Professional Documents
Culture Documents
16-1. a. The production cycle relates to the conversion of raw materials into finished goods,
and includes production planning and control of the types and quantities of goods to
be manufactured, the inventory levels to be maintained, and the transactions and
events pertaining to the manufacturing process.
c. The production cycle interfaces with (1) the expenditure cycle through the purchase
of raw materials and incurrence of various overhead costs, (2) the personnel services
cycle through the incurrence of factory labor costs, and (3) the revenue cycle through the
sale of finished goods.
16-2. a. The transaction class audit objectives for the production cycle are:
Occurrence. Recorded manufacturing transactions represent material, labor, and
overhead transferred to production and the movement to completed production to
finished goods during the current period (EO1). Recorded cost of sales represent the sale
of inventory during the year (EO2).
Completeness. All manufacturing transactions (C1) and cost of sales (C2) that occurred
during the period were recorded.
Accuracy. Manufacturing transactions (VA1) and cost of sales (VA2) are accurately
valued using GAAP and correctly journalized, summarized and posted.
Cutoff. All manufacturing transactions (EO1 and C1) and cost of sales (EO2 and C2)
have been recorded in the correct accounting period.
Classification. All manufacturing transactions (PD1) and cost of sales (PD2) have been
recorded in the proper accounts.
b. Several account balance audit objectives for the production cycle are:
Existence. Inventories included in the balance sheet physically exist (EO3).
Completeness. Inventories include all materials, products and supplies on hand at the
balance sheet date (C3).
Rights and Obligations. The reporting entity has legal title to recorded inventories at
the balance sheet date (RO1).
Valuation and Allocation. Inventories costing assumptions have been properly applied
(VA3) and inventories are properly stated at the lower of cost or market (VA4).
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16-3. a. In a manufacturing company, inventories and cost of goods sold are usually
significant to the company's financial position and results of operations. Further, due
to the cost of observing inventory the auditor will normally allocate a significant
amount of overall materiality o the audit of inventory, without exceeding an amount
that the auditor believes will affect the analysis of a financial statement user.
b. Several factors that affect inherent risk for assertions related to the production cycle
are:
The volume of purchases, manufacturing, and sales transactions that affects these
accounts is generally high, increasing the opportunities for misstatements to
occur.
There are often contentious issues surrounding the identification, measurement,
and allocation of inventoriable costs such as indirect materials, labor, and
manufacturing overhead, joint product costs, the disposition of cost variances,
accounting for scrap, and other cost accounting issues.
The wide diversity of inventory items sometimes requires the use of special
procedures to determine inventory quantities, such as geometric volume
measurements of stockpiles, aerial photography, and estimation of quantities by
experts.
Inventories are often stored at multiple sites, adding to the difficulties associated
with maintaining physical controls over theft and damage, and properly accounting
for goods in transit between sites.
The wide diversity of inventory items may present special problems in
determining their quality and market value.
Inventories are vulnerable to spoilage, obsolescence, and other factors such as
general economic conditions that may affect demand and salability, and thus the
proper valuation of the inventories.
Inventories may be sold subject to right of return and repurchase agreements.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-2
Ratio Formula Audit Significance
Finished Goods Finished Goods Quantities Useful in estimating the efficiency of
Produced to Direct Direct Labor Hours the manufacturing process. May be
Labor helpful in evaluating the
reasonableness of production costs.
Product Defects per Number of Product Defects as Useful in estimating the effectiveness
Million a Percent of Each Million of the manufacturing process. May
Produced be helpful in evaluating the
reasonableness of production costs
and warranty expenses.
16-4. a. Control environment factors that may impact the production cycle include:
The organizational structure should include an officer who has overall
responsibility for production, including authority over the production planning
and control department and each manufacturing department.
The assignment of authority and responsibility should include timely
accountability for the use of the entitys resources.
Management's philosophy and operating style should include its approach to
taking and monitoring business risks related to production decisions and
inventory levels.
The entity's human resource policies and practices pertaining to production
department employees can significantly impact the use of, and accountability for,
the factors of production.
16-5. The documents and records are summarized in the following table:
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16-6. Controls that are important in determining and recording manufacturing costs are:
Computer checks on the agreement of entries for the allocation of manufacturing costs to
work in process with data on materials and labor usage in daily production activity
reports.
Computer checks on the agreement of entries for the transfer of work in process to
finished goods with data in completed production reports.
