Professional Documents
Culture Documents
SOLMANny 7
SOLMANny 7
7-2
List the four major evidence decisions that must be made on every
audit.
Answers
The four major audit evidence decisions that must be made on every audit
are:
7-4
Describe what is meant by an audit program for accounts
receivable. What four things should be included in an audit
program?
Answers
An audit program for accounts receivable is a list of audit procedures that
will be used to audit accounts receivable for a given client. The audit
procedures, sample size, items to select, and timing should be included in
the audit program.
7-5
Explain why the auditor can be persuaded only with a reasonable
level of assurance, rather than convinced, that the financial
statements are correct.
Answers
There are two primary reasons why the auditor can only be persuaded with a
reasonable level of assurance, rather than be convinced that the financial
statements are correct:
7-6
1
Identify the two factors that determine the persuasiveness of
evidence. How are these two factors related to audit procedures,
sample size, items to select, and timing?
Answers
The two determinants of the persuasiveness of evidence are appropriateness
and sufficiency. Appropriateness refers to the relevance and reliability of
evidence, or the degree to which evidence can be considered believable or
worthy of trust. Appropriateness relates to the audit procedures selected,
including the timing of when those procedures are performed. Sufficiency
refers to the quantity of evidence and it is related to sample size and items
to select.
7-11
Explain the importance of analytical procedures as evidence in
determining the fair presentation of the financial statements.
Answers
Analytical procedures are useful for indicating account balances that may be
distorted by unusual or significant transactions and that should be
investigated intensively. They are useful in reviewing accounts or
transactions for reasonableness to corroborate tentative conclusions reached
on the basis of other evidence.
7-12
Identify the most important reasons for performing analytical
procedures.
Answers
The most important reasons for performing analytical procedures are:
1. Understanding the client's industry and business
2. Assessment of the entity's ability to continue as a going concern
3. Indication of the presence of possible misstatements in the financial
statements
4. Reduction of detailed audit tests
7-13
Your client, Hallab Oriental Sweets Company, has a contractual
commitment as a part of a bond indenture to maintain a current
ratio of 2.0. If the ratio falls below that level on the balance sheet
date, the entire bond becomes payable immediately. In the current
year, the client’s financial statements show that the ratio has
dropped from 2.6 to 2.05 over the past year. How should this
situation affect your audit plan?
Answers
The decrease of the current ratio indicates a liquidity problem for Hallab
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Oriental Sweets Company since the ratio has dropped to a level close to the
requirements of the bond indenture. Special care should be exercised by the
auditor to determine that the 2.05 ratio is proper since management would
be motivated to hide any lower ratio. The auditor should expand procedures
to test all current assets for proper cutoff and possible overstatement and to
test all current liabilities for proper cutoff and possible understatement.
7-26
The following questions concern persuasiveness of evidence.
Choose the best response.
a. Which of the following types of documentary evidence should the
auditor consider to be the most reliable?
(1)A sales invoice issued by the client and supported by a delivery
receipt from an outside Delivery company
(2)Confirmation of an account payable balance mailed by and returned
directly to the auditor.
(3)A check, issued by the company and bearing the payee’s
endorsement, that is included with the bank statements mailed
directly to the auditor.
(4)An audit schedule prepared by the client’s controller and reviewed
by the client’s treasurer.
b. The most reliable type of audit evidence that an auditor can obtain is
(1)physical examination by the auditor.
(2)calculations by the auditor from company records.
(3)confirmations received directly from third parties.
(4)external documents.
c. Audit evidence can come in different forms with different degrees of
persuasiveness. Which of the following is the least persuasive type of
evidence?
(1)Vendor’s invoice
(2)Bank statement obtained from the client
(3)Computations made by the auditor
(4)Prenumbered sales invoices
d. Which of the following presumptions is correct about the reliability of
audit evidence?
(1)Information obtained indirectly from outside sources is the most
reliable audit evidence.
(2)To be reliable, audit evidence should be convincing rather than
merely persuasive.
(3)Reliability of audit evidence refers to the amount of corroborative
evidence obtained.
(4)Effective internal control provides more assurance about the
reliability of audit evidence.
Answers
a. (2)
b. (1)
3
c. (4)
d. (4)
7-27
The following questions concern audit documentation. Choose the
best response.
a. Which of the following is not a primary purpose of audit documentation?
1) To coordinate the audit.
2) To assist in preparation of the audit report.
