Audit Case Bank

Chapter 1
An Overview of Auditing and Assurance Services

Review Questions
1-1
The Canadian Institute of Chartered Accountants (CICA) whose members are
chartered accountants (CAs). CAs are licensed to perform audits in all provinces and
also are employed in government, industry and education.
The Certified General Accountants Association of Canada (CGAAC) whose members
are certified general accountants (CGAs). CGAs perform audits in some provinces and
are employed in government, industry and education.
The Society of Management Accountants of Canada (SMAC) whose members are
certified management accountants (CMAs). CMAs are primarily employed in
government, industry and education.
The Institute of Internal Auditors (IIA) includes members who may have a certified
internal auditor (CIA) designation. Members are primarily in internal auditing but also in
other positions in government, industry and education.
The Informations Systems Audit and Control Association (ISACA) requires members to
sit an examination and have relevant work experience before receiving a CISA.
Members are primarily in internal auditing but also in other positions in government,
industry and education.
1-2
To do an audit, there must be information in a verifiable form and some
standards (criteria) by which the auditor can evaluate the information. Examples of
established criteria include generally accepted accounting principles and the Income
Tax Act. Determining the degree of correspondence between information and
established criteria is determining whether a given set of information is in accordance
with the established criteria. The information for Jones Limited's tax return are the
federal tax returns filed by the company. The criteria are the Income Tax Act and all
interpretations. For the audit of Jones Limited's financial statements, the information is
the financial statements being audited and the established criteria are generally
accepted accounting principles.
1-3
The primary evidence the Canada Customs and Revenue Agency auditor will
use in the audit of the Jones Ltd.s tax return include all available documentation and
other information available in Jones' office or from other sources. For example, when
the auditor examines taxable income, a major source of information will be bank
statements, the cash receipts journal and deposit slips. The auditor is likely to
emphasize unrecorded receipts and revenues. For expenses, major sources of
1-1
evidence are likely to be canceled cheques, vendors' invoices and other supporting
documentation.
1-4
This apparent paradox arises from the distinction between the function of
auditing and the function of accounting.
The accounting function is the process of recording, classifying and summarizing
economic events to provide relevant information to decision makers.
The rules of accounting are the criteria used by the auditor for evaluating the
presentation of economic events for financial statements and he or she must therefore
have an understanding of generally accepted accounting principles (GAAP), as well as
generally accepted auditing standards (GAAS).
The accountant need not, and frequently does not, understand what auditors do, unless
he or she is involved in doing audits, or has been trained as an auditor.
1-5
Audits of
Compliance
Operational
Financial Statements
Audits
Audits
________________________________________________________________
Purpose
To determine whether
To determine
To evaluate
the financial statements whether the
whether operating
are presented in
client is followprocedures are
accordance with GAAP. ing specific
efficient and
procedures set by effective.
higher authority.
_______________________________________________________________
Users of
Audit Report
Different groups for
Authority setting
Management of
different purposes -down procedures, organization.
many outside entities
internal or external.
________________________________________________________________
Nature
Highly standardized
Not standardized, Highly nonbut very specific
standard.
often very
subjective and
usually objective
________________________________________________________________
Performed By:
Public Accountant Almost universally
Occasionally
Frequently
________________________________________________________________
Government
Auditors
Occasionally
Frequently
Frequently
________________________________________________________________
1-2
Canada Customs
And Revenue Agency
Auditors
Never
Universally
Never
________________________________________________________________
________________________________________________________________
Internal Auditors Never although
Frequently
Frequently
they might review
them for
management
________________________________________________________________
1-6
Five specific examples of operational audits that could be conducted by an

internal auditor in a manufacturing company are:
1.
Examination of employee time cards and personnel records to determine if
sufficient information is available to maximize the effective use of
personnel.
2.
Review the processing of sales invoices to determine if it could be done
more efficiently.
3.
Review the acquisitions of goods, including costs to determine if they are
being purchased at the lowest possible cost considering the quality
needed.
4.
Review and evaluate the efficiency of the manufacturing process.
5.
Review the processing of cash receipts to determine if they are deposited
as quickly as possible.
The students will probably suggest other examples.
1-7
The major differences in the scope of audit responsibilities are:

1.
Public accountants perform audits in accordance with generally accepted
auditing standards of published financial statements prepared in
accordance with generally accepted accounting principles.
2.
Government auditors from the auditor generals (federal or provincial)
perform compliance or operational (value-for-money) audits in order to
assure the Parliament that the expenditure of public funds is in
accordance with its directives and the law and is done with efficiency,
economy and effectiveness. They also do financial statement audits of
Crown Corporations, or sub-contract this work to external public
accountants.
3.
Canada Customs and Revenue Agency auditors perform compliance
audits to enforce the federal tax laws as defined by Parliament, interpreted
by the courts, and regulated by the Income Tax Act.
4.
Internal auditors perform compliance or operational audits in order to
assure management or the board of directors that control and policies are
properly and consistently developed, applied and evaluated.
1-3
1-8
1.
2.
3.
Risk-free interest rate. This is approximately the rate the bank could earn
by investing in Canadian treasury bills for the same length of time as the
business loan.
Business risk for the customer. This risk reflects the possibility the
business will not be able to repay its loan because of economic or
business conditions such as a recession, poor management decisions, or
unexpected competition in the industry.
Information risk. This risk reflects the possibility that the information upon
which the business risk decision was made was inaccurate. A likely cause
of the information risk is the possibility of inaccurate financial statements.
Auditing has no effect on either the risk-free interest rate or business risk. However,
auditing can significantly reduce information risk.
1-9 The CICA Accounting and Assurance Handbooks provides guidance in general
circumstances to service the largest numbers of situations and users. Where there
is no guidance in the handbook accountants rely on their professional judgment to
fairly present the economic reality of the situation. Leaving the application open to
judgment may result in general acceptance of a minimum level of auditing or
accounting practice.
The existence of standards are a means of transmitting wisdom and avoiding

unintentional error due to ignorance.
Standards may be a more efficient and desirable way of creating a body of GAAP
or GAAS than expensive lawsuits and the development of case law.
Compliance with a documented set of standards can provide a better defense
against legal liability.
If the CICA did not develop standards, then other groups or agencies would.
Standards instill confidence in the fairness and reliability of financial statements
to users
On the other hand, market research suggests that too many standards are
ineffective in assisting the operation of the market.
Standard setting is expensive for the profession; the cost may exceed the benefit
Given the complexity of the economic reality that financial statements attempt to
portray, no set of standards can be theoretically correct or deal appropriately with
all situations.
1-10 The major characteristics of public accounting firms that permit them to fulfill their
social function competently and independently are:
1.
Organizational structure - usually a partnership employing a professional

staff of sufficient size to prevent one client from constituting a significant
portion of total income and thereby endangering the firm's independence.
1-4
2.
Conduct - employs a professional staff of sufficient size to provide a broad

range of expertise. Continuing education is supported. The firm promotes
a professional, independent attitude and competence among its
professional staff. Consultation among professional staff is encouraged.
1-11 The CICA is the organization that sets accounting and auditing standards that
have been given quasi-legal status by legislative acts such as the Canadian Business
Corporations Act and by the provincial securities administrators.
The CICA/CGAAC/SMAC conduct research and publish materials on many different
subjects related to accounting, auditing, management advisory services, and taxes. The
organizations also prepare and grade the CA, CGA, and CMA accounting examinations,
respectively, and provide continuing education to their members. Finally, the
organizations set out professional standards regulating the professional conduct of their
members.
1-12 The CICA Handbook codifies as recommendations, generally accepted

accounting principles (GAAP), and generally accepted auditing standards (GAAS). In
addition, the Handbook includes Accounting Guidelines and Assurance and Related
Services Guidelines. The Guidelines are either interpretations of the recommendations,
or a statement on a matter of concern. The handbook is prepared by the CICA, which
serves two main functions; 1) it is the umbrella organization to which all CAs belong,
and 2) it has been given the authority by the Canada Business Corporations Act and the
various provincial incorporating acts to set the accounting and auditing standards which
must be followed by public accountants doing audits chartered under one of the acts.
1-13 Generally accepted auditing standards are eight general guidelines to aid
auditors in fulfilling their professional responsibilities. These guidelines include one
general standard concerned with adequate technical training and proficiency in auditing,
due care and an objective state of mind; three examination standards including planning
and supervision, understanding and evaluation of internal control, and the gathering of
sufficient appropriate evidential matter; and four standards of reporting including
identification of the responsibilities of management and the responsibilities of the auditor
with respect to the financial statements, the scope of the examination, and an opinion
on the financial statements as to whether the financial statements present fairly the
financial position, results of operations and changes in financial position in accordance
with an appropriately disclosed basis of accounting, usually GAAP.
Generally accepted accounting principles are specific rules for accounting for
transactions occurring in a business enterprise.
Examples may be any of the Accounting Recommendations (GAAP) and Assurance
Recommendations (GAAS) of the CICA Handbook.
1-5
1-14 Auditors can obtain adequate technical training and proficiency through formal
education in auditing and accounting, adequate practical experience, and continuing
professional education.
Auditors can demonstrate their proficiency by becoming licensed to practice as public
accountants. The various provinces have different rules as to who can be licensed to
perform audits; in British Columbia CAs and CGAs can be licensed, in Alberta CAs,
CGAs and CMAs can be licensed while in Ontario only CAs can be licensed.
1-15 Where there is a conflict, the CICA Handbook would take precedence. However,
a Canadian auditor may be engaged to conduct an audit in accordance with IFAC
standards, in which case, the IFAC standards would have to be satisfied. In all cases,
the CICA Handbook provides the minimum standard that a Canadian auditor must meet
in GAAS.
1-16 Quality controls are established by individual public accounting firms to help
ensure that their firm meets its professional responsibilities to clients. Quality controls
are the procedures used by a public accounting firm that help it meet generally
accepted auditing standards consistently on every engagement. Quality controls are
therefore established for the entire public accounting firm as opposed to individual
engagements.
1-17 The element of quality control is hiring. The purpose of the requirement is to help
assure the public accounting firm that all new personnel should be qualified to perform
their work competently. A public accounting firm must have competent employees
conducting the audits if quality audits are to result.
1-18 A practice inspection is a review, by practice inspectors employed by the

provincial institute or ordre, of a public accounting firm's compliance with its quality
control procedure system for auditing and accounting engagements and its compliance
with the CICA Handbook. Practice inspection is mandatory in those provinces that have
instituted it. The discussion in the text pertains to CAs in public practice in Ontario.
Practice inspection can be beneficial to the profession and to individual firms. By
helping firms meet quality control standards, the profession gains if inspections result in
practitioners doing higher quality audits. A firm having a practice inspection can also
gain if it improves the firm's practices and thereby enhances its reputation and
effectiveness, and reduces the likelihood of lawsuits. Of course, practice inspections are
costly. There is always a trade off between cost and benefits. A CA firm also gives up
some independence of activities when it is reviewed by the practice inspectors. The
consensus is that practice inspection has been successful in increasing the quality of
public practice.
1-6
Multiple Choice Questions

1-19 a.
(3)
b.
(4)
1-20 a.
(4)
b.
(4)
1-21 a.
(3)
b.
(1)
c.
c.
(3)
(3)
d.
(2)
Discussion Questions and Problems