16-8. a. Factors that should be considered by an auditor in specifying the acceptable level of
detection risk for assertions pertaining to merchandise inventory include the relevant
transaction class inherent and control risk assessments for the purchases and sales
transactions that affect the merchandise inventory account, as well as inherent and
control risk factors associated directly with the merchandise inventory balance.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-4
16-9. Several ratios and their formulas that may be used in applying analytical procedures to
inventory balances are:
Ratio Formula Audit Significance
Inventory Turn Days Avg. Inventory Cost of Good Prior experience in inventory turn
Sold x 365 days combined with knowledge
of cost of sales can be useful in
estimating current inventory
levels. A lengthening of the
period may indicate existence
problems.
Inventory Growth to Cost ((Inventory n Inventory n-1) 1) Ratios larger than 1.0 indicate
of Sales Growth ((Cost of Sales n Cost of that inventories are growing
Sales n-1) 1) faster than sales. Large ratios
may indicate possible inventory
obsolescence problems.
Finished Goods Finished Goods Quantities Useful in estimating the
Produced to Raw Raw Material Quantities efficiency of the manufacturing
Material Used process. May be helpful in
evaluating the reasonableness of
production costs.
Finished Goods Finished Goods Quantities Useful in estimating the
Produced to Direct Direct Labor Hours efficiency of the manufacturing
Labor process. May be helpful in
evaluating the reasonableness of
production costs.
Product Defects per Number of Product Defects as Useful in estimating the
Million a Percent of Each Million effectiveness of the
Produced manufacturing process. May be
helpful in evaluating the
reasonableness of production
costs and warranty expenses.
16-10. a. Five tests of details of balances that may be applied to inventories are:
Observe client's physical inventory count.
Test clerical accuracy of inventory listings.
Test inventory pricing.
Confirm inventories at locations outside the entity.
Examine consignment agreements and contracts.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-5
3. In evaluating the client's inventory taking plans, the auditor should determine
that the plan includes all of the following:
Names of employees responsible for supervising the inventory taking.
Date of the counts.
Locations to be counted.
Detailed instructions on how the counts are to be made.
Use and control of prenumbered inventory tags and summary
(compilation) sheets.
Provisions for handling the receipt, shipment, and movement of goods
during the counts if such activity is unavoidable.
Segregation or identification of goods not owned.
16-11. a. In testing inventory pricing for purchased inventories, the auditor should (1) vouch
costs to representative vendor invoices and (2) verify both cost and market when the
lower of cost or market method is used. In testing inventory pricing for manufactured
inventories, the auditor should review the methods used in costing the inventories for
propriety and the accuracy and consistency of application. For example, when
standard costs are used, the auditor should test the calculation of the standards,
compare the calculations with engineering specifications, determine that the
standards are current, and evaluate whether the standards approximate actual costs
by examining the variance accounts.
b. Confirmations may be used in the audit of inventories to obtain evidence about the
existence of inventories stored in public warehouses or with other outside custodians
such as consignees.
16-12. a. When the auditor is testing net realizable value the auditor needs to determine if the
client will be able to sell inventory on hand at year-end in the normal operating cycle
and not suffer a loss (break-even) in the process. The auditor is testing the clients
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-6
estimates of future outcomes the value of future sales. This is particularly
problematic with inventory that is considered obsolete.
b. When auditing the net realizable value of inventory the auditor will want to
understand managements process for estimating any allowance for obsolete
inventory. The auditor will need to understand how long it takes the client to turn its
inventory and evaluate recent history (the last several inventory turn cycles) for
evidence of the clients ability to turn its inventory and break even. The auditor will
also want to review sales prices after year-end to the extent possible.
16-13. a. The personnel services cycle involves the events and activities that pertain to
executive and employee compensation.
b. This cycle interfaces with two other cycles: (1) the paying of the payroll and payroll
taxes involves cash disbursements in the expenditure cycle; (2) the distribution of
factory labor costs to work in process pertains to the production cycle.
16-14. a. Gross earnings of personnel are generally the largest operating expense in
merchandising (after costs of goods sold) and service companies. They also are a
major component in costing work in process. Employee fraud is a major inherent risk
that the auditor should consider.
b. The auditor's usual strategy is to use a lower assessed level of control risk approach
in auditing payroll transactions because:
The audit risk is primarily in the processing of payroll transactions.
Most companies have extensive internal controls for the routine nature of payroll
transactions.
Year-end payroll liability balances are often immaterial.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-7
16-15. The audit objectives for payroll transactions and related assertions are:
Balance Objectives
Existence. Employee compensation, benefits and payroll tax liabilities represent
amounts owed at the balance sheet date (EO2).
