operating unit that (1) provides separate accounting; (2) is
managed as a separate segment; or (3) could be easily separated from the company, such as by a sale of the segment.
Representative sample: A sample with characteristics the same as those of the population.
Review: An attestation engagement that results in a negative assurance as to the CPAs awareness of any information indicating that
the assertions are not presented in conformity with the applicable criteria.
Review of financial statements (SSARS review): A review of unaudited financial statements designed to provide limited assurance
that no material modifications need be made to the statements in order for them to be in conformity with generally accepted
accounting principles or, if applicable, with another comprehensive basis of accounting.
Review of interim financial statements: Reviews of interim, unaudited financial information performed to help public companies
meet their reporting responsibilities to regulatory agencies.
Review of subsequent events: The audit procedures performed by auditors to identify and evaluate subsequent events.
Revised judgment about materiality (RJAM): A change in the auditors preliminary judgment about materiality made when the
auditor determines that the preliminary judgment about materiality was too large or too small.
Rights and obligations assertion: Implicit or explicit assertion made by the management that assets stated in the financial statements
are actually owned by the client and liabilities stated in the financial statements are actually owed by the client. For example,
management asserts that inventories are owned by the company and that accounts payable are owed to other parties.
Risk analysis approach (in auditing): An audit approach that begins with an assessment of the types and likelihood of misstatements
in account balances and then adjusts the amount and type of audit work to the likelihood of material misstatements occurring in
account balances.
Risk assessment: Managements identification and analysis of risks relevant to the preparation of financial statements in accordance
with generally accepted accounting principles.
Rollover method (approach): A method (approach) that quantifies the total likely material misstatements as of the current year-end
based on the effects of reflecting misstatements (including projecting material misstatements where appropriate) only during the
current year. For example, if expenses were materially misstated by $20,000 in the previous year, and $30,000 during the current year,
the rollover method would quantify the misstatement as $30,000, ignoring the previous years misstatement. Also see and compare
Key Terms
with iron curtain method (approach).