1-22
a.
The following parts of the definition of auditing are related to the narrative:
1.
Virms is being asked to issue a report about qualitative and quantitative

information relating to trucks. The trucks are therefore the quantifiable
information with which the auditor is concerned.
There are three criteria which must be evaluated and reported by Virms:
Existence of the trucks on the night of June 30, physical condition of each
truck and fair market value of each truck.
Susan Virms will accumulate and evaluate four basic types of evidence:
a.
Count the trucks to determine their existence.
b.
Use registrations documents held by Charon for comparison to the
serial number on each truck to determine ownership.
c.
Examine the trucks to determine each truck's physical condition.
d.
Examine the blue book to determine the fair market value of each
truck.
Susan Virms, public accountant, appears qualified as a competent,
independent person . She is a public accountant, and she spends most of
her time auditing used automobile and truck dealerships and has
extensive specialized knowledge about used trucks that is consistent with
the nature of the engagement.
The report results are to include:
a.
which of the 20 trucks are parked in Regional's parking lot the night
of June 30.
b.
the condition of each truck, using established guidelines.
c.
fair market value of each truck using the current blue book for
trucks.
2.
3.
4.
5.
b.
The only parts of the audit which will be difficult for Virms are:
1.
2.
Evaluating the condition, using the guidelines of poor, good, and excellent.
It is highly subjective to do so. If she uses a different criterion than the
"blue book," the fair market value will not be meaningful. Her experience
will be essential in using this guideline.
Determining the fair market value, unless it is clearly defined in the blue
book for each condition.
1-7
1-23 The most likely type of auditor and the type of audit for each of the examples are:
Example
Type of Auditor
Type of Audit
1.
Canada Customs & Revenue Agency Compliance
2.
Auditor General
Operational
3.
Internal Auditor
Operational
4.
Auditor General or Internal Auditor
Financial statements
5.
Auditor General
Operational
6.
Public Accountant
7.
Auditor General
8.
Canada Customs & Revenue Agency Compliance
9.
Public Accountant
10.
Internal Auditor or Public Accountant
Compliance
11.
Internal Auditor or Public Accountant
12.
Auditor General
Compliance
1-24 a. The conglomerate should either engage the management advisory services
division of a public accounting firm or its own internal auditors to conduct the operational
audit.
b.
The auditors will encounter problems in establishing criteria for evaluating the
actual quantitative events and in setting the scope to include all operations in
which significant inefficiencies might exist. In writing the report, the auditors must
choose proper wording to state that no financial audit was performed, that the
procedures were limited in scope and that the results reported do not necessarily
include all the inefficiencies that might exist.
1-25 Reviewers note: The text author has provided the following supplemental
information: The comments in the problem do summarize the beliefs of many
practitioners about quality control and practice inspection. The arguments against
quality control and practice inspection are stated in the comments and can be
summarized as five basic arguments.
1.
Relative cost for smaller firms is excessively high.
2.
Smaller firms have less need for quality control because of greater partner
involvement.
3.
It eliminates the major competitive advantage of smaller firms which is a
simple and efficient organizational structure.
4.
Quality control standards are not needed because they have already been
implemented by quality firms.
5.
Three other things already provide assurance of adequate quality: auditing
standards, legal liability and a competitive economic environment.
1-8
To support these comments it can be argued that the profession has functioned well
with relatively little controversy and criticism. A major reason many practitioners choose
the profession is the relative freedom to operate their professional practice as they see
fit.
Solution to text problem
a.
The arguments against these comments are primarily as follows:
1.
It will not be costly for most smaller firms to implement quality control
requirements because the quality control standards required are not
onerous.
2.
There is no need to eliminate the simple organizational structure now
enjoyed by many smaller public accounting firms.
3.
Certain critics of the public accounting profession have argued strongly
against self-regulation of the profession. Many public accountants believe
that only through self-regulation will it be possible to minimize government
interference. Even if the nine elements of quality control enunciated by the
text are in existence, the quality control and practice inspection
requirements may be necessary to avoid government interference.
4.
For those firms that already have the nine elements of quality control in
their practice, the additional implementation costs should be minimal.
Those lacking such elements will incur more cost, but presumably are
lacking in certain elements needed for a high quality practice.
5.
Partner involvement on engagements does not necessarily assure that all
quality control requirements have been met. For some smaller firms, top
partners may spend relatively little time on audits and therefore not be as
knowledgeable about auditing as may be necessary.
b.
1-26
There is no correct answer to this question. Different people reach different

conclusions, depending on the weights put on each of the five arguments stated
in part a. for and against quality controls and practice inspection. The authors
believe that both quality control and practice inspection are worth the cost.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
Engagement performance
Personnel management
Independence, integrity, and objectivity
Monitoring
Acceptance and continuation of clients and engagements
1-9
1-27 There are many misunderstandings concerning the auditors role and
responsibilities. The difference between the perception of users of the audit function
and those of the CA profession are called the expectations gap.
Perceived role:
Some users assume that an unqualified audit report gives assurance that:
Management is capable
The company is viable
The outlook is favorable
No fraudulent activities have taken place.
Current role and responsibilities of the auditor:
Auditors involvement adds an objective review and credibility to financial statements
and to managements assertions about those statements.
Corporations are aware that their records will be audited; thus, the audit function also
acts as an effective control.
The audit report, a form of communication to users of financial statements, informs them
that accounting principles used are GAAP, and that the statements fairly present the
financial position of the company. Since there are a variety of financial statement
users, with varying information needs, it is not possible for one set of financial
statements to cater to all the needs of users.
Expansion of the audit role and resolution of the expectations gap:
When discussing the business viability assertions several issues need to be considered:
There is a risk that if an auditor attests that a business may not be viable, that
in itself could cause the failure of the business
The future results ob a business are subject to management decisions and
are not controlled by the auditor.
If the auditor reports on future results, his objectivity may be affected.
Expansion of the auditors role with increased involvement would increase audit costs.
Who would pay for these costs? If parties other than the shareholders pay, then the
auditor will have to report to these other parties. Legal liability issues will arise if the
auditor reports directly to other users.
Auditors attempt to increase efficiency and reduce audit costs by increasing the use of
technicians, paraprofessionals, and computer programs.
Changes to the auditors role would increase the already high level of risk. Auditors
would need to seek ways of reducing risk by affordable insurance, and limited liability.
It would be beneficial to continue educating users to understand the auditors role and
the fact that they cannot guarantee success.
1-10
Auditors cannot be expected to assume responsibility for all information that is useful to
others in making their various decisions about a business. Certain information is too
subjective or too far removed from the auditors field of expertise. There will always be
information that is best asserted or attested to by other professionals.
Cases
1-28
Brief Description of
Holmes' Action Resulting in
Generally Accepted
Failure to Comply With
Auditing Standards
Generally Accepted Auditing Standards
____________________________________________________________________
General Standard
1. The examination is to be
performed by a person or
persons having adequate
technical training and
proficiency in auditing with
due care and with an
objective state of mind.
1. It was inappropriate for Holmes to hire the two

students to conduct the audit. The examination
must be conducted by persons with proper
education and experience in the field of auditing.
Although a junior assistant has not completed
his/her formal education, he/she may help in the
conduct of the examination as long as there is
proper supervision and review.
2. To satisfy the general standard, Holmes must
be without bias with respect to the client under
audit. Holmes has an obligation for fairness to
the owners, management, and creditors who
may rely on the report. Because of the
financial interest in whether the bank loan is
granted to Raymonde, Holmes is independent
in neither fact nor appearance with respect to
the assignment undertaken.
1-11
1-12
Generally Accepted
Auditing Standards
____________________________________________________________________
3. This standard requires Holmes to perform the
audit with due care which imposes on Holmes
and everyone in Holmes' organization a
responsibility to observe the examination and
reporting standards. Exercise of due care
requires critical review at every level of
supervision of the work done and the
judgments exercised by those assisting in the
examination. Holmes did not review the work
or the judgments of the assistants and clearly
failed to adhere to this standard.
Examination Standards
1. The work is to be adequately
planned and properly executed.
Assistants, if any are to be
properly supervised.
1. This standard recognizes that early appointment

of the auditor has advantages for the auditor
and the client. Holmes accepted the
engagement without considering the
availability of competent staff. In addition,
Holmes failed to supervise the assistants.
The work was not adequately planned.
2. The auditor should obtain a

sufficient understanding of
internal control to plan the
audit. Tests of controls must
be performed to gain
sufficient appropriate audit
evidence to support an
assessment of control risk
below maximum.
2. Holmes did not obtain an understanding of

internal control, nor did the assistants
obtain such an understanding. There
appears to have been no audit examination
at all. The work performed was more an
accounting service than it was an auditing
service.
1-13
Generally Accepted
Auditing Standards
____________________________________________________________________
Examination Standards
3. Sufficient, appropriate audit
3. Holmes acquired no evidence that would
evidence should be obtained
support the financial statements. Holmes
through inspection, observation,
merely checked the mathematical accuracy
inquiry, confirmation,
of the records and summarized the accounts.
computation and analysis
Standard audit procedures and techniques
to afford a reasonable basis
were not performed.
to support the auditor's
opinion on the financial
statements.
Standards of Reporting
1. The report should identify
the financial statements
and distinguish between
the responsibilities of
management and of
the auditor.
1. Cannot tell from the question whether this

standard was observed.
2. The scope of the auditors

examination should be
referred to in the report.
2. The scope of the work was so limited as not

to constitute an audit. The scope paragraph
should have indicated this.
3. The report shall either

contain an expression
of opinion on the
financial statements
or an assertion that an
opinion cannot be expressed.
3. Although Holmes report contains an

expression of opinion, such opinion is not
based on the results of a proper audit
examination. Holmes should deny an
opinion because he failed to conduct an
examination in accordance with generally
accepted auditing standards.
1-14
Generally Accepted
Auditing Standards
____________________________________________________________________
Standards of Reporting
4. Where an opinion is
expressed, it should
indicate whether the
financial statements
present fairly, in all
material respects,
the financial position
in accordance with
an appropriate
disclosed basis of
accounting, which
except in special
circumstances should
be generally accepted
accounting principles.
4. Holmes report made no reference to Canadian

generally accepted accounting principles
as an appropriate disclosed basis of
accounting. Because Holmes did not conduct
a proper examination, the report should state
that no opinion can be expressed as to the
fair presentation of the financial statements
in accordance with generally accepted
1-29 a) An audit would provide an independent review of EECs financial activities,

which would assure members that the financial statements are fairly represented.
An audit provides increased credibility by banks, government departments and other
third parties. Anytime public funds are used in a service organization such as EEC
they should be checked by an independent audit.
b) The systems of accounting, reporting and budgeting are an integral part of the
association. Therefore having them set up correctly in the beginning is a benefit not
only to the association but also to the public accountant. The public accountant is the
person who has a sound knowledge of accounting, finance and internal control issues
as it pertains to this organization.
c) Accounting:
Initial set up of chart of accounts
Choosing/designing processes for the subsystems (sales, ordering, purchasing,
point of sale, other)
Providing advice on accounting policies
Review monthly/quarterly/yearly financial statements for reasonableness
Prepare monthly/quarterly/yearly journal entries and assist with accounting
process
1-15
Control:
Design appropriate control systems
Training:
In accounting
In accounting systems
Management Advice/Assistance:
Appropriate job descriptions for accounting (and other) personnel
Financing/cash flow management assistance
Organizational structure design
(Students likely will provide other examples as well, but this gives them an idea of the
broad expertise within public accounting firms.)
1-16
Chapter 2
The Auditors Report
Review Questions
2-1
Auditors reports are important to users of financial statements because they
inform users of the auditors opinion as to whether or not the statements are fairly stated
or whether no conclusion can be made with regard to the fairness of their presentation.
Users especially look for any deviation from the wording of the standard unqualified
report and the reasons and implications of such deviations.
2-2
An unqualified report may be issued under the following five circumstances:

1.
2.
3.
4.
5.
2-3
An audit engagement has been undertaken.

The general standard has been followed in all respects on the
engagement.
Sufficient appropriate evidence has been accumulated and the auditor has
conducted the engagement in a manner that enables him or her to
conclude that the three examination standards have been met.
The financial statements, which include the balance sheet, the income
statement, the statement of cash flow, and the notes to the financial
statements are fairly presented in accordance with an appropriate
disclosed basis of accounting, which usually is generally accepted
There are no circumstances which, in the opinion of the auditor, would
require the addition of an explanatory paragraph or modification of the
wording of the report.
The unqualified auditors report consists of:

1.
2.
3.
4.
Report title. Section 5400.07 requires that the report be titled Auditors
Report.
Audit report addressee. The report is usually addressed to the company,
its shareholders, or the board of directors.
Introductory paragraph. The first paragraph of the report does three
things: first, it makes the simple statement that the public accounting firm
has done an audit. Second, it lists the financial statements that were
audited, including the balance sheet dates and the accounting periods for
the income statement and cash flow statement. Third, it states that the
statements are the responsibility of management and that the auditors
responsibility is to express an opinion on the statements based on an
audit.
Scope paragraph. The scope paragraph is a factual statement about what
the auditor did in the audit. In it the auditor states that the audit was
2-1
5.
6.
7.
8.
planned and performed in accordance with professional standards and

that the auditor made judgments in applying those standards. The
remainder briefly describes important aspects of an audit.
Opinion paragraph. The final paragraph in the standard report states the
auditors conclusions based on the results of the audit examination.
Name of Public Accounting Firm. The name identifies the public
accounting firm or practitioner that has performed the audit.
Place of Issue. Section 5400.32 requires the place of issue be identified in
the letterhead or at the foot of the report.
Audit report date. The appropriate date for the report is the one on which
the auditor has completed the most important auditing procedures in the
field.
The same eight parts are found in a qualified report as in an unqualified. There are also
often one or more additional paragraphs explaining reasons for the qualifications.
2-4
The introductory paragraph has three purposes: first, to state that the public
accounting firm has done the audit; second, to list the financial statements that were
audited, including the balance sheet date and the accounting periods for the income
statement and the cash flow statement; third, to state that the financial statements are
the responsibility of management and that the auditors responsibility is to express an
opinion on the financial statements.
2-5
The purposes of the scope paragraph in the auditor's report are to inform the
financial statement users that the audit was conducted in accordance with Canadian
generally accepted auditing standards, in general terms what those standards mean,
and whether the audit provides a reasonable basis for an opinion.
The information in the scope paragraph includes:
1.
2.
3.
4.
The auditor followed Canadian generally accepted auditing standards.