Completeness. Employee compensation, benefits and payroll tax liabilities include all
such amounts owed at the balance sheet date (C2).
Rights and Obligations. Employee compensation, benefits and payroll tax liabilities
are obligations of the reporting entity (RO1).
Valuation and Allocation. Employee compensation, benefits and payroll tax liabilities
are accurately computed and recorded (VA2).
Disclosure Objectives
Occurrence and Rights and Obligations. Disclosed employee compensation and
benefits transactions and balance have occurred and pertain to the entity (PD3).
Completeness. All employee compensation and benefits disclosures that should have
been included in the financial statements have been included (PD4).
Understandability. All employee compensation and benefits information is
appropriately presented and information in disclosures is understandable to users (PD5).
Accuracy and Valuation. All employee compensation and benefits information is
disclosed accurately and at appropriate amounts (PD6).
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16-16. Following are several examples of analytical procedures and a description of how they
might assist the auditor when auditing the production cycle.
Compare current Current year payroll tax Reasonableness test for payroll
year payroll liability liability prior year payroll tax liability if the ratio is significantly
with prior year payroll liability adjusted for growth in different from 1.0
liability payroll volume
Compute ratio of Payroll tax expense total Reasonableness test for payroll tax
payroll tax expense payroll expense expense based on prior year ratio of
to total payroll payroll tax expense to total payroll.
expenses
Employee benefits Total benefits expenses Reasonableness test of benefits
expenses as a gross payroll expenses. This is often compared
percent of gross with industry statistics.
payroll
16-17. The control environment is as relevant to the personnel services cycle as it is to any cycle.
The elements of human resources associated with hiring practices and the care with which
controls are established over putting new employees on the payroll is essential to good
control.
Management should actively assess the risks associated with errors and fraud and design
appropriate controls to reduce these risks consider the cost-benefit tradeoff when
implementing controls.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-9
Finally, management should monitor the system of internal controls, perhaps as a
responsibility of the internal audit function. Management needs to review the results control
failures that result in errors or fraud in the personnel services function and take actions to
correct exiting problems.
16-19. a. The responsibilities of the personnel department include: (1) hiring employees, (2)
preparing personnel authorization forms for new hires, (3) authorizing payroll
changes and terminations, and (4) maintaining employee personnel files.
b. The control procedures in preparing attendance and timekeeping data include (1)
using time clocks to record hours worked, (2) supervising clock card punching, (3)
supporting time clock hours with time tickets, (4) approving time worked in writing
by a supervisor, and (5) reconciling time tickets and clock cards.
16-20. a. Tests of controls for terminated employees involve making inquiries and observing
the processes for removing personnel from the payroll. Many companies create a
report of terminated employees that is reviewed in personnel. The auditor might
substantively for subsequent payment of terminated employees using generalized
audit software and selecting a sample of termination notices and scanning subsequent
payroll registers to determine that the terminated employees did not continue to
receive pay checks.
16-21. The following table provides example controls and tests of controls for each assertion (and
transaction level audit objective) related to the personnel services cycle. Examples
emphasize programmed control procedures where appropriate. Student should note that
tests of controls should also emphasize testing computer general controls, observing
exception reports, and testing manual follow-up of items that appear on exception reports.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-10
Personnel Services
Assertion (Audit Objective) Control Test of Controls
Existence and Occurrence Only a few key employees in Observe the process for changing the
(Occurrence) personnel can add a new employee to master payroll file, review the accuracy of
the master payroll file. reports of changes to the master file, and
reperform control.
Computer reports all changes to the
personnel data master file.
Management in personnel reviews
report of all master file changes.
Completeness Batch total of hours worked prepared Use CAATs to test the control by
(Completeness) by payroll department and verified submitting data that should be rejected by
by the computer. the control.
Existence and Occurrence / Manual controls check payroll cutoff Observe the process testing payroll cutoff
Completeness (Cutoff) and accrue payroll when pay periods and accruing payroll costs, and reperform
do not coincide with month end. control.
Valuation and Allocation Computer limit test on the number of Use CAATs to test the control by
(Accuracy) hours worked and the amount of each submitting data that should be rejected by
payroll check. the control.
Presentation and Disclosure Computer compares account Use CAATs to test the control by
(Classification) classification for hours worked with submitting data that should be rejected by
account classification on time cards. the control.