3) To support the financial statements.
4) To provide evidence of the audit work performed.
c. Although the quantity, type, and content of audit documentation will vary
with the circumstances, audit documentation generally will include the
1) copies of those client records examined by the auditor during the
course of the engagement.
2) evaluation of the efficiency and competence of the audit staff
assistants by the partner responsible for the audit.
3) auditor’s comments concerning the efficiency and competence of
client management personnel.
4) auditing procedures followed and the testing performed in obtaining
evidential matter.
Answers
a. (3)
b. (3)
c. (4)
d. (4)
7-28
The following are examples of documentation typically obtained by
auditors:
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1. Vendors’ invoices
2. General ledgers
3. Bank statements
4. Cancelled payroll checks
5. Payroll time cards
6. Purchase requisitions
7. Receiving reports (documents prepared when merchandise is received)
8. Minutes of the board of directors
9. Remittance advices
10. Signed lease agreements
11. Duplicate copies of bills of lading
12. Subsidiary accounts receivable records
13. Cancelled notes payable
14. Duplicate sales invoices
15. Articles of Association or incorporation
16. Title insurance policies for real estate
17. Notes receivable
Required
a. Classify each of the preceding items according to type of
documentation: (1) internal or (2) external.
b. Explain why external evidence is more reliable than internal evidence.
Answers
a. 1. External 7. Internal 13. External
2. Internal 8. Internal 14. Internal
3. External 9. External 15. External
4. External 10. External 16. External
5. Internal* 11. External** 17. External
6. Internal 12. Internal
7-29
List two examples of audit evidence the auditor can use in support
of each of the following:
a. Recorded amount of entries in the acquisitions journal
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b. Physical existence of inventory
c. Accuracy of accounts receivable
d. Ownership of fixed assets
e. Liability for accounts payable
f. Obsolescence of inventory
g. Existence of petty cash
Answers
Examples of audit evidence the auditor can use to support each of the
functions are:
7-30
The following are examples of audit procedures:
1. Review the accounts receivable with the credit manager to evaluate their
collectability.
2. Stand by the payroll time clock to determine whether any employee
“punches in” more than one time.
3. Count inventory items and record the amount in the audit files.
4. Obtain a letter from the client’s attorney or lawyer addressed to the audit
firm stating that the attorney or the lawyer is not aware of any existing
lawsuits.
5. Extend the cost of inventory times the quantity on an inventory listing to
test whether it is accurate.
6. Obtain a letter from an insurance company to the CPA firm stating the
amount of the fire insurance coverage on buildings and equipment.
7. Examine an insurance policy stating the amount of the fire insurance
coverage on buildings and equipment.
8. Calculate the ratio of cost of goods sold to sales as a test of overall
reasonableness of gross margin relative to the preceding year.
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9. Obtain information about internal control by requesting the client to fill
out a questionnaire.
10. Trace the total on the cash disbursements journal to the general
ledger.
11. Watch employees count inventory to determine whether company
procedures are being followed.
12. Examine a piece of equipment to make sure that a major acquisition
was actually received and is in operation.
13. Calculate the ratio of sales commission expense to sales as a test of
sales commissions.
14. Examine corporate minutes to determine the authorization of the issue
of bonds.
15. Obtain a letter from management stating that there are no unrecorded
liabilities.
16. Review the total of repairs and maintenance for each month to
determine whether any month’s total was unusually large.
17. Compare a duplicate sales invoice with the sales journal for customer
name and amount.
18. Add the sales journal entries to determine whether they were correctly
totaled.
19. Make a petty cash count to make sure that the amount of the petty
cash fund is intact.
20. Obtain a written statement from a bank stating that the client has
$15,671 on deposit and liabilities of $500,000 on a demand note.
Required
Classify each of the preceding items according to the eight types of audit
evidence: (1) physical examination, (2) confirmation, (3) inspection, (4)
analytical procedures, (5) inquiries of the client, (6) recalculation, (7)
reperformance, and (8) observation.