The audit is designed to obtain reasonable assurance about whether the
statements are free of material misstatement.
Discussion of the audit evidence accumulated.
Statement that the auditor believes the evidence accumulated was
appropriate for the circumstances to express the opinion presented.
2-6
The purpose of the opinion paragraph is to state the auditor's conclusions based
upon the results of the audit evidence. The most important information in the opinion
paragraph includes:
1.
The words "in our opinion" which indicate that the conclusions are based
on professional judgment.
2-2
2.
3.
The words "in all material respects" which indicate there is a degree of
imprecision in the financial statements.
A statement about whether the financial statements were presented fairly
and in accordance with Canadian generally accepted accounting
principles.
2-7
An appropriate disclosed basis of accounting might include financial statements
prepared in accordance with regulatory legislation or with contractual requirements. The
term disclosed is self-explanatory; the reference in the opinion paragraph would be to
the basis of accounting followed and not to generally accepted accounting principles.
The basis may differ from GAAP in a number of ways. Its principal difference is that it is
determined by statute or contract. However, both are acceptable.
The "appropriate disclosed basis" is acceptable if the auditor, in his or her opinion,
believe it to be acceptable. There are no written criteria to determine its
appropriateness.
2-8
The auditor's report should be dated February 17, 2002 the date on which the
auditor had completed the field work. The auditor assumes responsibility for subsequent
events up to that date.
2-9 Changing the method of amortization from straight line to an accelerated method
is a change that affects the consistency of the financial statements. A separate
explanatory paragraph is required if the amounts are material.
A change in an estimate, such as a change in the estimated useful life of an amortizable
asset, affects the comparability of the financial statements. No explanatory paragraph
for lack of comparability is needed, but the information may require disclosure in the
statements.
2-10 A "contingency" is an unusual uncertainty affecting an entity in which the

outcome of the matter cannot be reasonably estimated at the time the statements are
issued. An example might be an outstanding lawsuit against the entity, a threat of
expropriation, a tax reassessment or a guarantee of the indebtedness of others.
If the auditor believes that the contingency is adequately described in the notes to the
financial statements or is immaterial, no mention is made of it in the auditor's report.
Appropriate disclosure is a description of the contingency including an assessment of its
potential impact on the financial statements.
2-3
2-11 A "going concern" consideration exists when there is some uncertainly about the
ability of the company to continue to operate.
Such a condition might exist when one or several of the following factors are present:
1.
2.
3.
4.
5.
6.
7.
8.
Recurring operating losses

Serious deficiencies in operating capital
An inability to obtain financing sufficient for continued operations
An inability to comply with terms of existing loan agreements
The possibility of an adverse outcome of one or more contingencies
Insufficient funds to meet liabilities
A plan to significantly curtail or liquidate operations
External factors that could force an otherwise solvent enterprise to cease
operations
Appropriate disclosure would be a note to the financial statements describing the going
concern condition including the reason for it and the possible outcome. If such a
disclosure were made, no mention of the going concern would be made in the auditor's
report.
2-12
The two conditions requiring a departure from an unqualified opinion are:

1.
The scope of the auditor's examination has been restricted. One example
is when the client will not permit the auditor to confirm material
receivables. Another example is when the engagement is not agreed upon
until after the end of the client's year end when it may be impossible to
physically observe inventories.
2.
The financial statements have not been prepared in accordance with

generally accepted accounting principles. An example is when the client
insists upon using replacement costs for permanent assets.
2-13 A qualified opinion states that there has been either a limitation on the scope of
the audit or a departure from GAAP in the financial statements, but that the auditor
believes that the overall financial statements are fairly presented. This type of opinion
may not be used if the auditor believes the scope limitation or exceptions being reported
upon are material and pervasive, in which case a denial or adverse opinion would be
used.
An adverse opinion states that the auditor believes the overall financial statements are
so materially misstated or misleading that they do not present fairly in accordance with
GAAP the financial position, results of operations, or cash flow statement.
2-4
A denial of opinion states that the auditor has been unable to satisfy him or herself as to
whether or not the overall financial statements are fairly presented because of a
significant limitation of the scope of the audit examination.
Examples of situations which are appropriate for each type of opinion which is qualified
are as follows:
Opinion Type
Denial
Adverse
Qualified
Example Situation
Material physical inventories not observed and the inventory,
which has a significant impact on the financial statements cannot
be verified through other procedures.
A highly material departure from GAAP which has rendered the
financial statements meaningless.
Inability to confirm the existence of an asset which is material in
value or a material departure from GAAP.
2-14 The common definition of materiality as it applies to accounting and, therefore, to

audit reporting is:
A misstatement in the financial statements can be considered material if knowledge of
the misstatement would affect a decision of a reasonable user of the statements.
The auditor's determination of materiality will be affected primarily by:
1.
2.
3.
2-15
The dollar amount of some measure compared to a base such as net

earnings, total assets, current assets, and working capital.
The measurability of the misstatement.
The nature of the item, the kind of misstatement.
The three levels of materiality are:
immaterial, that is, a readers decisions are unlikely to be affected by the

misstatement if the misstatement is immaterial,
material, that is, decisions are likely to be affected only if the information in
question is important to the specific decision being made. The overall
financial statements are considered to be fairly stated.
Material and pervasive, that is, most or all decisions which are based on the
financial statements are likely to be significantly affected.
A non-GAAP condition, for example, an inappropriate accounting treatment, an

inappropriate valuation, or the failure to disclose information, would require an
explanatory paragraph, between the scope paragraph and the opinion paragraph, to
state the nature of the deviation and its effect on the financial statements, including the
2-5
amount of the misstatement, if known. The extra paragraph is required whether the
opinion is qualified (a material misstatement), or adverse (a misstatement that is
material and pervasive). If the deviation is immaterial, then an unqualified opinion (and
no extra paragraph) is appropriate.
2-16
Whenever there is a scope restriction, the appropriate response is to issue an

unqualified report,
a qualification of scope and opinion, or
a denial of opinion
The determining factors are the level of materiality and pervasiveness involved. When
the auditor cannot perform procedures he or she considers desirable but can be
satisfied with alternative procedures that the information being verified is fairly stated,
an unqualified report is appropriate. If alternative procedures cannot be performed, a
scope qualification and, depending on the materiality and pervasiveness, either an
opinion qualification or a denial of opinion is necessary. A reservation paragraph would
describe the restriction.
The auditor's opinion may be qualified by scope limitations caused by client restrictions
or by limitations resulting from conditions beyond the client's control. The former occurs
when the client will not, for example, permit the auditor to confirm material receivables
or physically observe inventories or when the client imposes time or fee limitations that
preclude the auditor from performing certain tests. The latter may occur when the
engagement is not agreed upon until after the client's year end when it may not be
possible to physically observe inventories.
A denial of opinion is issued if the scope limitation is so material and pervasive that the
auditor cannot determine if the overall financial statements are fairly presented. If the
scope limitation is caused by the client's restriction the auditor should be aware that the
reason for the restriction may be to deceive the auditor. For that reason, a denial is
more likely for client restrictions than for conditions beyond anyone's control.
When there is a scope restriction that results in the failure to verify material, but not
pervasive accounts, a qualified opinion may be issued. This is more likely when the
scope limitation is for conditions beyond the client's control than for restrictions by the
client.
2-6
2-17
Memo to Jan de Boer

President, Munroe Corp.
re: financial statements not in accordance with
Generally Accepted Accounting Principles
Our audit opinion will be qualified or adverse depending on our determination of the
materiality of the failure to record amortization of the companys capital assets.
Munroes financial statements would not be in compliance with GAAP. (Specifically,
Section 5510.19 of the CICA Handbook).
Our audit opinion will clearly state the nature of the deviation from GAAP, and the
amount of the misstatement, to the extent that we can determine it.
2-18
1.
2.
If the primary auditor decides that an unqualified opinion is appropriate,

the name of the secondary auditor is not mentioned.
If the primary auditor decides that a qualified or denial of opinion is
appropriate, due to an inability to rely on the work of a secondary auditor,
the explanation of the qualification in the third paragraph could mention
the auditor's inability to rely on the secondary auditor in explaining the
reason for the qualification.

2-19
a.
(2)
b.
(2)
c.
(2)
2-20
a.
(4)
b.
(2)
c.
(3)
d.
(1)

2-21 a.
The opinion paragraph is not intended to be a certification or a guarantee
of the accuracy and correctness of the financial statements, but rather is intended to be
an expression of professional judgment based upon a reasonable examination of the
statements and underlying records.
b.
"Our audit was performed to detect material misstatements in the financial

statements" has two shortcomings. First, in addition to discovering errors, the
auditor also has responsibilities for discovering fraud and irregularities. Second,
and more important, the purpose of the audit is to determine whether financial
statements are fairly stated, not to specifically search for material errors and
irregularities.
2-7
"We conducted our audit in accordance with Canadian generally accepted

auditing standards" identifies the auditor's responsibilities for conduct of the
audit, accumulation of evidence and reporting requirements. It is a much broader
statement than the alternative clause. It also implies that if the auditor has
conducted the audit in accordance with generally accepted auditing standards
but does not uncover certain material errors or irregularities, the auditor is
unlikely to have responsibility for failing to do so.
c.
"correctly stated" implies absolute accuracy, whereas the alternative report states
that no material misstatement is likely.
d.
The reference to generally accepted accounting principles specifies rules which

were followed in accounting for the transactions to date; whereas "the true
economic conditions" does not identify the specific accounting procedures
applied to produce the financial statements.
e.
The name of the public accounting firm rather than that of the individual
practitioner should appear on the accountant's report since it is the entire firm
which accepts responsibility for the report issued.
2-22
a.
Items that need not be included in the auditor's report are:
1.
2.
That Excelsior is presenting comparative financial statements.

The description of the change in method of accounting for long-term
construction contracts need not be mentioned in the auditor's report since
it is discussed in the footnotes and was correctly accounted for
retroactively.
The fact that normal receivable confirmation procedures were not used
should not be disclosed since the auditor was able to satisfy him or herself
through alternate audit procedures.
The lawsuit need not be discussed in the report since it has been included
in a footnote.
3.
4.
b.
The following deficiencies are in Roscoe's report:

1.
2.
3.
The audit report is not dated. The audit report date should be the last day
of field work.
The balance sheet is as of a particular date, whereas the income
statement and the statement of retained earnings are for a period of time.
The introductory paragraph should identify the period of time (usually one
year) and state that the financial statements were audited. In addition, the
introductory paragraph should state the responsibilities of management
and of the auditor.
There is really no scope paragraph as described in Section 5400. The
second and third sentences in the first paragraph in the question
2-8
4.
5.
approximate the first two sentences in a scope paragraph except that the
first of the two sentences should state that the audit was conducted in
accordance with generally accepted auditing standards rather than
accounting standards and the second of the two sentences should state
"the financial statements are free of material misstatement." The latter two
sentences in the scope paragraph of Section 5400.26 which describe an
audit are omitted from Roscoe's auditor's report.
An additional paragraph should be included between the scope (second)
paragraph and the opinion (third) paragraph which describes the dividend
restrictions and the refusal of the client to present a statement of changes
in financial position.
The opinion paragraph states that accounting principles were consistent
with those used in the prior year. The opinion paragraph should make no
reference to consistency.
The opinion paragraph includes the words "generally accepted accounting standards"
rather than the correct phrase "generally accepted accounting principles."
The phrase "in all material respects" should follow the phrase "present fairly."
The opinion should be qualified rather than being unqualified.
Qualifications are caused by the:
a.
b.
failure to present a cash flow statement.