Rights and Obligations N/A N/A
16-22. a. The likely acceptable level of detection risk for payroll balances is moderate or high
because moderate or low assessments of control risk are usually possible.
b. When moderate or high detection risk levels are acceptable, substantive tests may be
limited to applying analytical procedures and limited tests of details. If unexpected
fluctuations are found, more extensive tests of details will be required.
c. When auditing pension expenses, the auditor should also evaluate the reasonableness
of the key actuarial estimates such as the discount rate that is used to determine the
projected benefit obligation and the long-term rate of return assumption used for the
expected return on plan assets. The discount rate should be in line with current
annuity purchase rates for high-quality fixed income investments. The long-term
rate of return assumption should reflect the actual and anticipated returns for the
plans assets.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-11
d. With respect to accounting for stock option expense, most companies structure their
stock option plans to meet the requirements of APB No. 25, so that they may use the
intrinsic value approach and report no compensation expense associated with the use
of stock options. Stock appreciation rights, however, require the recognition of
compensation expense, regardless of whether the right is exercised during the period.
FASB No. 123 requires these companies to disclose pro forma net income and
earnings per share as if the fair value approach were used. As a result the auditor
must audit the valuation model used to determine the fair value of the stock options.
When evaluating fair presentation in the financial statements, the auditor evaluates
assumptions that include the risk-free rate, the expected life of the option, the
expected volatility of the stock price, and expected dividends.
Comprehensive Questions
a. The following table includes the calculations for part a. (Note the calculations use
ending balances rather than average balances. Also note that AP turn days is calculated by
using Accounts Payable Purchases x 365.)
b. The trends show an increase in inventory turn days, a decrease in accounts payable
turn days, and a steady gross margin. The gross operating cycle is constant due to
the improvement in accounts receivable turn days. The net operating cycle does not
show the same level of improvement as gross operating cycle due to the decrease in
payable turn days.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-12
c. If tolerable misstatement is $45,000 this translates to an expectation range of plus or
mine 9 days based on the following calculation.
$45,000 $1,859,000 *365 = 8.8 days which rounds to 9 days.
d. The increase in inventory turn days indicates that inventory may be overstated. A
further risk may be associated with unrecorded liabilities. The combination may
result in an overstatement of net income.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-13
Unaudited Audited Audited
20X4 20X3 20X2
Sales $ 12,005,336 $ 10,291,333 $ 8,892,133
a. Calcualtions
Cost of Goods Sold $ 7,148,933 $ 6,016,063 $ 5,217,093
Gross Profit Margin 40.5% 41.5% 41.3%
Inventory Turn Days 24.0 20.1 19.2
Number of Units per Ton of Raw Mat'l 1175 1260 1250
Number of Units per Direct Labor Hr. 95 102 100
Cost per ton of materials $ 525.00 $ 510.00 $ 500.00
Cost per direct labor hour $ 24.63 $ 23.47 $ 22.47
Payroll taxes and benefits as a% o
direct labor cost 34.2% 32.2% 32.2%
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-14
Increases in gross profit margin are inconsistent with this underlying information
related to the cost of production. The dramatic increase in inventory turn days, and
the cost per unit of inventory are consistent with the fact that inventory appears to be
overvalued, probably as a result of problems with the valuation of inventory (or
possibly the existence of inventory). Audit tests need to focus carefully on the cost
build-up for ending inventory, and the allocation of cost between ending inventory
and cost of sales.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-15
No indication is given of book to Book to physical inventory adjustments should
physical inventory adjustments. be made and investigated when appropriate.
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To obtain assurance that the cost system, as an integral part of the system of
internal control, provides proper accounting control over costs incurred and
related inventories.
To ascertain, as a service to management, that the cost system is economical and
effectively provides information for reducing or controlling costs and for
determining the cost and profitability of products, and other related data
necessary for informed managerial decisions.
b. The audit procedures to be applied to determine that cost standards and related
variance accounts applicable to materials are acceptable and have not distorted the
financial statements would include the following:
Review the internal control structure to estimate the amount of testing necessary.
Test check the arithmetic of the standard cost cards.
Determine that the data on the standard cost cards are reasonably current. Out-of-
date standards may result in abnormal variances.
Ascertain the accuracy of the specifications on the standard cost cards by
comparison with engineering specifications or other independent sources.
Determine that the procedure for establishing standard material yields gives
consideration to spoilage, scrap loss and
by-products of the process.
Determine that, in establishing standard material prices, consideration was given
to the following factors: normal quality, normal quantity, normal sources, and
delivery by normal carrier. The treatment in the accounts of discounts, whether
excluded or included in the standard costs, should be investigated for
consistency.