Answers
1. Inquiry of client
2. Observation
3. Physical examination
4. Confirmation
5. Recalculation
6. Confirmation
7. Inspection
8. Analytical procedures
9. Inquiry of client
10. Reperformance
11. Observation
12. Physical examination
13. Analytical procedures
14. Inspection
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15. Inquiry of client
16. Analytical procedures
17. Inspection
18. Recalculation
19. Physical examination
20. Confirmation
7-31
Eight different types of evidence were discussed. The following
questions concern the reliability of that evidence:
Required
a. Explain why confirmations are normally more reliable evidence than
inquiries of the client.
b. Describe a situation in which confirmation will be considered highly
reliable and another in which it will not be reliable.
c. Under what circumstances is the physical observation of inventory
considered relatively unreliable evidence?
d. Explain why recalculation tests are highly reliable but of relatively
limited use.
e. Give three examples of relatively reliable documentation and three
examples of less reliable documentation. What characteristics
distinguish the two?
f. Give several examples in which the qualifications of the respondent or
the qualifications of the auditor affect the reliability of the evidence.
g. Explain why analytical procedures are important evidence even though
they are relatively unreliable by themselves.
Answers
a. Confirmations are normally more reliable evidence than inquiries of the
client because of the independence of the outside party confirming the
information.
b. Confirmation of bank balances is considered highly reliable whereas
confirmation of a department store charge account is often not
considered reliable. Banks are accustomed to confirmations from
auditors and normally maintain excellent accounting records, whereas
most customers of department stores have neither characteristic.
c. If an auditor is not qualified to distinguish between valuable inventory
(such as diamonds) and worthless inventory (such as glass), the
physical examination of inventory would not be considered to be
reliable evidence.
d. Recalculation tests are highly reliable because the auditor is able to
gain 100% assurance of the accuracy, but the tests only verify whether
the recorded amounts are accurately totaled. These tests do not
uncover omissions or fictitious amounts.
e. Relatively reliable documentation examples include: vendor
statements, bank statements, and signed lease agreements. Relatively
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unreliable documentation examples may be: copies of customer
invoices, internal memoranda and other communications, and a listing
of fixed asset additions.
The difference between reliable and unreliable documentation
examples above is whether they originate from outside or inside the
client's organization. External information is considered more reliable
than internal documentation.
f.
1. Confirmation of accounts receivable – corporation accustomed to
confirmations compared to a member of the general public.
2. Examination of the corporate minutes – experienced partner
compared to a new assistant.
3. Physical observation of inventory – auditor knowledgeable in the
client's inventory compared to one who is not.
4. Attorney's letter – general counsel compared to an attorney
involved only with patents.
7-32
The following are nine situations, each containing two means of
accumulating evidence:
1. Confirm receivables with consumers versus confirming accounts
receivable with business organizations.
2. Physically examine 3-inch steel plates versus examining electronic
parts.
3. Examine duplicate sales invoices when several competent people are
checking each other’s work versus examining documents prepared by
a competent person on a one-person staff.
4. Physically examine inventory of parts for the number of units on hand
versus examining them for the likelihood of inventory being obsolete.
5. Discuss the likelihood and amount of loss in a lawsuit against the client
with client’s in-house legal consultant versus discussion with the audit
firm’s own legal consultant.
6. Confirm the oil and gas reserves with a geologist specializing in oil and
gas versus confirming a bank balance.
7. Confirm a bank balance versus examining the client’s bank
statements.
8. Physically count the client’s inventory held by an independent party
versus confirming the count with an independent party.
9. Obtain a physical inventory count from the company president versus
physically counting the client’s inventory.
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Required
a. Identify the six factors that determine the reliability of evidence.
b. For each of the nine situations, state whether the first or second type
of evidence is more reliable.
c. For each situation, state which of the six factors affected the reliability
of the evidence.
Answers
a. The six factors determining the reliability of evidence are:
1. Independence of provider
2. Effectiveness of client's internal controls
3. Auditor's direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness
b. and c.
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7-34
The following audit procedures were performed in the audit of
inventory to satisfy specific balance-related audit objectives as
discussed in Chapter 6. The audit procedures assume that the
auditor has obtained the inventory count sheets that list the client’s
inventory. The general balance-related audit objectives from
Chapter 6 are also included.
Audit Procedures
1. Test extend unit prices times quantity on the inventory list, test foot
the list, and compare the total to the general ledger.
2. Trace selected quantities from the inventory list to the physical
inventory to make sure that it exists and the quantities are the same.
3. Question operating personnel about the possibility of obsolete or slow-
moving inventory.
4. Select a sample of quantities of inventory in the factory warehouse and
trace each item to the inventory count sheets to determine if it has
been included and if the quantity and description are correct.