failure to disclose the dividend restrictions.
2-23 1.
Denial of opinion. Because the client refuses to allow the auditor to
expand the scope of his examination, a denial of opinion is appropriate rather than a
qualified as to scope and opinion.
2.
Denial of opinion. The auditor cannot issue an unqualified opinion on the income
statement or the statement of changes in financial position because a denial of
opinion is necessary for the beginning balance sheet.
3.
Unqualified opinion. The auditor is able to satisfy him or herself that with the use
of alternative procedures, a qualified opinion is not necessary.
4.
Qualified opinion or adverse opinion for failure to follow generally accepted

accounting principles. The materiality of twenty percent of net earnings before
taxes would be sufficient for many auditors to require an adverse opinion if there
are going concern issues.
2-9
5.
You probably should not issue any opinion but should consider resigning from
the engagement. It may be possible to reperform the audit with independent staff,
which would result in an unqualified opinion.
6.
Unqualified opinion. The company has made a decision to follow a different

financing method which is adequately disclosed. There is no change of
accounting principle
2-24
1.
2.
3.
4.
5.
(2). Opinion qualified only except for. MATERIAL. The standards requires
the use of a qualified opinion for the failure to include a statement of changes in
financial position.
(5). Adverse opinion. MATERIAL AND PERVASIVE. The question does not
seem to suggest that Jet Stream's footnotes disclose its precarious financial
position and so an adverse opinion for failure to adhere to GAAP is required. If
the students assume appropriate note disclosure then a clean opinion should be
given.
(1) Unqualified standard wording. SO MATERIAL. The name of the
secondary auditor can be mentioned only if the primary auditor believes that
there was a limitation in the scope of the audit and the limitation was caused by
the secondary auditor.
(3) Scope and Opinion qualified. MATERIAL. The client has restricted the
scope of the auditor and the auditor was not able to satisfy him or herself by
alternative procedure.
(1)
Unqualified standard wording. IMMATERIAL. There is no indication
questioning the ability of the business to continue operations. Disclosure of the
risky nature of the new direction is adequate.
Condition
1.
2.
3.
4.
5.
6.
Failure to follow GAAP

Substantial doubt as to Going Concern.
Report involving other auditors.
Scope of the auditor's examination has been restricted.
None.
None
2-10
2-25
CONDITION
1. Failure to
follow GAAP
MATERIALITY LEVEL
MATERIAL
2. Scope of
auditors examination
has been
restricted.
N/A
(1) Unqualified
standard wording
3. Failure to
follow GAAP
MATERIAL
(2) Qualified opinion

onlyexcept for
4. Failure to
follow GAAP
MATERIAL & PERVASIVE (5) Adverse
5. Scope of the
has been
restricted.
MATERIAL
(3) Qualified scope and

opinion, or
MATERIAL & PERVASIVE (4) Denial
6. Scope of the
has been
restricted.
MATERIAL & PERVASIVE (4) Denial
2-26
TYPE OF REPORT
(2) Qualified opinion
onlyexcept for
or
MATERIAL & PERVASIVE (5) Adverse
The Auditor's Report would be something like the following:

Auditor's Report
To the Shareholders of Kootenay Real Estate Holdings Limited

We have audited the consolidated balance sheet of Kootenay Real Estate Holdings Ltd.
as at December 31, 2001 and the consolidated statements of income, retained earnings
and cash flow of the year then ended. These financial statements are the responsibility
of the company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.
2-11
We conducted our audit in accordance with Canadian generally accepted auditing

standards. Those standards require that we plan and perform an audit to obtain
reasonable assurance 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.
As explained in Note 11 to consolidated financial statements the year end of Kootenay
(U.S.) Inc. a wholly-owned subsidiary is September 30, 2001 and its amounts are
consolidated as of that date. However, events have occurred since that date that we
believe will have a material effect on the continued viability of Kootenay (U.S.) Inc.
These events have not been reflected in the accompanying financial statements or
notes to those statements. Nor have we been able to determine the effect of these
events on the consolidated financial statements.
In our opinion, because of the fact that the company failed to record or disclose the
events described in the preceding paragraph, these financial statements do not present
fairly the financial position of the company as at December 31, 2001 and the results of
its operations and the changes in its financial position for the year then ended in
accordance with Canadian generally accepted accounting principles.
March 9, 2002
Public Accountants
2-27
a.
the memo might take the following form:
To:
From:
Date:
Re:
A. Partner
A. Senior
July 23, 2002
Saskatoon Building Products Ltd. audit
SBP's working capital rate has dropped below the 2:1 floor specified in its loan
agreement with Prairie Bank. Al Harmon the president of SBP, is proposing to reclassify
some Province of Saskatchewan bonds that are presently classified as long-term
investments, and some land, presently classified as a fixed asset, as current assets
because SBP plans to sell both in the coming year. The reclassification would make the
working capital ratio 2.2:1.
Technically, the bonds and land should be classified as current if the company plans to
sell them in the current year. I am not sure what the company's intent really is but will
include the matter in our letter of representation to be signed by Harmon.
As you know, SBP is a public company. Avril Chui, the manager of the Saskatoon
branch of the Prairie Bank, advised me that she understands SBP is having financial
2-12
difficulties and that she is "looking forward to receiving the statements." Relations
between our firm and SBP have not been cordial.
My concern is that the reclassification is cosmetic and that SBP does not plan to sell the
assets described above. The interest rate on the bond is 5% and they would have to be
sold at a substantial discount; the land will command a low price because of the
depressed real estate market. I believe that we should require SBP to disclose their
precarious financial position in a note to the financial statement; if they do we can give
them a clean opinion. If Harmon refuses to do so, I believe we will have to give an
adverse opinion based on non-compliance with GAAP.
b.
The auditor's report below assumes that SBP does not write the required note.
Auditor's Report
To the Shareholders of Saskatoon Building Products Limited

We have audited the balance sheet of Saskatoon Building Products Ltd. as at
December 31, 2002 and the statements of income, retained earnings and changes in
financial position for the year then ended. These financial statements are the
responsibility of the company's management. Our responsibility is to express an opinion
on these financial statements based on our audit.
We conducted our audit in accordance with Canadian generally accepted auditing
standards. Those standards require that we plan and perform an audit to obtain
reasonable assurance 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.
The accompanying financial statements, in our opinion, do not 'draw attention' explicitly
to doubts concerning the company's ability to realize its assets and discharge its
liabilities in the normal course of business. A condition of the company's loan in the
amount of $X from the Prairie Bank is that the working capital ratio not fall below 2:1;
failure to maintain that ratio will result in default on the loan. No arrangements have
been made to refinance should Prairie Bank call the loan.
In our opinion, except for the omission of the disclosure described in the preceding
paragraph, these financial statements do present fairly the financial position of the
company as at December 31, 2002 and the results of its operations and the changes in
its financial position for the year then ended in accordance with Canadian generally
accepted accounting principles.
Date
Public Accountants
2-13
2-28
a.
Situation 1
The auditor will likely be concerned that Xact Ltd. will not be a going concern because
of two problems:
1.
Operating losses in the past three years totaled $700,000.
2.
An inability to refinance the $500,000 debt will require classification of this

amount as a current liability.
If management discloses the situation adequately in the notes to the financial

statements, then the auditor would give an unqualified opinion.
If management did not disclose the situation adequately in the notes, the financial
statements would not be in compliance with GAAP and a qualified or adverse opinion
would be required.
Situation 2
It can be assumed that the value of the shares has been impaired by:
1.
Bird Ltd's continued losses of the last few years.
2.
The appraisal value ($150,000) and sales value ($135,000) indicate that
current fair value is less than cost.
As the company is willing to provide information in the notes, the alternatives available
to the auditor follow.
Qualification: The opinion paragraph should be qualified with an "except for" as follows:
"In our opinion, except for the valuation of the investment in Bird Ltd. as explained in
Note X to the financial statements..."
Reasons:
1.
It is current practice to write down the carrying value of long-term

investments when a permanent impairment in value takes place. Failure to
follow this practice would require qualification.
2.
The effect of the loss in value of shares is of a material nature. Thus,

failure to recognize the effect of the event in the statements prevents an
unqualified opinion.
2-14
Standard Auditor's Report: The standard auditor's report is an acceptable alternative,

and it is not necessary to deviate from it.
Reasons:
b.
1.
If the intention of the company is to hold the securities for a long period of
time, the present value may not be a permanent impairment in the life of
the company's investment.
2.
Where adequate and proper disclosure is provided on the financial

statements, there is no necessity to qualify an opinion.
Situation 1
Minimum note disclosure:

1.
A description of the debenture in question including, at a minimum, the

dollar value and the maturity date.
2.
The fact that this debenture is not to be renewed.
Additional note disclosure:

1.
2.
Management is seeking other financing possibilities to replace the

debenture but no acceptable alternative has yet been found.
The effect on the company if no suitable financing can be found. A
statement of the affairs would not be sufficient unless the assumption is
made that the company may have to liquidate (discontinue operations).
Situation 2
Minimum note disclosure:
1.
That the valuation as determined by recent appraisal differs from carrying
value (cost) must be disclosed. A simple disclosure of appraisal value
(cross-referenced to face of balance sheet) is considered adequate.
Additional note disclosure:
1.
Reasons for the decline in value may be reported, i.e. sale of the investee
company's shares by others, and continued losses of that company.
2.
Management's opinion with respect to the permanence of the decline in
value.
3.
Management's intention with respect to the period over which the shares
are to be held, i.e. temporary or long-term investment.
2-15
2-29
Deficiencies in the staff accountant's tentative report include the following:

1.
The report should be generally addressed to the board of directors or

shareholders, not to the audit committee.
2.
The introductory paragraph should state, "we have audited," not "we have
examined."
3.
No reference should be made to the secondary auditor.
4.
No reference should be made to the specialist Dr. Irwin Same.
5.
The second paragraph is an inappropriately worded scope paragraph. It

should be stated as follows:
We conducted our audit in accordance with Canadian generally accepted
auditing standards. 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 as significant estimates made by
management, as well as evaluating the overall financial statement
presentation.
6.
The cash flow statement was not identified in the opinion paragraph, and
financial statements were not referred to in the opinion paragraph as
"consolidated."
7.
There is no inclusion of the phrase, "in all material respects" in the opinion
paragraph.
8.
It needs to be specified that Canadian GAAP was used in the opinion

paragraph.
9.
There has been a change in generally accepted accounting principles. No

mention was made of whether or not the prior year's financial statements
were restated. If they weren't, then an "except for" qualification would be
required with a reference to Note 7. If they were restated then no mention
of the change in accounting principle is required. In either event, the fourth
paragraph (As fully discussed in Note 7 ... equipment manufactured by the
company) should be eliminated.
10.
Generally, the date of completion of the field work should be used as the
date of the auditor's report. Dual dating may be used when a subsequent
event disclosed in the financial statements occurs after the completion of
2-16
field work but before issuance of the report. Since the auditor's report is
dated March 1, 2002, the dual dating as of January 8, 2002 is
inappropriate.
Cases
2-30 The auditor's report on his examination of the financial statements of the Young
Manufacturing Corporation includes the following deficiencies:
1.
The auditor's report has no title. It should include a phrase such as

"auditor's report."
2.
The auditor's report is addressed to the president. It is usually more

appropriate to address it to the shareholders or board of directors.
3.
The date of the auditor's report should be the date of the completion of the
auditor's field work, not the balance sheet date.
4.
The report includes only two paragraphs. It should be three paragraphs if

it is standard wording, or more if there is a violation of GAAP, which there
is, or a scope limitation.
5.
There must be reference to the 2001 financial statements in the

introductory and opinion paragraphs.
6.
The auditor's report is deficient because the dates of the balance sheet
and the period covered by the income statement are not given. These
dates should be given so that the reader will clearly understand that the
opinion is limited to specific financial statements. Clarification as to the
statements covered by the opinion is imperative because comparative
financial statements are presented.
7.
The title "Balance Sheet" is used in the report, but "statement of condition"
is employed as the title of the financial statement. Different titles should
not be used because a criterion of professional work is that uniform and
accurate terminology be used.
8.
Although the auditor's report states that he or she examined the Statement
of Income and Retained Earnings, the attached financial statements do
not include the Retained Earnings statement. All financial statements
referred to in the auditor's report should be appended to the report.
9.
The difference of $66,481 between the opening and closing balances of

the Retained Earnings account is not reconcilable to the reported net
income for the year of $52,924. Because an amount of $13,557 in the
Retained Earnings account is not accounted for, the auditor's report
2-17
should contain at least a qualification on the grounds of inadequate

disclosure. If the auditor's examination disclosed that the $13,557 is a net
amount of charges and credits to the Retained Earnings account, some of
which bear directly upon the current year's income statement, the auditor
may be compelled to render an adverse opinion.
10.
There is no reference in the introductory paragraph to the responsibilities

of management and of the auditor.
11.
The mandatory standard scope paragraph is excluded in its entirety; there

is a vague reference to the old wording of the scope paragraph in the
opinion paragraph.
12.
Two items in the Statements of Condition, "Accounts receivable" and