Routine transaction: A transaction for a recurring financial activity recorded in the accounting records in the normal course of
business, such as sales, purchases, cash receipts, cash disbursements, and payroll.
Rules of conduct: Detailed guidance to assist the CPA in applying the broad principles contained in the Code of Professional Conduct
(CPC); the rules have evolved over time as members of the profession have encountered specific ethical dilemmas in complying with
the principles of the CPC.
Safeguarding of assets (a control activity): Those policies and procedures that provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the audit clients assets that could have a material effect on the
Sample exception rate (SER): Number of exceptions in the sample divided by the sample size.
Sampling risk: The risk of reaching an incorrect conclusion inherent in tests of less than the entire population because the sample is
not representative of the population. Sampling risk may be reduced by using an increased sample size or a more appropriate method
of selecting sample items from the population.
Sampling unit: The individual member of the population being sampled.
Sarbanes-Oxley Act of 2002: A federal securities law passed in 2002 that provides for additional regulation of public companies and
their auditors; the Act established the Public Company Accounting Oversight Board (PCAOB) and requires auditors to attest to
management reports on the effectiveness of internal control over financial reporting (ICFR). See Section 404.
Scaling the audit: In an integrated audit of ICFR, the auditor takes into consideration the size and complexity of the client, its
business processes, and business units that affect the way in which the client achieves effective internal control objectives.
Scanning: Reviewing accounting data to identify significant or unusual items; including the identification of anomalous individual
items within account balances or other client data through the scanning or analysis of entries in transaction listings, subsidiary ledgers,
general ledger control accounts , adjusting entries, suspense accounts, reconciliations, and other detailed reports.
Scienter: Intent to deceive, manipulate, or defraud. The U.S. Supreme Court held in the Ernst & Ernst v Hochfelder case that scienter
must be proved for the auditors to be held liable under the Securities Exchange Act of 1934.
Scope limitation: A restriction that prevents the auditor from being able to apply all of the audit procedures that s/he considers
necessary under the circumstances. Scope limitations may be client imposed or may be imposed by other circumstances.
Scope paragraph: The paragraph of an auditors report in which the auditor describes the characteristics of the audit tests.
Second Restatement of the Law of Torts: A summary of tort liability, which when applied to auditor common law liability, expands
audits liability for ordinary negligence to include third parties of a limited class of known or intended users of the audited financial
statements.
Section 404 (of Sarbanes-Oxley Act of 2002): The primary section of the Sarbanes-Oxley Act dealing with management and auditor
reporting on internal control over financial reporting. Section 404(a) requires that each annual report filed with the SEC includes an
internal control report prepared by management in which management acknowledges its responsibility for establishing and
maintaining adequate internal control and an assessment of internal control effectiveness as of the end of the most recent fiscal year.
Section 404(b) requires that the auditor attest to and report internal control.
Securities Act of 1933: A federal statute dealing with companies that register and sell securities to the public; under the statute, third
parties who are original purchasers of securities may recover damages from the auditor if the financial statements are misstated, unless
the auditor proves that the audit was performed with due diligent or that the third partys loss was caused by factors other than
misleading financial statements.
Securities Exchange Act of 1934: A federal statute dealing with companies that trade securities on national and over-the counter
exchanges; auditors are involved because the annual reporting requirements include audited financial statements. The act requires
auditors to act in good faith and creates civil and criminal penalties for misrepresentation.
Securities and Exchange Commission (SEC): A federal agency that oversees the orderly conduct of the securities markets; the SEC
assists in providing investors in public corporations with reliable information upon which to make investment decisions.
Separation (segregation) of duties: Separation of the following activities in an organization: (1) custody of assets from accounting,
(2) authorization from custody of assets, (3) operational responsibility from record keeping, and (4) IT duties from outside users of IT.
Sequential (stop-or-go) sampling: An audit sampling technique in which the sample is selected in stages, with the need for each
subsequent stage being conditional on the results of the previous stage.
Service organization: An organization or segment of it that provides services to user entities that are likely to be relevant to user
entities internal control as it related to financial reporting.
Shared opinion report (report involving other auditors): An auditors report in which the principal auditor decides to share
responsibility with other auditors who have audited some parts (subsidiaries, branches, or segments) of the same audit client. The
sharing of responsibility is done by making reference to the other auditors work.
Shareholders capital stock master file: A record of the issuance and repurchase of capital stock for the life of a corporation. See
also Capital stock certificate record.
Short selling (Short sales): Short selling or "shorting" is the practice of selling a financial instrument that the seller does not own at
the time of the sale. Short selling is done with the intent of later purchasing the financial instrument at a lower price. Short-sellers