5. Compare the quantities on hand and unit prices on this year’s
inventory count sheets with those in the preceding year as a test for
large differences.
6. Examine sales invoices and contracts with customers to determine
whether any goods are out on consignment with customers. Similarly,
examine vendors’ invoices and contracts with vendors to determine
whether any goods on the inventory listing are owned by vendors.
7. Send letters directly to third parties who hold the client’s inventory and
request that they respond directly to the auditors.
General Balance-Related Audit Objectives
Existence Cutoff
Completeness Detail tie-in
Accuracy Realizable value
Classification Rights and obligations
Required
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general balance-related audit objective or objectives
satisfied by each audit procedure.
Answers
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B.
A. Balance-
Type of audit related
Audit procedure evidence audit objective
1. Test extend unit prices Recalculation Detail tie-in
times quantity on the
inventory list, test foot the
list and compare the total
to the general ledger.
2. Trace selected quantities Physical Existence
from the inventory list to examination Accuracy
the physical inventory to
make sure that it exists
and the quantities are the
same.
3. Question operating Inquiry of the Realizable value
personnel about the client
possibility of obsolete or
slow-moving inventory.
4. Select a sample of Physical Completeness
quantities of inventory in examination Accuracy
the factory warehouse
and trace each item to the
inventory count sheets to
determine if it has been
included and if the
quantity and description
are correct.
5. Compare the quantities on Analytical Accuracy
hand and unit prices on procedures
this year's inventory count
sheets with those in the
preceding year as a test
for large differences.
6. Examine sales invoices Inspection Rights and
and contracts with obligations
customers to determine
whether any goods are
out on consignment with
customers. Examine
vendors' invoices and
contracts with vendors to
determine if any goods on
the inventory listing are
owned by vendors.
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B.
A. Balance-
Type of audit related
Audit procedure evidence audit objective
7. Send letters directly to Confirmation Existence
third parties who hold the Completeness
client's inventory and Accuracy
request they respond
directly to us.
7-35
Nefret Stores is a large discount cosmetic department store chain. The
company has recently expanded from 5 to 15 stores by borrowing from
several large financial institutions and from a public offering of common
stock. A recent investigation has disclosed that Nefret materially overstated
net income. The company understated their accounts payable and recorded
fictitious supplier credits that further reduced accounts payable. As a result,
an Income & Sales Tax Department investigation was critical of the evidence
gathered by Nefret’s audit firm, Abdul & El-Emir, in testing accounts payable
and the supplier credits.
1. Kashir Advertising Credits—Nefret had arrangements with some
vendors to share the cost of advertising the vendor’s product. The
arrangements were usually agreed to in advance by the vendor and
supported by evidence of the placing of the ad. Nefret created a 250-
page list of approximately 1,000 vendors, supporting advertising
credits of $500,000. Nefret’s auditors selected a sample of 8 of the
2,500 items for direct confirmation. One item was confirmed by
telephone, one traced to cash receipts, one to a vendor’s credit memo
for part of the amount and cash receipts for the rest, and one to a
vendor’s credit memo. Two of the amounts confirmed differed from the
amount on the list, but the auditors did not seek an explanation for the
differences because the amounts were not material.
The rest of the credits were tested by selecting 30 items (several
from each page of the list). Fourteen of the items were supported by
examining the ads placed, and sixteen were supported by Nefret debit
memos charging the vendors for the promotional allowances.
2. Nashwa Credits—Nefret created 28 fictitious credit memos totaling
$363,000 from Nashwa Distributions, the main supplier of health and
beauty aids to Nefret. Nefret’s controller initially told the auditor that
the credits were for returned goods, then said they were a volume
discount, and finally stated that they were a payment so that Nefret
would continue to use Nashwa as a supplier. However, an Abdul & El-
Emir staff auditor noticed the amount and concluded that a $257,000
payment to retain Nefret’s business was too large to make economic
sense.
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The credit memos indicated that the credits were for damaged
merchandise, volume rebates, and advertising allowances. The audit
firm requested a confirmation of the credits. In response, Ramses
Abdullah, the president of Nefret Stores, placed a call to Saria Wasir,
the president of Nashwa, and handed the phone to the staff auditor. In
fact, the call had been placed to an officer of Nefret. The Nefret officer,
posing as Wasir, orally confirmed the credits. Nefret refused to allow
Abdul & El-Emir to obtain written confirmation supporting the credits.