"Inventories," are listed as "pledged," but no footnotes or comments
disclose the nature or extent of the commitments. The item "other
liabilities" probably represents the liability for which the assets serve as
security; its nature should be appropriately disclosed in the statements.
Also, the terms of the long-term mortgage should be disclosed. Therefore,
the auditor should disclose this information in a separate paragraph in the
report and his or her opinion should be appropriately qualified.
13.
The opinion paragraph should contain the phrase "in our opinion" to
clearly disclose that the statement as to fair presentation is a professional
opinion, not a statement of fact.
14.
A cash flow statement is not included in the financial statements of the

auditor's report's introductory paragraphs. A qualified opinion is required
when a cash flow statement is not included.
15.
There is no inclusion of the phrase "in all material respects" after the
phrase "presents fairly" in the opinion paragraph.
16.
There should be no reference to consistency in the opinion paragraph.
17.
The opinion paragraph should include no reference to what is done on the

audit. That should be in the scope paragraph (see 11 above).
18.
As stated above, the opinion paragraph should not be unqualified,

because of the missing statements of retained earnings and cash flow
statement and the omitted footnotes.
2-18
2-31
a) Audit report considerations:
1. Amortization
The retroactive amortization claim would need to be noted in the auditors report
The audit opinion would have to be qualified if the residual value could not be verified
and the adjustment to amortization was material.
2. Legal dispute
If the amounts were considered to be material, the report would have to be qualified
because of a disagreement on valuation.
The potential $250,000 payments would have to be disclosed in the notes to the
companys financial statements.
3. Research and Development Costs
The audit report would have to be qualified if CA was unable to determine that the costs
actually were development costs or that the proposed amortization period was
reasonable.
4. Computer Software costs
The audit report would have to be qualified because of the disagreement on valuation, if
the resulting difference was to be considered material.
5. Gain on building
If the presentation was not corrected, the audit report would have to be qualified for
failure to comply with GAAP.
6. Capitalized interest
If the amount was material the audit report would have to be qualified for failure to
comply with GAAP.
7. Related party transactions
If this transaction was not disclosed, the audit report would have to be qualified.
b) An example of an appropriate report would be:
In our audit report dated __________, we expressed a qualified opinion on the financial
statements for the year ended July 31, 2001 as the company had not recorded
amortization in accordance with generally accepted accounting principles. The
company has retroactively made the adjustments required to the financial statements
for the year ended July 31, 2001 to record the appropriate amount of amortization
expense and accumulated amortization. Accordingly the comparative financial
statements presented differ from the financial statements upon which our previous
years report is based.
2-19
In our opinion, these financial statements present fairly the financial position of the
company as at July 31, 2002 and the results of its operations and the changes in
financial position for the year then ended in accordance with Canadian generally
accepted accounting principles applied, after giving retroactive effect to the recording of
amortization, on a basis consistent with that of the previous year.
2-32
Audit report effect
There is a scope limitation due to the auditors inability to obtain documentation to
support the proposed selling price of $1,100,000. Because the effect of this scope
limitation does not render the financial statements useless, it would be inappropriate to
deny an opinion in this case. In addition the treatment of the loss as a prior period
adjustment and an extraordinary item is a departure from generally accepted accounting
principles.
Details of each qualification should be presented in a separate paragraph, with the
scope limitation immediately following the scope paragraph. The paragraph describing
the departure from generally accepted accounting principles may refer to the note to the
financial statements, which fully discloses the matter. Since, however the description of
the scope of the examination is the auditors responsibility, it is not appropriate that the
limitation in the scope of the auditors examination be explained in the note to the
financial statements.
2-20
Chapter 3
Professional Ethics
Review Questions
3-1
A code of professional ethics is needed for public accountants to gain public
confidence in the quality of the service provided, regardless of the individual providing it.
A public accountant's code of professional ethics should be similar to that of other
professions by prohibiting discreditable acts, and requiring that practitioners be
competent, that they follow specific technical standards, and that they recognize their
responsibility to clients. The major difference between professional groups such as
lawyers and dentists and public accountants is in independence. It is essential that
auditors be independent both in fact and appearance. In the case of lawyers and
dentists and most other professionals, the professional should be an advocate for the
client or patient.
3-2
Part
1. Principles of professional conduct
Purpose
1. Provide ideal standards of ethical
conduct. Characteristics that the
professional body deems desirable in
its member conduct.
2. Provide minimum standards of ethical
conduct as stated by specific,
enforceable rules.
3. Provide formal interpretations of the
rules of conduct to answer questions
that frequently arise about the rules of
conduct.
2. Rules of conduct
3. Interpretation of the rules of conduct*
* While many professional accounting bodies have established interpretations of their

rules of conduct over time, not all bodies have done so. The text focuses on the first two
parts above; it is up to the Instructor to determine what he or she wishes to do with
respect to interpretations.
3-3
Members or students should regard the rules of professional conduct as a floor
or minimum level of conduct and should strive to always conduct themselves at a higher
level of conduct. Any level of performance just slightly below the minimum is
substandard or unacceptable performance.
3-1
3-4
Independence in fact exists when the auditor is actually able to maintain an
unbiased attitude throughout the audit, whereas independence in appearance is
dependent on others' interpretation of this independence and hence their faith in the
auditor.
Activities which may not affect independence in fact, but which are likely to affect
independence in appearance are:
1.
2.
3.
4.
5.
Ownership of a financial interest in the audited client.

Directorship or officer of an audit client.
Performance of management advisory or bookkeeping or accounting
services and audits for the same company.
Dependence upon a client for a large percentage of audit fees.
Engagement of the public accountant and payment of audit fees by
management.
3-5
Independence in auditing means taking an unbiased viewpoint. Users of financial
statements would be unlikely to rely on the statements if they believed auditors were
biased in issuing audit opinions.
3-6
Facet
1)
Financial independence
2)
Independence of mental
attitude
3)
Investigative
independence
4)
Reporting independence
Purpose
Relates to having financial interest in the client (i.e. owning
stock in client, owing money to or being owed money by
client, etc.). Affects independence in appearance.
Relates to not allowing audit approach or evaluation to be
affected by long term friendship with client or belief that
management or employees are either honest or dishonest.
Affects both independence in fact and appearance.
Relates to having adequate time and resources (fee) to
obtain sufficient appropriate evidence and prevent scope
restriction. Affects independence in fact.
Relates to reporting at a sufficiently high level that the
report will be acted on (i.e. to audit committee). Affects
independence in fact.
3-7
A method to reduce the appearance of lack of independence is the use of an
audit committee made up of directors who are not a part of management to nominate
the auditors, set the audit fee and determine the scope of the audit with the auditors.
3-2
3-8
The rationale for the client permission requirement for divulging the public
accountant's working papers is that confidentiality is necessary to ensure that
relationships with clients are maintained, the client is not harmed and the client divulges
all pertinent audit information to the auditor. Client permission is not required if working
papers are subpoenaed by court order or are used as part of a practice inspection.
3-9
A breach of the rules of conduct by a member must be reported to their
profession's disciplinary body because the three professional bodies are self-regulating
and therefore, must police themselves.
Before making such a report, the reporter must first advise the member of the intent to
report them as there may be mitigating circumstances of which the reporting member is
unaware.
3-10 A public accounting firm has several options when it decides it is not competent
to perform an audit:
1.
2.
3.
4.
Withdraw from the engagement.

Obtain the expertise through continuing education and self studies.
Hire someone who has the expertise.
Work on a consulting basis with another public accounting firm.
3-11 Audits should be maintained at a high level of quality even if advertising and
tendering are allowed for several reasons:
1.
2.
3.
4.
Professionals do high-quality work because it is a characteristic of being a

professional.
A reputation of doing high-quality work usually pays off in more clients and
a more profitable practice.
Potential legal liability is also a deterrent to substandard work.
The rules of professional conduct require a high quality of performance.
3-12 The rules of conduct ban contingency fees because contingency fees impair the
auditor's independence in fact and appearance. If the auditor's fee was contingent on
the client earning a certain profit, the auditor might be willing to permit the issuing of
misstated financial statements so that the desired profit (and fee) would result.
3-13 Successor auditors must communicate with the incumbent before accepting
appointment as the auditor to inquire if there are any circumstances of which the
incumbent is aware that might preclude the successor from accepting the appointment.
3-3
This protects the prospective successors, and thus the profession, from getting involved
with undesirable clients.
If the incumbent does not reply, the successor should be reluctant to accept the
engagement.
A non-reply is a violation of the rules of conduct, and should be reported to the
appropriate professional body after informing the firm in writing that you will do so.

3-14
a.
(1)
b.
(3)
3-15
a.
(3)
b.
(2)

3-16 Independence of mental attitude requires the auditor be unbiased in regards to
evidence obtained in the audit. The danger exists that Trish Mulcahy may be biased in
favour of the client she will believe the client even where evidence seems to point in
the other direction. Even if Trish remains completely unbiased, independence in
appearance may be impaired. Therefore, using another junior on the audit would be
appropriate.
3-17 a. Likely not in violation. Implication that ownership by staff members (other than
partners) not involved in the audit is acceptable. However, many firms have their own
rules on independence which frequently are more stringent than those of the
professional bodies.
b.
Violation. Phyllis Allen is associating herself with information that she believes is
false or at least questionable. She should not have completed the return.
c.
Violation. Tanabe is implying by accepting the engagement, that she has the
necessary competence; the client does not know that the computer consultant is
not a member of Tanabe's firm or that Tanabe does not have the competence to
review the consultant's work. As well, Tanabe is not maintaining the reputation of
the profession, she is not performing with integrity nor is she keeping herself
informed of developments in functions in which she is relied upon because of her
profession.
Tanabe must obtain from the consultant a written agreement that he will preserve the
confidentiality of any information provided by the client to the consultant.
3-4
d.
Violation. The client should have been notified that the review was to take place,
and an attempt made to obtain the client's permission for such review because
the review was not a part of a professional practice review program. The firms
violated the rule by not obtaining consent from the client for the review. If they
want to do this regularly, they should place a clause in their engagement letter
whereby consent is given in the event that this client is selected for working
paper review.
e.
No violation. Thurgood may be charged with professional misconduct by the

professional conduct committee. However, the rule is vague; the offense does
not relate to his professional conduct. Since it is a criminal offence, the only
obligation is to report the conviction to the professional association of which the
accountant is a member.
f.
Violation. Appearance of independence has been impaired by Bill Wendal's

agency's financial dealing with his audit clients and participation in a business
which impairs his objectivity. It is also a conflict of duties to recommend his own
firm to review the adequacy of the existing insurance coverage of existing clients.
It is a violation of confidentiality to pass information to Renate Joans.
g.
No violation of any rule as long as Rankin remains objective.
3-18 a.
No violation as long as Danielli does not perform or give advice on
management functions of the organization.
b.
No violation. The rental of block time on the public accounting firms' computers to
clients is permitted. However, the sale of block time constitutes a business rather
than a professional relationship and must be considered together with all other
relationships to determine the effect on member's independence.
c.
Violation. A public accountant is not permitted to pay a commission to obtain a

client to anyone other than another practicing public accountant. This rule is
intended to discourage obtaining clients on the basis of a commission to an
advisor, rather than on the basis of the quality of the services or fee to the client.
d.
No violation. Allowed provided Barnes does not offer superior skills or make
promises which she can not to keep. Advertising is allowed provided it is not
false, misleading or deceptive.
e.
No violation. This is normal practice and is done as a part of almost all audits.
f.
No violation. The only questionable part of the information is the statement by the
tax article that Gutowski is a tax expert. It may be difficult for Gutowski to
demonstrate that he is in fact an expert, but he is no longer precluded from
making such a statement.
3-5
g.
Violation. The public accountant should keep confidential any information

obtained from the client; there does not seem to be a difference between audit,
tax and management services-related working papers.
3-19 a.
An audit committee is a special committee formed by the board of
directors and made up of board members. It is ideally a group of outside directors who
have no active day-to-day operations role and who are a liaison between the
independent auditor and the board of directors. The audit committee assists and
advises the full board of directors, and, as such, aids the board in fulfilling its
responsibility for public financial reporting.
b.
The functions of an audit committee may include the following:

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
Select the independent auditor; discuss audit fee with the auditor; review
auditor's engagement letter.
Review the independent auditor's overall audit plan (scope, purpose, and
general audit procedure).
Review the annual financial statements before submission to the full board
of directors for approval.
Review the results of the auditor's examination including experiences,
restrictions, cooperation received, findings, and recommendations.
Consider matters that the auditor believes should be brought to the
attention of the directors or shareholders.
Review the independent auditor's evaluation of the company's internal
control structure.
Review the company's accounting, financial, and operating controls.
Review the reports of internal audit staff.
Review interim financial reports to shareholders before they are approved
by the board of directors.
Review company policies concerning political contributions, conflicts of
interest, and compliance with federal, provincial, and local laws and
regulations, and investigate compliance with those policies.
Review financial statements that are part of prospectuses or offering
circulars; review reports before they are submitted to regulatory agencies.
Review independent auditor's observations of financial and accounting
personnel.
Participate in the selection and establishment of accounting policies;
review the accounting for specific items or transactions as well as
alternative treatments and their effects.
Review the impact of new or proposed pronouncements by the accounting
profession or regulatory bodies.
Review the company's insurance program.
Review and discuss the independent auditor's management letter.
3-6
c.
Management is frequently under considerable pressure from shareholders and

the board of directors to maintain high earnings for the company. In some cases
this may in turn motivate management to put pressure on auditors to permit a
violation of accounting principles and therefore affect the reported earnings and
disclosures in the financial statements. The board of directors has a greater
responsibility to the shareholders for fairness in reported earnings. Directors,
especially those who are outside directors, have less responsibility for high
reported earnings.
They are also, therefore, less likely to put pressure on auditors to deviate from
high professional standards. The audit committee can therefore deal with the
auditor in a less biased manner than can management. In addition, the board of
directors has a legal responsibility to review the policies and actions of
management; thus, there is considerable incentive for them to work closely with
the auditor. A small committee of outside directors from the audit committee are
therefore equipped to help the auditor to maintain a more independent
relationship with the client. If management exerts any pressure on the auditor,
the auditor is likely to discuss that with the audit committee and thereby resolve
the problem. The criticism of audit committees has been made by many smaller
public accounting firms. There may be some validity to the comment. At the
same time audit committees do have a responsibility to help a company control
costs. Therefore if the cost of a smaller audit firm is significantly less than a large
firm, assuming equal quality, the audit committee would be obligated to use the
less expensive firm.
d.
To make the audit committee more effective, she could expand their role to
include functions other than just the minimum requirement of reviewing the
financial statements (for example, those listed in part b. above). However, the
increased quality of financial reporting which results from this increased
involvement must be offset against the related increase in time and costs.
3-20 Harris is caught between two rules. One requires disclosure of material facts
known by the member i.e. that Master Furniture is not likely to realize its substantial
receivable from Fine Deal and so its receivables are significantly overstated. The
second requires Harris to maintain the confidentiality of the information gained as
auditor of Fine Deal. This situation is not uncommon in smaller centres where the same
public accounting firm may do the audit for a number of companies which have
business dealings with each other.
Harris should first ask Fine Deal to disclose their financial condition to Master Furniture
so that the latter can value their accounts receivable. Perhaps, Fine Deal could be
persuaded to issue their financial statements with an appropriate note.
Harris knows that the bank is about to make a sizable bank loan to Master Furniture
based on the financial statements on which he is presently working; if the financial
3-7
statements do not include some warning about the collectibility of the material
receivable from Fine Deal, they will be misleading. Should Master Furniture get into
financial difficulties, the bank would probably look to Harris for damages. Harris also
knows that Master Furniture is in a hurry for their statements and that she will have
some trouble delaying their issue. Accordingly, Harris' second choice is to resign from
the Master Furniture audit he cannot, in good conscience, issue their statements
without a note about the probable bad receivable from Fine Deal. However, if she does
attempt to resign, Master Furniture will probably be quite upset.
You might ask the students which rule they believe should take precedence
confidentiality or full and fair disclosure. There is no easy answer, since one rule cannot
take precedence over the other.
3-21 The rules of professional conduct and interpretations are not clear as to what
constitutes a violation in these three situations. A central point is that Marie Janes must
maintain independence in fact and appearance because she is not an employee of the
company and must not permit the impression that she is one.
Rules of Conduct Violated?
1. Marie Janes has likely not
violated the rules; the discount
is available to customers on a
widespread basis. Presumably
many of the employees of the
public accounting firm buy
automobiles from the agency.
Appropriate Action?
1. Marie Janes should discuss the discount with
the firm's management partner if she intends or
wants to buy the automobile. She should
certainly not feel compelled to buy the
automobile but she should also not
automatically turn it down. The situation would
be entirely different if the sale were limited to
employees. In such a case it would likely be a
violation.
2. If Marie Janes were to eat there 2. Marie Janes should eat elsewhere if it is
on an ongoing basis that would
practical to do so but if the only practical place
likely be a violation of the rules
for her to eat is the lunchroom, she should
of conduct. It would not likely be
make arrangements with her firm to make
a violation if she occasionally
certain that the company is reimbursed for the
eats with employees she is
expenses.
dealing with at the audit.
3. Accepting such a gift is likely to 3. Ideally Janes should not accept the gift and
be a violation of the rules of
state that since she is not an employee, she
conduct. That gift is reasonably
would prefer not to take it. If she believes that it
large and would be considered
would be embarrassing to the company, she
by many employees as
should graciously accept it and return it with an
equivalent to a bonus.
explanation of her reasons as soon as
practical.
3-8
3-22 The answers to some of these questions are more judgmental than most others
in the chapter. They may, in some cases, be a violation of the spirit of the code if the
public accountant is acting in a particular manner, and they may not be a violation if the
public accountant is acting in a different manner. For example in 4, if Gustafson is
sending business executives in small companies to his small loan company, there's
likely to be a violation of the rule of conduct. On the other hand if he recommends the
small loan company along with several others, only for those clients who truly need the
services of a small loan company, he is not likely to be in violation, assuming the loans
are immaterial to his financial situation.. (Changing the facts throughout the discussion
may increase the value of the case.)
1.
This would not be a violation of the rules of conduct or interpretations. It is

common and acceptable for a partner in a public accounting firm to invest
in a limited partnership as an investment opportunity. It is possible that a
partner could be a limited partner with a client. In many cases the limited
partners do not know of the other investors in the limited partnership. If the
public accountant and owner of Rodrigues Marine Ltd. either earn or lose
significant sums in the investment, it should have no effect on their
relationship or on the audit of Rodrigues Marine Ltd.
2.
Since the contingent fee is not associated with an assurance engagement,

it is acceptable. There is no violation.
3.
Advertising is permitted provided the activities are not false, misleading, or

deceptive. It is not acceptable to make comparison of public accounting
firms, unless they're based upon verifiable facts. The information in the
advertisement expressly states two facts: 14 of 36 of the largest drug
stores are audited by her firm and second, the average audit fee, as a
percentage of total assets, is lower than any of the other public accounting
firms in the city. Contel must be able to support those factual statements.
If she cannot there is a violation.
4.
The only rule relating to this practice is that regarding objectivity.

Restrictions in preventing a public accountant from concurrently engaging
in a business or occupation which would create a conflict of interest in
rendering professional services. Gustafson spends almost no time in the
business and none of his employees are involved. There may still be a
violation, however, if Gustafson or his employees consistently send clients
of Gustafson to the small loan company and/or encourage them to make
loans from such company. Assuming that he does not do that, there is no
violation, also assuming that any client loans are immaterial to
Gustafsons financial situation.
5.
There may well be a material indirect interest in an audit client as a result

of this most recent purchase by the mutual fund. Elbert owns a material
amount of stock and if the mutual fund in turn invests a large portion of its
3-9
money in an audit client of Elbert, Elbert in essence has a material

investment in an audit client.
Simply because the mutual fund's investment has increased dramatically
in the audit client does not mean there is a material investment, however.
It may for example have increased from one percent to three percent of
the total holdings of the mutual company. Nevertheless Elbert must
evaluate whether the holding could be a material indirect investment, in
which case it would be a violation.
CASES
3-23 Generally the rules of conduct of CAs and CGAs require their members to
practice public accounting (that is perform audits) using the sole proprietor or
partnership form of organization. In addition, sole proprietors must use his/her own
name in the firm name and not a name such as Financial Services, Inc. The name
should indicate the firm is a firm of chartered accountants, certified general accountants
or public accountants if the partners are CAs or CGAs.
The failure to issue a qualified or adverse opinion for the client's failure to disclose the
existence of and terms of the lien against assets is a violation. Adequate footnotes are
an integral part of the financial statements and a pledging of an asset of the nature
described requires disclosure.
Gilbert was associated with false and misleading financial information. Also, disclosing
the lien directly to the insurance company and to Bradley was a violation of
confidentiality.
3-24 a.
It's an ethical dilemma for Barbara because she has a decision to make
about what behavior is appropriate. If she throws the schedules away, as suggested by
her supervisor, she may not be carrying out her professional responsibility to the public
or the client. If she does not throw the schedules away, she will likely cause a
confrontation between herself and her supervisor.
b.
1.
2.
3.
Obtain relevant facts: A number of errors were discovered. The aggregate

of all discovered and undiscovered errors may be material. The audit
supervisor wants Barbara to throw away some of her work.
Ethical issues: Is it ethical to throw away the schedules containing some
small errors when her supervisor instructs her to do so?
Who is affected and how?
3-10
Who is Affected?
Barbara
How?
1.
Being asked to ignore errors is a possible
violation.
2.
Performance evaluation may be affected.
3.
Future with the firm may be affected.
Jack
Green, Thresher & Co.
1.
2.
1.
2.
3.
Delancey Fabrics
1.
2.
4.
Alternatives
a.
b.
c.
d.
e.
5.
Future with the firm may be affected.

Performance evaluation may be affected
If audit is completed late, they may lose the
engagement.
May be sued if material errors are not
detected.
Client may be unhappy with auditor if errors
are subsequently discovered.
May not have opportunity to correct errors if
they are not brought to light.
May be required to adjust financial
statements if errors exist.
Throw away schedules.

Inform Jack that she will not throw schedules away.
Talk to manager or partner about Jack's request.
Refuse to work on the engagement.
Quit the firm.
Consequences
b.
The errors may be discovered subsequently and the firm may lose the
client, or be sued. Even if the errors are not material, the client may be
justifiably upset because the problems giving rise to the error may have
been solved sooner.
c.
Barbara informs Jack that she won't throw away schedules. This may
result in a confrontation. She may get an unfavorable review.
d.
If she talks to the manager or partner, they may admire Barbara's attempt
to be ethical, or they may think she is out of line for bypassing Jack's
authority without thoroughly discussing the matter with him in detail.
e.
If she refuses to continue on the engagement, it will not look good on

Barbara's record. She may be labeled as "hard to get along with."
3-11
f.
6.
If she quits, she will likely miss out on some potentially valuable
experiences in public accounting.
Appropriate Action
Only Barbara can decide. One reasonable approach is for Barbara to start by
discussing the matter further with Jack. She should listen carefully to his
reasoning and express her reservations about throwing the schedules away. She
should not subordinate her judgment to Jack, as this would be a violation. If Jack
satisfies her that it is acceptable to throw the schedules away (this seems
unlikely in the circumstances), then she may be justified in doing so. However, if
she still has reservations, she should inform Jack that she intends to contact a
manager or partner.
3-25 This question seems to focus on Giles Nadeau and his problems; students may
see him as the problem and ignore Bob Smith's role. The case lends itself to discussion
also of the dangers of living beyond your means in an attempt to build or maintain an
"image."
The case also illustrates how one can be "sucked in" to a problem that grows and
grows. Giles' problem is small at first but then as he gets more involved, he finds he
can't seem to extricate himself he is trapped.
Another question that might be asked is whether it was appropriate for Giles to take
over the audit of XYZ Securities. Did he have or was he able to acquire the necessary
expertise?
1.
Practitioners voluntarily agree to abide by the rules of professional

conduct for their respective accounting organization as they enter public
practice. It is imperative that individuals at least comply with the minimum
standards specified by their particular code of professional conduct,
despite pressures one may face. Concealing a known material
misstatement in a client's financial statements is clearly a violation of a
practitioner's responsibility to society.
2.
Bob Smith in essence condoned Oakes' behavior by doing nothing. His

inaction is worthy of sanction. He is also in violation and became an
accomplice.
3.
At a minimum, practitioners must draw the line by complying with their

professional body's codified rules of conduct. Violations of the rules are
not acceptable. Hopefully, most practitioners strive to uphold the ethical
principles specified in their rules of professional conduct.
3-12
Chapter 4
Legal Liability
Review Questions
4-1
Several factors that have changed the legal environment in which public
accountants in Canada operate are:
1.
2.
3.
4.
5.
6.
The growing awareness of the responsibilities of public accountants on the

part of users of financial statements.
An increased consciousness on the part of the various securities
commissions regarding their responsibility for protecting investors'
interests.
The greater complexities of auditing and accountancy due to the
increasing size of businesses, the existence of the computer, and the
intricacies of business operations.
Society's increasing acceptance of lawsuits.
The willingness of public accounting firms to settle their legal problems out
of court.
The many alternative accounting principles from which clients can elect to
present their financial statements, and the lack of clear-cut criteria for the
auditor to evaluate whether the proper alternative was selected.
4-2
Business risk, in this context, is the risk that a business will fail financially and, as
a result, will be unable to pay its financial obligations. Audit risk is the risk that the
auditor will conclude that the financial statements are fairly stated and an unqualified
opinion can therefore be issued when, in fact, they are materially misstated.
When there has been a business failure, but not an audit failure, it is common for
statement users to claim there was an audit failure, even if the most recently issued
audited financial statements were fairly stated. Many auditors evaluate the business risk
in an engagement in determining the appropriate audit risk.
4-3
The prudent person concept states that a person is responsible for conducting a
job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected
to conduct an audit using due care, but does not claim to be a guarantor or insurer of
financial statements.
4-4
A partner in a public accounting firm is liable for errors in the work of (the
question asks for two):
4-1
1.
Employees of the firm. The employees are agents of the partner who is a
principal in law and therefore liable for the acts of his or her agents.
2.
Fellow partners in the firm even if they work in an office that is