attempt to profit from an expected decline in the price of a financial instrument. Short selling or "going short" is contrasted with the
more conventional practice of "going long", which typically occurs when a financial instrument is purchased with the expectation that
its price will rise. Thus, being "long" is just a way of saying that one owns a positive number of the securities; being "short" is just a
way of saying that one owns a negative number of the securities. Typically, the short-seller will "borrow" or "rent" the securities to be
sold, and later repurchase identical securities for return to the lender. If the security price falls, the short-seller profits from having sold
the borrowed securities for more than he later pays for them. However, if the security price rises, the short seller loses by having sold
them for less than the price at which he later has to buy them. The practice is risky in that prices may rise without bound, even beyond
the net worth of the short seller. The act of repurchasing a shorted security is known as "closing" or "covering" a position.
Significant account or disclosure (in ICFR): An account or disclosure is significant if there is a reasonable possibility that it could
contain misstatements that individually, or when aggregated with others, could have a material effect on the financial statements.
Significant deficiency (in internal control): A control deficiency, or a combination of control deficiencies, in internal control over
647
648
Appendix F
Key Terms
financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for
oversight of the companys financial reporting.
Single Audit Act: Federal legislation that provides for a single coordinated audit to satisfy the audit requirements of all federal
funding agencies.
Sinking fund: A fund into which a company sets aside money over time, in order to retire its preferred stock, bonds or debentures. In
the case of bonds, incremental payments into the sinking fund can soften the financial impact at maturity. Investors prefer bonds and
debentures backed by sinking funds because there is less risk of a default.
Specialist (expert): A person or firm possessing special skill or knowledge in a field other than accounting or auditing, such as an
actuary. The auditor engages a specialist to provide evidential matter. For example, a valuation specialist may be engaged by the
auditor to determine the fair values of intangible assets.
S-1 review: Procedures carried out by auditors at the clients facilities on or as close as practicable to the effective date of a
registration statement filed under the Securities Act of 1933.
Standard bank confirmation: A standard bank confirmation form sent to all banks with which the client had business during the year
to obtain information about the year-end bank balance and additional information about loan outstanding.
Standard bank confirmation form: A form approved by the AICPA and American Bankers Association through which the bank
responds to the auditor about bank balance and loan information provided on the confirmation.
Standard costs: Costs assigned to products based on expected costs, which may differ from actual costs.
Standard cost records: Records that indicate variances between projected material, labor, and overhead costs and the actual costs.
Standard audit report: The standard wording of an unqualified auditors report, not including such modifications as emphasis of a
matter, substantial doubt about going-concern, lack of consistency in applying GAAP, or a shared opinion audit report.
Standard unqualified opinion (report) (unqualified opinion): A report issued when the auditor believes that the overall financial
statements are fairly stated in accordance with GAAP and that all auditing conditions have been met and no material misstatements
have been discovered or left uncorrected.
State Board of Accountancy: Each state has a State Board of Accountancy. A State Board of Accountancy usually consists of five to
seven CPAs and at least one public member, who are generally appointed by the governor of each state. The State Board of
Accountancy works independently of the AICPA and the State Society (or Association) of CPAs. It issues, renews, suspends or
revokes a CPA's licenses to practice.
Statements on Auditing Standards (AUs): Pronouncements issued by the AICPA to interpret generally accepted auditing standards.
Statements on Standards for Accounting and Review Services (SSARS): Standards issued by the AICPA Accounting and Review
Services Committee that govern the CPAs association with unaudited financial statements of nonpublic companies.
Statements on Standards for Attestation Engagements (SSAE): Statements issued by the AICPA to provide a conceptual
framework for various types of attestation services.
Statistical sampling: The auditor uses the laws of probability to calculate formal statistical results and quantify sampling risk.
Statutory law: Written law created by state or federal legislative bodies, such as the Sarbanes-Oxley Act of 2002.
Stock certificate book: A book of serially numbered certificates with attached stubs. Each stub shows the corresponding certificate
number and provides space for entering the number of shares represented by the certificate, the name of the shareholder, and the serial
number of the certificate surrendered in exchange for the new one. Surrendered certificates are canceled and replaced in the certificate
book.
Stock option: An option in which the underlier is the common stock of a corporation, giving the holder the right to buy or sell its
stock, at a specified price, by a specific date.
Stock option re-pricing: The exchanging of newly issued incentive stock options priced at the current market price for previously
granted options that are out-of-the-money (or under water). Re-pricing rewards managers of companies with stock prices that have
declined.
Stock registrar: An independent institution charged with responsibility for avoiding over-issuance of a corporations stock. Every
new certificate must be presented to the registrar for examination and registration before it is issued to a stockholder.
Stock transfer agent: Outside agent engaged by a corporation to maintain the stockholder records and to disburse cash dividends.