The accounting system for recording standard costs should be reviewed for
reasonableness, and test checks should be applied to determine that the system is
functioning effectively. Source documents (vendors' invoices, requisitions,
production reports, and other internally generated accounting evidence) should
be examined and related to the transactions flowing through the cost system. In
this connection reference would be made to the standard cost cards to determine
that standard cost data flowing through the accounting system are being
accurately compiled.
Review the material price variance and material usage variance accounts for
over-all reasonableness. The variance accounts should also be reviewed for
excessive variations in the month to month charges, and satisfactory explanations
should be obtained where necessary.
The impact of the variances on the financial statements should be considered. If
the variances are of amounts so substantial that placing them in the income
statement would distort current operating results and inventory valuations, then
consideration should be given to allocating them on a pro rata basis to cost of
goods sold and inventories.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-17
Inventory File Data Might Be Helpful
Observe the physical count, Determining which items are to be test counted by
making and recording test counts making a random sample of a representative
where applicable. number of items from the inventory file as of the
data of the physical count.
Test the mathematical accuracy of Mathematically computing the dollar value of each
the inventory compilation inventory item counted by multiplying the quantity
(summary). on hand by the cost per unit and verifying the
addition of the extended dollar values.
Compare the auditor's test counts Arranging test counts in a file format identical to
to the inventory records. the inventory file and matching the records
Compare physical count data to Comparing the total extended values of all items
inventory records. counted and the extended values of each inventory
item counted to the inventory
Test the pricing of the inventory Preparing a file in a format identical to the
by obtaining a list of costs per inventory file and matching the files.
item from buyers, vendors, or
other sources.
Examine purchases and sales Listing a sample of items on the inventory file for
cutoffs. which the date of last purchase and date of the last
sale are on or immediately prior to the date of the
physical count.
Ascertain the propriety of items Listing items located in public warehouses.
of inventory located in public
warehouses.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-18
Select items noted as possibly unsalable or obsolete during the physical inventory
observation and print out information about purchases and sales for further
consideration.
Recalculate the prices used to value the year-end FIFO inventory by matching prices and
quantities to the most recent purchases.
Select a sample of items for comparison to current sales prices.
Identify and print out unusual transactions. (These are transactions other than purchases
or
sales for the year, or physical inventory adjustments as of January 5, 20x2.)
Recalculate the ending inventory (or selected items) by taking the beginning balances
plus purchases, less sales, (quantities and/or amounts) and print out the differences.
Recalculate the cost of sales for selected items sold during the year.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-19
16-31. (25 Minutes)
OBJECTIVE: TO OBTAIN EVIDENCE THAT THE BOOK VALUE OF INVENTORY AT DECEMBER 31, 20X1 IS NOT
MATERIALLY MISSTATED.
POPULATION AND POPULATION IS THE DOLLAR BALANCE OF INVENTORY; LOGICAL SAMPLING UNIT = LINE ITEM ON
SAMPLING UNIT: INVENTORY LISTING.
SAMPLE SIZE: BOOK VALUE OF POPULATION 2,960,000 (BV)
RISK OF INCORRECT ACCEPTANCE 5 % RF= 3.00
TOLERABLE MISSTATEMENT 200,000 (TM)
ANTICIPATED MISSTATEMENT 50,000 (AM) RF= 1.60
SAMPLE SIZE = n = (BV * RF)/(TM - (AM * EP)) 74 (n)
SAMPLE SELECTION: SAMPLING INTERVAL = BV/n 40,000 (SI)
RANDOM START 34,189
LOGICAL SAMPLING UNITS SELECTED LISTED
ON W/P
EXECUTION OF AUDIT PROCEDURES APPLIED LISTED ON W/P
SAMPLING PLAN: BOON AND AUDIT VALUES FOR SAMPLE ITEMS WITH MISSTATEMENTS LISTED BELOW
EVALUATION OF PROJECTED MISSTATEMENT PROJECTED
SAMPLE RESULTS: BOOK AUDIT TAINTING SAMPLING MISSTATEMENT
VALUE VALUE % (TP) = INTERVAL (TP * SI) OR
(BV) (AV) ((BV - AV)/BV) (SI) (BV - AV)
1 15,700 12,500 20.00 40,000 8,000
2 56,000 50,400 NA NA 5,600
3 23,000 22,040 5.00 40,000 2,000
4
5
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16-32. (Estimate Time 25 Minutes)
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16-33. (Estimated time - 25 minutes)
a. There are three basic shortcomings in the payroll procedures currently used at the
Galena plant:
Actual payroll hours are not approved by production management.