geographically separate. Partners are jointly and severally liable for the
acts of the other partners in the partnership.
3.
Other auditing firms (Section 6930) or specialists (Section 5360 and 5365)
such as actuaries on whom the partner relies in obtaining sufficient
appropriate audit evidence to arrive at his or her opinion on the financial
statements. Dupuis v. Pan American Mines is an example; Thorne were
liable for negligence by Seidman & Seidman on whom they relied.
4-5
A criminal action is one brought under the provisions of criminal statute law such
as the Criminal Code of Canada. An example might be theft of inventory from the audit
client; the individual committing the theft would be prosecuted by the Crown under the
appropriate section of the Criminal Code. A civil action is one brought by one individual
(or company, etc.) against another because the former believes that the latter has
wronged him or her. An example might be where an individual believes that another
individual has breached a contract between the two and brings an action to have the
contract completed or for damages.
4-6
The auditor is responsible for conducting an audit in accordance with generally
accepted auditing standards. The auditor's responsibility for detecting defalcations is
dependent on whether an audit done in accordance with GAAS would have detected
such a defalcation. Section 5400.01 states that the auditor's report when performing an
audit provides an opinion on the financial statements. Section 5200.06 states that
among management's responsibilities is "preventing and detecting error and fraud." This
position is supported by the courts in International Laboratories Limited v. Dewar et al.
Section 5135.14 states "The auditor may encounter circumstances which make him or
her suspect the financial statements are materially misstated. In that event, the auditor
should perform procedures to confirm or dispel that suspicion." Section 5135.15 states
that GAAS require the auditor to design tests and procedures to reduce the risk of not
detecting a material error or fraud in the accounts to an appropriately low level.
4-7
Contributory negligence used in legal liability of auditors is a defense used by the
auditor when he or she claims the client or user also had a responsibility in the legal
case.
An example is the claim by the auditor that management knew of the potential for fraud
because of weaknesses in internal control but refused to correct them. The auditor
thereby claims that the client contributed to the fraud by not correcting material
weaknesses of internal control. Kane Agencies v. Coopers & Lybrand is an example.
4-2
4-8
In recent years the auditor's liability to a third party has become affected by
whether the party is known or unknown. A known third party, under common law (for
example, Haig v. Bamford and Toromont v. Thorne, usually has similar rights as a party
that is privy to the contract. Caparo and related cases such as Dixon v. Deacon,
Morgan, McEwan, Easson et al. is an example of that.
It presently seems as if auditors may be liable for negligence to shareholders at the time
the financial statements are issued; there does not appear to be a similar liability to third
parties who rely on the financial statements to make decisions (for example, the limited
class who will rely on the financial statements in Haig v. Bamford) after they have been
issued.
4-9
The auditor's legal liability to the client can result from the auditor's failure to
properly fulfill his or her contract for services. The lawsuit can be for breach of contract,
which is a claim that the contract was not performed in the manner agreed upon, or it
can be a tort action for negligence. An example would be the client's detection of an
error in the financial statements, which would have been discovered if the auditor had
performed all audit procedures required in the circumstances (e.g., misstatement of
inventory account resulting from an inaccurate physical inventory not properly observed
by the auditor).
The auditor's liability to third parties under common law results from any loss incurred
by the claimant due to reliance upon misleading financial statements. An example would
be a bank which has loans outstanding to an audited company. If the audit report did
not disclose that the company had contingent liabilities which subsequently became real
liabilities and forced the company into bankruptcy, the bank would proceed with legal
action against the auditors for the material omission.
Criminal liability of the auditor may result from federal or provincial laws if the auditor
defrauds another person through knowingly being involved with false financial
statements. An example of an act which could result in criminal liability would be an
auditor's providing a standard audit opinion on financial statements which he or she
knows overstate income for the year and the financial position of the company at the
audit date.
4-10 Some of the ways in which the profession can positively respond and reduce
liability in auditing are:
1.
2.
Continued research in auditing.

Standards must be revised to meet the changed need of auditing.
4-3
3.
4.
5.
6.
7.
The CICA through the Auditing Standards Board can establish

requirements that the better practitioners always follow in an effort to
increase the overall quality of auditing.
Establish practice inspection requirements.
Public accounting firms should defend unjustified lawsuits rather than
settling out of court.
Users of financial statements need to be better educated regarding the
attest function.
Improper conduct and performance by members must be sanctioned.
4-11 Some of the ways in which an individual public accountant can positively respond
and reduce liability in auditing are:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Deal only with clients possessing integrity.

Hire qualified personnel and train and supervise them properly.
Follow the standards of the profession.
Maintain independence.
Understand the client's business.
Perform quality audits.
Document the work properly.
Obtain an engagement letter and a letter of representation.
Maintain confidential relations.
Carry adequate insurance.
Seek legal counsel.

4-12
4-13
a.
a.
(1)
(3)
b.
b.
(3)
(2)
c.
(4)

4-14 The president of Mountain told Frost that the Bank of Trail was prepared to
increase their loan to Mountain based on the financial statements for the year ended
December 31, 2001. Therefor while the Bank of Trail was not in privity, they were a
member of a limited class of users of which the auditor had actual knowledge at the
time of the audit.
Insofar as the actual negligence by Frost, and thus Helmut & Co., is concerned, the
matter is not clear-cut. Frost, although experienced, is new to Helmut & Co., who did not
seem to provide much supervision. Frost was assisted by two juniors who were also
probably not too familiar with Helmut & Co.'s practices. Mountain was a new client to
Helmut & Co. so Frost would not have the prior year's working papers to rely on.
4-4
In addition, Frost gave the two juniors the most important parts of the financial
statements (for this client at least) and he does not seem to have done much
supervision. The question says that Helmut provided a "cursory review." Mountain was
in a hurry to get the statements and Helmut seems to have obliged the client.
Independence can be affected by time pressures (i.e. inadequate time); that seems to
have been the case in this audit.
In summary, Helmut & Co. seems to owe a duty of care to the Bank of Trail and both
Helmut & Co. and Frost seem to have been negligent the liability would be that of
Helmut & Co. since they were the principal. There seems to be no doubt that the Bank
of Trail relied on the financial statements to make their decision, and therefore it is
probably that the Bank of Trail would succeed.
4-15 a.
Brown, Cosden and Co. should use the defenses of meeting generally
accepted auditing standards and contributory negligence. The fraud perpetuated by
Joslin Supply Inc. was a reasonably complex one and difficult to uncover except by the
procedures suggested by Cosden.
In most circumstances it would not be necessary to physically count all inventory
at different locations on the same day. Furthermore the president of the company
contributed to the failure of finding the irregularity by refusing to follow Cosden's
suggestion. There is evidence of that through his signed statement.
b.
There are two defenses Brown, Cosden and Co. should use in a suit by
Maritimes Eastern Bank. First there is a lack of privity of contract. Even though
this was a known third party, it does not necessarily mean that there is any duty
to that party in this situation. That defense is unlikely to be successful in most
jurisdictions today.
The second defense which Cosden is more likely to be successful with is that the
firm followed generally accepted auditing standards in the audit of inventory,
including the employment of due care. Ordinarily it is unreasonable to expect a
public accounting firm to find such an unusual problem in the course of an
ordinary audit. Because the public accounting firm did not uncover the fraud does
not mean it has responsibility for it.
c.
The firm is likely to be successful in their defense against the client because of
the contributory negligence. The company has responsibility for instituting
adequate internal control. The president's statement that it was impractical to
count all inventory on the same day because of personnel shortages and
customer preferences puts considerable burden on the company for its own loss.
4-5
It is also unlikely that Maritimes Eastern Bank will be successful in a suit. The
court is likely to conclude that Cosden followed due care in the performance of
her work. The fact that there was not a count of all inventory on the same date is
unlikely to be sufficient for a successful suit.
Note: Caparo and related cases in the U.K. and Canada may have some impact
here in determining whether or not Brown, Cosden & Co. owed a duty of care to
Maritimes Eastern Bank. Failing that defense, but it is fairly clear that Brown,
Cosden & Co. followed GAAS in conducting the audit and was not negligent.
d.
The issues and outcomes should be essentially the same whether Joslin Supply
Inc. is a public company or a private company.
4-16 Yes. Normally a public accounting firm will not be liable to third parties with whom
it has neither dealt with nor for whose benefit its work was performed. One notable
exception to this rule is fraud. When the financial statements were fraudulently
prepared, liability runs to all third parties who relied upon the false information contained
in them. Fraud can be either actual or constructive. Here, there was no actual fraud on
the part of Small or the firm in that there was no deliberate falsehood made with the
requisite intent to deceive.
However, it would appear that constructive fraud may be present. Constructive fraud is
found where the auditor's performance is found to be grossly negligent. That is, the
auditor really had either no basis or so flimsy a basis for his or her opinion that he or
she has manifested a reckless disregard for the truth. Small's disregard for standard
auditing procedures would seem to indicate such gross negligence and, therefore, the
firm is liable to third parties who relied on the financial statements and suffered a loss as
a result.
4-17 The accounting firm, Spark, Watt, and Wilcox, is potentially liable to its client
because of the possible negligence of its agent, the in-charge accountant on the audit,
in carrying out duties that were within the scope of his employment. Should there be a
finding of negligence, liability would be limited to those losses that would have been
avoided had reasonable care been exercised. Since all but $20,000 was recovered, the
liability would likely be limited to $20,000 plus costs.
There being no evidence of the assumption of a greater responsibility, the in-charge
accountant's conduct is governed by the usual standard; i.e., that the accountant
perform his duties with the profession's standards of conduct prevailing. The question
arises as to whether the duty of reasonable care was breached when the in-charge
accountant failed to make further investigation after being apprised by a competent
subordinate of exceptions to six percent of the vouchers payable examined. Moreover,
a question of causation arises; i.e., whether further actions by the in-charge accountant
4-6
would have disclosed the fraud. If both lack of due care and causation are established,
recovery for negligence will be available.
4-18 a.
The legal issues involved in this case revolve around the auditor's
compliance with generally accepted auditing standards and contributory negligence.
Section 5303.28 of the CICA Handbook states that accounts receivable be confirmed by
the auditor except under specific circumstances. This procedure was employed in the
case, and the legal issue is whether or not the auditor used due care in following up the
confirmation replies received.
As a defense in the lawsuit, the auditor would claim to have followed generally
accepted auditing standards by properly confirming accounts receivable. In
addition, the auditor may defend him or herself by testifying that the company
controller was responsible for investigating the reason for the differences
reported on the confirmation replies. The auditor may state that he or she had a
right to conclude that the controller had reviewed the explanations provided by
the bookkeeper, and concluded they were correct. The auditor might also use the
defense that there was contributory negligence. The controller should not have
delegated the work to the bookkeeper and should have recognized the potential
for intentional wrong-doing by the bookkeeper.
b.
The public accountant's deficiency in conducting the audit of accounts receivable

was his or her failure to investigate and obtain evidence to substantiate the
explanations provided by the bookkeeper. The auditor should have investigated
each of the timing differences, through which he or she may have discovered that
no sales allowance had been granted to the customer, but in fact, the customer
had mailed payment for the merchandise which the bookkeeper had stolen.
4-19 Baerg & Vetzel would probably use International Laboratories v. Dewar et al. as
their defense. Management has the principal responsibility for the prevention and
detection of fraud. The case does not mention engagement letters or management
letters but they both might be evidence to support Baerg & Vetzel's case. This would be
especially true if they had written a letter to South-western Development pointing out
weaknesses in internal control flowing from the decentralized management Southwestern uses.
Baerg & Vetzel's strongest defense would be that they had exercised due care in
performing the audit and that they had adhered to generally accepted auditing
standards. The fact that Jasper & Co. later found fraud should not significantly affect the
case in as much as they were specifically engaged to determine the existence of fraud,
not to do an ordinary audit.
Baerg & Vetzel are likely to have to demonstrate that the audit was adequately planned
and sufficient appropriate audit evidence was accumulated and properly evaluated. For
4-7
example, the case states that the managers who were defrauding the company
negotiated lower than normal rents in return for the kickbacks. It is possible that
analytical procedures or other audit tests might have revealed that some rents were
abnormally low. The auditor may have to prove that such procedures were not
necessary in the circumstances or would not have uncovered the fraud. Similarly, the
decentralization of lease negotiation may also be cited by the plaintiff that internal
control was inadequate and additional testing was necessary and would have
uncovered the fraud. Baerg & Vetzel may have to prove that the understanding of
internal control they obtained was adequate and the audit evidence they accumulated
was appropriate, given the decentralized lease negotiations.
4-20
a. Being both the auditor for Lively Plays and personal tax advisor to the senior
management representative of the firm leaves Parely & Karson in a conflict of
interest between the confidentiality owed to Drewerson and the responsibility to
supply the forensic report to the board of directors
The role of the auditor is to be objective and carry out the engagement with due
care and to act in accordance with the prudent person concept.
b. By being associated with financial statements known to be materially misstated
or false could lead to the auditor being found guilty of criminal fraud.
4-21
a.
The lenders on the private placement might succeed if they could prove:
1.
2.
3.
4.
Rossi owed a duty of care to the lenders.