Stratification: Dividing a population into two or more relatively homogeneous subgroups (strata). Stratification increases the
efficiency of most sampling plans by reducing the variability of items in each stratum. The sample size necessary to evaluate the strata
separately is smaller than would be needed to evaluate the total population.
Subrecipient (in government audit): An organization receiving federal financial assistance passed through from a recipient.
Subsequent discovery of facts: Auditor discovery that the financial statements are materially misstated after the audit report issue
date.
Subsequent events: Transactions and other pertinent events that occurred after the balance sheet date that affect the fair presentation
of disclosure of the financial statements being audited.
Subsequent period: The time extending from the balance sheet date to the date of the auditors report date and the auditors report
issue date.
Substantive tests: Procedures performed by the auditor to detect material monetary misstatements in account balances and
disclosures.
Substantive tests of transactions: Procedures performed by the auditor to detect material monetary misstatements in classes of
transactions and disclosures.
Successor auditors: The auditors who have accepted an engagement or who have been invited to make a proposal for an engagement
to replace the CPA firm that formerly served as auditor.
Sufficient audit evidence: Sufficient audit evidence is a measure of the quantity of the evidence required.
Systematic sample selection: A probabilistic method of sample selection in which the auditor calculates a sample interval (the
population size divided by the sample size) and selects the items for the sample based on the size of the interval and a randomly
selected starting point between zero and the length of the interval.
SysTrust: An attestation service designed to provide reasonable assurance that a companys computer system complies with Trust
Services principles and criteria.
Key Terms
Tagging and tracing: A technique for testing programmed control activities in which selected transactions are tagged when they are
entered for processing. A computer program provides a printout of the steps in processing the tagged transactions that may be
reviewed by the auditors.
Test data: A method of auditing an information technology system that uses the auditors test data to determine whether the clients
computer program correctly processes valid and invalid transactions.
Tests of (details of) balances (TOB) (substantive tests): Procedures performed by the auditor to detect material monetary
misstatements in account balances, classes of transactions and disclosures. It is also known as substantive tests of transactions.
Tests of controls (TOC): Procedures performed by the auditor to detect the effectiveness of internal controls in support of an assessed
control risk.
Third-party beneficiary: A person, not the auditors or their client, who is named in a contract (or known to the contracting parties)
with the intention that such person should have definite rights and benefits under the contract.
Those charged with governance: The person(s) with responsibility for overseeing the strategic direction of the entity and its
obligations related to the accountability of the entity, including overseeing the financial reporting and disclosure process.
Threats (to independence): Circumstances that could impair independence. The AICPA categorizes seven types of threats- selfreview, advocacy, adverse interest, familiarity, undue influence, financial self-interest, and management participation.
Tick mark: A symbol used in working papers by the auditor to indicate a specific step in the audit work performed. Whenever tick
mars are used, they should be accompanied by a legend explaining their meaning.
Time budget: An estimate of the time required to perform each step in the audit.
Time card: A document indicating the time that the employee started and stopped working each day and the number of hours worked.
Timing different: A reported difference in a confirmation from a debtor that is determined to be a timing difference between the
clients and debtors/creditors records and therefore not a misstatement. For example, in-transit shipments or payments.
Tolerable exception (deviation) rate (TER): The exception rate that the auditor will tolerate (permit) in the population and still be
willing to conclude the control is operating effectively or the amount of monetary misstatements in the balances/transactions is
acceptable (also see tolerable misstatement, TM).
Tolerable misstatement (TM): The materiality allocated to any given account balance/transaction used in audit planning.
Top-down approach (in ICFR): a Top-Down approach starts at the top, the financial statements elements and entity-level controls,
and links the financial statement elements and entity-level controls to significant accounts, relevant assertions, and to the major classes
of transactions.
Tort: A civil wrong. For financial statements audits, the primary tort involved is that of performing the engagement negligently.
Tracing: An audit procedure where recorded transactions or amounts are examined to support documentations.
Transaction cycle: The sequence of procedures applied by the client in processing a particular type of recurring transaction. The term
cycle reflects the concept that the same sequence of procedures is applied to each similar transaction. Ordinarily, an audit clients
transactions are organized around six major transactions cycles from revenue cycle to general cash and investments.
Transaction cycle approach (in auditing): An audit approach that begins with an assessment of controls within each transaction
cycle of the client to determine the amount and type of audit work for TOC and TOB.
Transaction-related information assertions/objectives: Assertions (objectives) about classes of transactions and events during the
period under audit.
Treasury stock: Shares of its own stock acquired back by a corporation for the purpose of being reissued at a later date.
Trust indenture: The formal agreement between bondholders and the issuer as to the terms of the debt.