There is inadequate segregation of duties within the payroll department.
Personnel department should not have access to payroll checks on a regular basis.
The following corrective action should be taken to improve the internal control of
payroll processing procedures:
All incoming time cards should be signed by both the employee and supervisor.
The payroll clerk who prepares the input for data processing should not do the
reconciliation but, rather, a second clerk should reconcile the payroll register to
the time cards.
An employee of supervisory level should authorize voiding of computer-
generated checks and the subsequent preparation of a manual replacement check.
Replacement checks should be processed following good internal control
procedures.
All payroll checks, including unsigned replacement checks, should then be given
to the accounting department rather than to the personnel department for storage
in a secure location until payday.
b. Each of the three basic shortcomings mentioned above could lead to material errors
and irregularities. The inadequate segregation of duties within the payroll department
clearly is a material weakness. The payroll clerk is in a position to submit fictitious
input data and to conceal the irregularities by 'fudging" the reconciliations of the
payroll register.
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a. Misstatements b. Recommended Improvements
A supply of blank time The supply of blank time cards should be removed. At the
cards is kept near the beginning of each week the payroll department should
entrance. provide each worker with a time card stamped with the
worker's name.
Time worked is penciled A time clock should be installed and the workers required to
on the time card by each punch in and out. A responsible employee should be
worker. stationed at the time clock to determine that workers are not
punching the time cards of other workers who may be late or
absent, or who may have left work early.
Time cards are dropped The foreman should collect the time cards at the end of the
in a box at the end of the week, approve them, and turn them over to the payroll clerk.
week. All time cards should be accounted for and any missing
cards investigated.
Payroll clerks divide the The payroll clerks' work should be arranged so that they
cards alphabetically and check each other. Under the existing system of computing
have full responsibility the payroll, the clerk who does not do the original computing
for each section. should check the original work of the other clerk. As an
alternative, one clerk may make the original computations
for the full payroll and the other clerk do all the rechecking.
Payroll checks are Payroll checks should be prenumbered to control their
manually numbered. issuance.
Employees are Employees should only be removed upon written notice
automatically removed signed by the foreman and personnel manager.
from the payroll when
they fail to turn in a time
card.
Payroll checks are signed Checks should be signed by the treasurer.
by the chief accountant.
The foreman distributes The checks should be distributed by a paymaster or a
the checks. responsible person other than the foreman.
The foreman arranges Unclaimed wages should be kept by the treasurer
for the distribution or some other responsible personnel.
of unclaimed wages.
The payroll bank account The payroll bank account should be independently
reconciled.
is reconciled by the chief
accountant.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-23
a. Possible Misstatement b. Possible Test of Controls
recorded. documentation.
3. Actual payroll transactions may not be Examine authorizations and approvals.
authorized.
4. Payroll checks may be distributed to Witness distribution of checks.
unauthorized recipients.
b.
Evidence Obtained Audit Objective Satisfied Example of How Evidence
During the Audit with the Evidence Would Support Value-added
Services
Production Cycle
The auditor notes Valuation of inventory and The auditor develops strategies
significant increases in valuation of plant and for more effective utilization of
overhead allocation rates equipment (depreciation production facilities or
and observes under rates). strategies to dispose of
utilization of capacity nonproductive facilities.
The auditor notes a Valuation of inventory at The auditor develops strategies
significant amount of slow net realizable value. to identify and liquidate slow
moving inventory. moving inventory to speed the
inventory turn cycle.
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Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-25
Cases
16-37. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
Phase I
This case allows the professor to explore the challenges of auditing privately held companies.
While privately held companies do not receive the attention of public companies, they represent a
significant portion of audits performed by CPAs. This case allows students to explore the control
environment issues associated with an owner-managed company with a domineering owner
manager. This case was developed based on an actual case that led to fraudulent financial reporting
in a privately held company.