Although the staff auditor doubted the validity of the credits, the audit
partner, Mufti Hussein, accepted the credits based on the credit
memoranda, telephone confirmation of the credits, and oral
representation of Nefret officers.
3. Zaki Credits-$130,000 in credits based on 35 credit memoranda from
Zaki, Inc., were purportedly for the return of overstocked goods from
several Nefret stores. An Abdul & El-Emir staff auditor noted the size of
the credit and that the credit memos were dated subsequent to year-
end. He further noticed that a sentence on the credit memos from Zaki
had been obliterated by a felt-tip marker. When held to the light, the
accountant could read that the marked-out sentence read, “Do not
post until merchandise received.” The staff auditor thereafter called
Omar Zaki, treasurer of Zaki, Inc., and was informed that the $130,000
in goods had not been returned and the money was not owed to Nefret
by Zaki. Abdullah, president of Nefret, advised Hussein, audit partner,
not to have anyone call Zaki to verify the amount because of pending
litigation between Nefret and Zaki, Inc.
4. Accounts Payable Accrual—Abdul & El-Emir assigned a senior with
experience in the retail area to audit accounts payable. Although
Nefret had poor internal controls, Abdul & El-Emir selected a sample of
50 for confirmation of the several thousand vendors who did business
with Nefret. Twenty-seven responses were received, and 21 were
reconciled to Nefret’s records. These tests indicated an unrecorded
liability of approximately $290,000 when projected to the population of
accounts payable. However, the investigation disclosed that Nefret’s
president made telephone calls to some suppliers who had received
confirmation requests from Abdul & El-Emir and told them how to
respond to the request.
Abdul & El-Emir also performed a purchase cutoff test by vouching
accounts payable invoices received for nine weeks after year-end. The
purpose of this test was to identify invoices received after year-end
that should have been recorded in accounts payable. Thirty percent of
the sample ($150,000) was found to relate to the prior year, indicating
a potential unrecorded liability of approximately $500,000. The audit
firm and Nefret eventually agreed on adjustment to increase accounts
payable by $260,000.
Required
14
Identify deficiencies in the sufficiency and appropriateness of the evidence
gathered in the audit of accounts payable of Nefret Stores.
Answers
These are deficiencies in the sufficiency and appropriateness of the evidence
in the audit of accounts payable for Nefret Stores.
Kashir Advertising Credits: An insufficient number of confirmations
(eight) were sent. The use of alternative procedures is probably acceptable.
However, one credit was confirmed by telephone, rather than by written
confirmation. Although the differences found were immaterial, the auditors
should have determined the reason for the differences, and any errors
should have been projected to the population. Also, only six confirmations
were received back and the other two were not followed up on.
Thirty additional credits were selected for testing. Whether this is a
sufficient number is a matter of judgment, and depends on several factors.
With a fairly small sample, it is critical that the items selected for testing
adequately represent the population. The testing relied on internal
documentation, which is insufficient to support the credits. The placing of the
ad is insufficient evidence without supporting evidence from the vendor
supporting the reduction in accounts payable.
Nashwa Credits: These credits were confirmed by telephone, and
were not supported by a written confirmation. The staff auditor was
suspicious of the client’s unwillingness to allow written confirmation of the
amounts, as well as the client’s changing explanation of the nature of the
credits, but did not perform additional testing to resolve any doubts about
the validity of the credits.
Zaki Credits: The auditor obtained an oral confirmation that these
credits were not valid. The client indicated that the auditor's information was
incorrect, but would not allow the auditor to obtain written confirmation for
these credits. In addition, the credit memos had been altered, which should
have further indicated to the auditor that the credits were not valid.
Accounts Payable Accrual: The auditors sent 50 accounts payable
confirmations. Whether this is a sufficient number of confirmations are a
matter of auditor judgment. However, the adequacy of the confirmations as
evidence is significantly undermined by the knowledge that the client told
suppliers how to respond. As a result, the auditor should have verified the
confirmed balances using alternative procedures. There is no discussion of
the performance of alternative procedures for non-responses, or the
resolution of the six responses that were not reconciled to Grande’s records.
There is no action on the US$290,000 unrecorded liability found through
extrapolating confirm testing.
The auditors agreed to an adjustment of US$260,000 when their cutoff
tests indicated a potential liability of US$500,000 for cutoff and US$290,000
for confirms. It would be appropriate for the auditors to agree to a lower
amount only if additional testing supported a lower accrued liability.
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