Trust Services: Engagements that provide assurance on systems. Trust Services provide assurance on one or more of the following
Trust Principles: (a) security, (b) availability, (c) processing integrity, (d) online privacy, and confidentiality.
Ultramares doctrine: A common-law approach to third-party liability, established in 1931 in the case of Ultramares Corporation V.
Touche, in which ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the
third party and the auditor, unless the third party is a primary beneficiary.
Unasserted claim: A potential legal claim against an audit client where the condition for a claim exists but no claim has been filed.
Understanding specific audit objective: the specific audit objective of verifying that financial and other information in disclosures
are expressed clearly.
Unqualified opinion (report) (standard unqualified opinion): A report issued when the auditor believes that the overall financial
statements are fairly stated in accordance with GAAP and that all auditing conditions have been met and no material misstatements
have been discovered or left uncorrected.
Unqualified opinion (report) with explanatory paragraph or modified wording: A report issued when the auditor believes that the
overall financial statements are fairly stated in accordance with GAAP and that all auditing conditions have been met and no material
misstatements have been discovered or left uncorrected, but the auditor believes it is important, or is required, to provide additional
information.
Valuation and allocation assertion: Implicit or explicit assertion made by the management that asset and liability balances stated in
the balance sheet, and revenue and expenses transactions stated in the income statement have all been recorded in the financial
statement at the appropriate amount. For example, management asserts that inventories are valued at the lower of cost or market and
that depreciation is made to plant and equipment in the appropriate amount.
Value-added network (VAN): The intermediary that serves as an electronic mail service for electronic data interchange transactions.
Variable sampling: An audit sampling technique designed to estimate a numerical measurement of a population, such as a dollar
value.
Vouching: An audit procedure where documentations are examined to support recorded transactions or amounts.
Vendors invoice: A document that specifies the details of an acquisition transaction and amount of money owed to the vendor for an
acquisition.
Vendors statement: A statement prepared monthly by the vendor, which indicates the customers beginning balance, acquisitions,
payments, and ending balance.
Vertical analysis: A form of analysis that presents financial statement amounts for a period as a percentage of some financial
statement bases. This analysis involves the preparation of common-size financial statements.
649
650
Appendix F
Key Terms
X
Y
Z
Voucher: A document used to establish a formal means of recording and controlling acquisitions, primarily by enabling each
acquisition transaction to be sequentially numbered. It is usually in the form of a voucher packet.
Voucher packet: A cover sheet or folder that contains the purchase order, copy of the packing slip, receiving report, and vendor
invoice. After payment, a copy of the check is added to the voucher packet.
Voucher register: A recording system that is used instead of a purchase journal. It records all vendor invoices for goods and services
purchases originating from a voucher (or voucher packet). The debit entries are the cost distribution of the purchases, and the credits
are vouchers payable (or accounts payable subsidiary ledger). When a voucher register is used instead of a purchases journal, the total
of unpaid vendor invoices in the voucher register is the total accounts payable.
Walk-through test: An audit testing procedure that involves the tracing of a selected few transactions through the accounting system
to determine that controls are in place, and to assist in assessing control risk (CR).
Walk-through (in ICFR): The auditor traces a transaction from origination through the clients processes and information system
until it is reflected in the clients financial reports to understand likely sources of misstatements, and to assist in selecting controls to
test (TOC).
WebTrust: An attestation service designed to provide reasonable assurance that a companys Web site complies with Trust Services
principles and criteria for business-to-consumer electronic commerce.
Wide area networks (WANs): Networks that connect computer equipment, databases, software, and peripheral equipment that reside
in many geographic locations, such as client offices located around the country.
Working papers: Papers that document the evidence gathered by auditors to show the work they have done, the methods and
procedures they have followed, and the conclusions they have developed in an audit of financial statements or other type of
engagement.
Work order (of plant assets): A serially numbered accounting document authorizing the acquisition of plant assets. A second series
of work orders may be used to authorize the retirement or disposal of plant assets, and a third series of work order may be used to
authorize repair or maintenance of plan assets.
Working trial balance: A listing of the general ledger accounts and their year-end balances. It also provides columns for the auditors
adjustments and reclassifications and for the final amounts that will appear in the financial statements.
Written representations: Written assertions provided by management to auditors on matters such as the fairness of the entitys
financial statements, availability of all financial records and related data, internal control over financial reporting, and other specific
representations about the financial statements,
XBRL (eXtensible Business Reporting Language): AN international information format designed specifically for business
information. It assigns all individual disclose items within business reports unique electronically readable tags that are mapped to
taxonomies.
651
0101762846
2013 SharedBook Inc.; Content distributed through