The table below shows an increase in inventory turn days, a decrease in accounts payable turn days,
and a steady gross margin. The gross operating cycle is constant due to the improvement in
accounts receivable turn days. The net operating cycle does not show the same level of
improvement as gross operating cycle due to the decrease in payable turn days. The increase in
inventory turn days indicates that inventory may be overstated. A further risk may be associated
with unrecorded liabilities. The combination may result in an overstatement of net income.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-26
Question 3: Risk Assessment
a. Many of the financial statement level risks that have a pervasive effect on the financial
statements also involve control environment issues. In particular:
o Jessica, the owner-manger, was increasing her intrusion into the companys financial
reporting process.
o Jessica paid particular attention to accounting results, particularly in the last two quarters
of the year.
o Jessica regularly discussed accounting for particular transactions. Jessica was monitored
the year-end close on a daily basis, to discuss closing entries and their impact on
earnings.
o Jessica had a history of overriding accounting decisions.
o Jessica would not accept explanations for draft financial statements that showed
performance falling below her expectations.
o Accounting was not a high priority in the company.
o Accounting was understaffed (not allowing for adequate segregation of duties) and
everyone worked long hours.
b. When it comes to incentives and pressures, Jessica put considerable pressure on the
accounting staff to achieve accounting results. In addition, the company had to met
particular debt covenants, and Jessica wanted particular year-end results to support
distribution of earnings to shareholders in a Subchatper S Corporation.
The person who had the opportunity to influence the outcome of the accounting system was
the CFO, Rob Kaiser. There were no controls over Robs activities in the financial reporting
process.
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Rob was under considerable pressure from Jessica to deliver expected results. Jessicas
intrusion into the financial reporting process lessened only when reported results matched
the owner-mangers expectations.
A number of recommendations can be discussed in this letter, most of which will deal with the
control environment. Students could focus on any of the issues raised in question 1. Following is
an example letter.
Date
In planning and performing our audit of the financial statements of Circuits Technology, Inc. (CTI)
for the year ended December 31, 2002, we considered its internal control in order to determine our
audit procedures for the purpose of expressing an opinion on the financial statements and not to
provide assurance on internal control. However, we noted certain matter involving the internal
control and its operation that we consider to be reportable conditions under standards established by
the American Institute of Certified Public Accountants. Reportable conditions involve matters
coming to our attention related to significant deficiencies in the design or operation of internal
controls that, in our judgment, could adversely affect the organizations ability to record, process,
summarize and report financial data consistent with the assertions of management in the financial
statements.
Control Environment
The control environment represents the tone set by management of an organization that influences
the control consciousness of its people. It is important because it represents the foundation for all
other components of internal control, providing discipline and structure. A weak control
environment will lessen the effectiveness of other control activities that may prevent or detect
misstatements on a timely basis.
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An important aspect of the control environment involves a commitment to competence and
investment in human resource polices that support a sound financial reporting system. In the past
we have noted financial statement misstatements that have resulted from the fact that the account
staff is stretched too thin. This lack of investment in account personnel has also led to a situation
where a good system of checks and balances and segregation of duties cannot be achieved. We
recommend that CTI consider the addition of an additional staff person in accounting during peak
periods to encourage better control activities.
A strong control environment also involves a management philosophy and operating style that
reinforces representational faithfulness in financial reporting. During our audit we noticed several
situations that are considered significant risk indicators including the daily involvement of the
owner-manager in accounting issues associated with the closing process. A sound control
environment delegates a higher degree of responsibility for financial reporting to the accounting
staff and it places a premium on financial reporting that fairly presents underlying results of
operations.
This report is intended solely for the information and use of the Board of Directors of Circuits
Technology, Inc., management and others within the organization and is not intended for any other
purposes. We thank you for the opportunity to continue to be of service to you.
Signature.
Part II.
a. If the results of the sample of 35 are representative of the population the project the an
estimated audit value of $ 839,179 based on the calculation below using ratio estimation.
In addition, payroll costs in the amount of $21,060 were capitalized as part of work in
process inventory when the project was complete and billed to the customer. In total
inventory was overstated, cost of goods sold was understated, and gross margin was
overstated by $208,881. This represents 20% of the book value of inventory and is material.
b. At a minimum, the auditor should extend the sample for price testing inventory to determine
if the known misstatements are representative of the inventory as a whole. The pricing
errors are extensive and all in the same direction. Given the fraud risk indicators, it is likely
that misstatements are intentional with the intent of overstating inventory to achieve
budgeted results.
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The auditor might want to approach the accounting personnel, and the CFO, with the results and
determine the extent of their involvement with the pricing of inventory. If these pricing
errors and inappropriate capitalization of payroll costs rest solely with the CFO, the auditor
needs to question Rob Kaiser to determine the extent of misstatements in inventory and
other areas. Once presented with the audit evidence, the CFO might admit to his
involvement in financial statement misstatements. If the CFO does not admit to
involvement in the misstatements, the audit needs to be extended to determine the full extent
of the misstatements.