AcademicPub AcademicPub licensors or as otherwise indicated
on the AcademicPub site. SharedBook and AcademicPub are
trademarks of SharedBook Ltd. in the US and internationally. All
rights reserved by their respective parties. Patents granted and
pending for the SharedBook technology. For educational use only.
NOT FOR RESALE. LIABILITY LIMITED TO COST OF PRODUCT.
0 848032 091906

ACCT 506 - Financial and Integrated Audits

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ACCT 506 - Financial and Integrated Audits

Uploaded by

Copyright:

Available Formats

Frederick Choo

Financial and Integrated

2 The Auditor's Professional Environment

3 The Auditor's Ethical Environment

4 The Auditor's Legal Environment

5 Audit Plan - Preplan and Documentation

6 Audit Plan - Objectives

7 Audit Plan - Evidence

8 Audit Plan - Internal Control

9 Audit Plan - Materiality and Risk

10 Audit Plan - Program and Technology

11 Audit Sampling for Tests of Controls

12 Audit Sampling for Tests of Balances

13 Revenue Cycle - TOC and TOB

14 Expenditure Cycle - TOC and TOB

15 Inventory Cycle - TOC and TOB

16 Payroll Cycle - TOC and TOB

17 Capital Cycle - TOC and TOB

18 General Cash and Investments - TOC and TOB

19 Completing the Audit

21 Other Audit Engagements

Financial and Integrated Audits - Frederick Choo

1 Financial and Integrated Audits

Chapter 1 Financial and Integrated Audits

The Demand for Auditing

Financial and Integrated Audits - Frederick Choo

Types of Audit Opinion Report

Figure 1-1 The Demand for Auditing in a Principal-Agent Framework

The Demand of Other Users

Use of Audited Financial Statements

1 Financial and Integrated Audits

Use of Audited Financial Statements

Determine whether to make a loan to a company.

Four Broad Types of Attestation services

Financial and Integrated Audits - Frederick Choo

Four Broad Types of Attestation services

Figure 1-3 An Overview of the Financial Audit (Private Company)

Implements internal controls

Prepares financial statements

Issues financial statements

Issues audit report:

1 Financial and Integrated Audits

Figure 1-4 An Overview of the Integrated Audit (Public Company)

Management Report on ICFR contains

Issues audit report:

Prepares financial statements

Issues audit report:

Issues financial statements

ICFR = Internal Control Over Financial Reporting

Information Systems Reliability

Financial and Integrated Audits - Frederick Choo

systems, and to provide comparative analyses on costs and delivery systems.

Management Consulting Services

Source: Adapted from the Elliott Committee Report (AICPA, 1997)

1 Financial and Integrated Audits

Table 1-8 Types of Auditor

AICPA, CPA Associations

IRA, Internal Auditor, DCA

IRS, IIA, DCA Agency

= Internal Revenue Agent

The function of the various types of auditor is shown in Table 1-9.

IRA, Internal Auditor,

Federal and State