Finally, the auditor should consider the implication for other aspects of the audit. If
evidence suggests that prices and inventory values were changed to hit earnings targets, the
scope of other audit work should also be increased throughout the audit. The auditor might
want to suggest that management hire a forensic auditor to perform a fraud audit to
determine the extent of misstatements in the financial statements.
Following is a draft of a management letter comment that should be discussed with the board of
directors. This comment is drafted based on the audit evidence alone.
During the audit we found evidence of overstatements of inventory by the Chief Financial
Officer in order to overstate gross margins with the purpose of achieving desired financial
results. In a sample of 35 items we found 17 items with pricing errors, all of which resulted
in the overpricing of the value of inventory. In addition, we found evidence of inappropriate
capitalization of payroll costs as part of work in process inventory. In total, we estimate
that inventory values presented for audit were overstated by almost $210,000 (or 20% of the
value of inventory). Due to the extensiveness of the misstatements, 17 out of 35 items
sampled, we recommend retesting the entire inventory for pricing errors.
If Rob Kaiser admits to his involvement in overstating inventory, this should also be discussed with
the board of directors. The auditor needs to recommend (1) changes in the control environment that
led to the fraudulent financial reporting and (2) replacement of the CFO.
The auditor cannot have any conversations with the bank about the potential fraud or financial
statement misstatements due to ethical rules on confidential client information. If CTI corrects the
financial statements, the First State Bank will get financial statements that present fairly in all
material respects.
If the corrected financial statements disclose violations of debt covenants, the client should
approach First State Bank about the potential violations of debt covenants and ask the Bank to
waive the violations. If the bank is unwilling to waive the debt covenant violations, the auditor
needs to consider whether long-term debt to the bank should be reclassified as current before
issuing an opinion on the financial statements.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-30
Professional Simulation
Payroll
Controls
Research Inventory
Situation Audit
Procedures
The suggested evaluation of the system of internal controls presented above is included in the
following table.
Recommend Improvements for Significant
Assertion Adequacy of Controls Deficiencies
Existence and Controls are sufficient Time cards should be preprinted and/or prepunched
Occurrence A significant deficiency exits and prenumbered.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-31
Research
Payroll Inventory
Situation Controls Audit
Procedures
The issues associated with the clients use of statistical sampling to determine inventory quantities
is addressed in AU 331.11 which is stated below.
.11 In recent years, some companies have developed inventory controls or methods of determining
inventories, including statistical sampling, which are highly effective in determining inventory
quantities and which are sufficiently reliable to make unnecessary an annual physical count of
each item of inventory. In such circumstances, the independent auditor must satisfy himself that
the client's procedures or methods are sufficiently reliable to produce results substantially the
same as those which would be obtained by a count of all items each year. The auditor must be
present to observe such counts as he deems necessary and must satisfy himself as to the
effectiveness of the counting procedures used. If statistical sampling methods are used by the
client in the taking of the physical inventory, the auditor must be satisfied that the sampling plan
is reasonable and statistically valid, that it has been properly applied, and that the results are
reasonable in the circumstances. [Revised, June 1981, to reflect conforming changes necessary
due to the issuance of Statement on Auditing Standards No. 39.]
Inventory
Audit
Procedures
Payroll Research
Situation Controls
Audit procedure
A. Understand the key economic drivers that influence the entitys cost of sales, gross margins and
the possibility of obsolete inventory.
B. On a test basis, trace data from purchases, manufacturing, completed production, and sales
records to inventory accounts.
C. Vouch the items on the final inventory listing to inventory tags, count sheets and test counts
taken during the inventory observation.
D. Trace test counts taken during the inventory observation to the final inventory listing.
E. Examine sales invoices after year-end and determine the net realizable value of inventory.
F. Confirm inventories at locations outside the entity.
G. Based on test of beginning inventory, production costs, and ending inventory, determine the
appropriateness of cost of goods sold.
H. Confirm agreements for assigning and pledging inventories.
I. Examine vendors paid invoices for purchased inventory prior to year-end.
J. Evaluate the completeness of presentation of disclosures to determine conformity with GAAP
by reference to a disclosure checklist.
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Determine the audit procedure that best addresses the following risks.
Risk (A) (B) (C) (D) (E) (F) (G) (H) (I) (J)
1. Inventory that was counted and on hand at year-end
may not be included in the final inventory listing.
2. Inventory quantities may be correct, but inventory
may be incorrectly valued at FIFO.
3. Inventory that is said to be on hand in a public
warehouse may not exist.
4. Inventory may have to be sold at a loss in order to
move inventory.
5. All manufacturing costs may not be included in the
underlying accounting records supporting costs of
sales.
Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-33