Rossi was negligent in the performance of his duties on the engagement.
The lenders suffered a loss.
There was a connection between Rossi's negligence and the loss suffered
by the lenders.
The plaintiffs (the lenders) might be able to prove that Rossi owed a duty of care to
them using Haig v. Bamford.
Proving that Rossi had been negligent would be far more difficult. The case seems to
suggest that Rossi had not been negligent in fact.
The plaintiff must prove all four points outlined above to succeed.
b.
Rossi's lawyers would probably respond with the Caparo related cases
that no duty of care was owing. Their strongest defence however would be
that Rossi was not negligent; management perpetuated a fraud and that
caused the financial statements to be misstated.
4-8
4-22
The 1136 Tenants case is an excellent example of the problems that lack of an
engagement letter and failure to follow up unexplained and unusual items case
for an auditor. An engagement letter (also discussed in Chapter 7) is a signed
agreement between the public accounting firm and the client identifying the work
being done and the responsibility being undertaken by the auditor. It usually will
state that the auditor is not responsible for the detection of fraud. In short, an
engagement letter is a written understanding between the auditor and the client.
A public accountant acting as auditor or accountant has a responsibility to follow up

unusual and unexplained items because of what they might indicate. For example, a
missing invoice in a sample may be part of a much larger problem and a large number
of missing invoices. Only by the following up of unusual or unexplained items can the
auditor determine the magnitude and kind of problem (if any) that the item is indicative
of.
Cases
4-23 a. Assessing managements integrity should be considered before accepting the
audit engagement. Some considerations are:
Check references from other professionals
Does the client deal ethically with outside parties
b. If during the assessment of management it is suspected that integrity is lacking
the auditor would not put much reliance on managements assertions but would
increase the amount of evidence and collect more from external sources.
c. The normal responsibility is to carry out the audit with professional skepticism. It
is not the auditors job to find criminal activity. The auditor will carry out
procedures necessary to support his work and at the same time if anything
comes to his attention that needs further investigation, will pursue it to its
conclusion.
d. When management or directors are involved in criminal activity their creditably is
minimal at best. This indicates a larger audit risk.
e. If it were found that a prudent person (other auditors) would have gathered more
evidence that would have led to the discovery of the fictitious sales then it would
be considered negligence.
4-9
Chapter 5
Audit Responsibilities and Objectives
Review Questions
5-1
The objective of the ordinary examination of financial statements by the
independent auditor is the expression of an opinion on the fairness with which the
financial statements present financial position, results of operations, and changes in
cash flows in conformity with generally accepted accounting principles.
The auditor meets that objective by accumulating sufficient appropriate audit evidence
to determine whether the financial statements are fairly stated.
5-2
It is management's responsibility to adopt sound accounting policies, maintain
adequate internal control and make fair representations in the financial statements. The
auditor's responsibility is to conduct an audit of the financial statements in accordance
with generally accepted auditing standards and report the findings of the audit in the
auditor's report.
5-3
Errors are unintentional misstatements of the financial statements. Fraud and
other irregularities are intentional misstatements. The auditor is responsible for
conducting the audit in accordance with generally accepted auditing standards. In most
cases, that will result in finding material errors in the financial statements. In many
cases, it will also uncover material fraud and other irregularities.
An audit must be designed to provide reasonable assurance of detecting material
misstatements in the financial statements. Further, the audit must be planned and
performed with an attitude of professional skepticism in all aspects of the engagement.
Because there is an attempt at concealment of fraud and other irregularities, they are
usually more difficult to uncover. Auditors, therefore, have less responsibility to detect
fraud and other irregularities than errors, but there is still considerable responsibility.
The auditors' best defense when material misstatements (either errors or fraud) are not
uncovered in the audit is that the audit was conducted in accordance with generally
accepted auditing standards.
5-4
Employee fraud is the theft of assets by employees. Management fraud is the
intentional misstatement of financial information by management or a theft of assets by
management.
Employee fraud ordinarily occurs because of either inadequate internal control or a
violation of that internal control. The best way to prevent employee fraud is through
adequate internal control that functions effectively. Many times employee fraud is
relatively small in dollar amounts and will have no effect on the fair presentation of
5-1
financial statements. There are also the cases of large employee fraud that result in
bankruptcy to the company.
Management fraud is inherently difficult to uncover because it is possible for one or
more members of management to override internal control. Fraud and other
irregularities may include misstatements of the financial statements and theft of assets.
In many cases, the amounts are extremely large and may affect the fair presentation of
the financial statements. In addition, in many cases, it is difficult to detect management
fraud.
5-5
Consideration
1. Management
motivated to commit
fraud to cover up
unwise business
decisions or to obtain
sufficient capital to
continue in business.
2. Structure and style of
operating the
business are
deliberately designed
to be conducive to
management fraud.
3. Individuals in
management have
previously been
involved in illegal or
unethical business
practices.
Audit Steps
1.
Perform analytical procedures to evaluate the
possibility of business failure.
2.
Investigate whether material transactions occur
close to year-end.
1.
2.
1.
2.
In all material transactions, evaluate whether the

parties are economically independent and have
negotiated the transaction on an arm's length
basis.
When there are material non-arm's length
transactions, each one should be evaluated to
determine its nature and the possibility of its being
recorded at an improper amount.
Investigate the history of the firm and its
management.
Discuss the possibility of management fraud with
previous auditor and company lawyer after
obtaining permission to do so from management.
In complying with GAAS, an auditor may not detect an illegal act or become aware that
an illegal act has occurred. Section 5136 suggests that the auditor should inquire of
management about its policies designed to prevent illegal acts and obtain written
representations from management [that there are no] violations or possible violations of
laws and government regulations, that would affect the financial statements. The
section goes on to say that, other than inquiry of management, the auditor should not
search for illegal acts unless there is reason to believe they may exist.
5-2
5-6
Illegal acts are defined in Section 5136 as a violation of a domestic or foreign
statutory law or government attributable to the entity under audit, or to employees acting
on the entitys behalf. Two examples of illegal acts are a violation of income tax laws,
and a violation of an environmental protection law.
5-7
The cycle approach is a method of dividing the audit such that closely related
types of transactions and account balances are included in the same cycle. For
example, sales, sales returns, and cash receipts transactions and the accounts
receivable balance are all a part of the sales and collection cycle. The advantages of
dividing the audit into different cycles are to divide the audit into more manageable
parts, to aid in the assignment of tasks to different members of the audit team and to
help in keeping closely related parts of the audit together.
5-8
There is a close relationship between each of these accounts. Sales, sales
returns and allowances, and cash discounts all affect accounts receivable. Allowance
for uncollectible accounts is closely tied to accounts receivable and should not be
separated. Bad debts is closely related to allowance for uncollectible accounts. To
separate these accounts from each other implies that they are not closely related.
Including them in the same cycle helps the auditor keep their relationship in mind.
Note however that although the goods and services tax is related to sales, it is included
in the acquisition and payment cycle because it is essentially a flow-through account
and because the unremitted tax represents a liability.
5-9
Audit objectives follow from and are closely related to management assertions.
Audit objectives, however, are intended to provide a framework to help the auditor
accumulate sufficient appropriate audit evidence required by the third examination
standard.
Audit objectives are more useful to auditors than assertions because they are more
detailed and more closely related to helping the auditor accumulate sufficient
appropriate audit evidence.
5-10
Recording Misstatement
Repair expense is recorded in
the wrong accounting period.
Expense is capitalized as a
capital asset rather than
expensed as a repair.
Transaction-related Audit Objective Violated

Timing (specifically cutoff): Transaction near the
balance sheet date is recorded in the proper
period.
Classification: Transactions included in the
clients journals are properly classified.
5-3
5-11 The existence objective deals with whether amounts included in the financial
statements actually exist. Completeness is the opposite of existence. The completeness
objective deals with whether all amounts which should be included have actually been
included.
In the audit of accounts receivable, an invalid (or non-existent) account receivable will
lead to overstatement of the accounts receivable balance. Failure to include a
customer's account receivable balance, which is a violation of completeness, will lead to
understatement of the accounts receivable balance.
5-12 For the specific objective, all recorded capital assets exist at the balance sheet
date, the management assertion and the general balance-related audit objective are
existence.
5-13
The four phases of the audit are:

1.
2.
3.
4.
Plan and design an audit approach.

Perform Test of controls.
Perform analytical procedures and Test details of balances.
Complete the audit and issue an auditor's report.
The auditor uses these four phases to meet the overall objective of the audit, which is to
express an opinion on the fairness with which the financial statements present financial
position, results of operations and changes in cash flows in conformity with GAAP. By
accumulating sufficient appropriate audit evidence for each objective, the overall
objective is met. The accumulation of evidence is accomplished by performing the four
phases of the audit.

5-14
a.
(3)
b.
(3)
c.
(1)
5-15
a.
(2)
b.
(2)
c.
(2)
Discussion Questions And Problems

5-16
a.
5-4
d.
(4)
1.
The function of the auditor in the audit of financial statements is to provide

users of the statements with an informed opinion as to the fairness with
which the statements portray financial position and the results of
operations in accordance with generally accepted accounting principles.
GAAP presumes the principles were applied on a basis consistent with
that of the preceding year.
2.
The responsibility of the independent auditor is to express an opinion on

the financial statements he or she has examined. Inasmuch as the
statements are the representation of management, responsibility rests
with management for the proper recording of transactions in books of
account, for the safeguarding of assets, and for the substantial accuracy
and adequacy of the financial statements.
In developing the basis for his or her opinion, the auditor is responsible for
making an examination which conforms to generally accepted auditing
standards. These standards constitute the measure of the adequacy of his
or her examination.
The informed judgment of a qualified professional accountant is required
of him or her. He or she must exercise this judgment in selecting the
procedures he or she uses in the examination and in arriving at an
opinion.
In presenting himself or herself to the public as an independent auditor, he
or she makes himself or herself responsible for having the abilities
expected of a qualified person in that profession. Such qualifications do
not include those of an appraiser, valuer, expert in materials, expert in
styles, insurer, or lawyer. He or she is entitled to rely upon the judgment of
experts in these other areas of knowledge and skill.
b.
Audits cannot be expected to provide the same degree of assurance for the
detection of material management or employee fraud as is provided for an
equally material error. The difficulty of detecting fraud, because of the effort at
concealment by management, makes fraud more difficult for auditors to find. The
cost of providing equally high assurance for detection of management fraud and
errors is economically impractical for both auditors and society.
Auditors do, however, have considerable responsibility for finding material management
and employee fraud. In recent years there has been increased emphasis on auditors'
responsibility to evaluate factors that may indicate an increased likelihood that
management fraud may be occurring. For example, assume that management is
dominated by a president who makes most of the major operating and business
decisions himself. He has a reputation in the business community for making optimistic
projections about future earnings and then putting considerable pressure on operating
5-5
and accounting staff to make sure those projections are met. He has also been
associated with other companies in the past that have gone bankrupt. These factors,
considered together, may cause the auditor to conclude that the likelihood of
management fraud is fairly high. In such a circumstance, the auditor should put
increased emphasis on searching for material management fraud.
The auditor may also uncover circumstances during the audit that may cause
suspicions of management fraud. For example, the auditor may find that management
has lied about the age of certain inventory items. When such circumstances are
uncovered, the auditor must evaluate their implications and consider the need to modify
audit evidence.
Adequate internal control should be the principal means of thwarting and detecting
fraud. To rely entirely on an independent auditor's examination for the detection of
employee fraud would require expanding his or her work to the extent that the cost
might be prohibitive. Moreover, the examination might not uncover certain types of fraud
involving unrecorded transactions, forgeries or collusion. Good internal controls and
fidelity bonds probably supply the more effective and economic safeguards against
fraud.
Similar to what is done for assessing the likelihood of material management fraud, the
auditor should also evaluate the likelihood of material employee fraud. That is normally
done initially as a part of understanding the entity's internal control and assessing
control risk. Audit evidence should be expanded when the auditor finds an absence of
adequate controls or failure to follow prescribed procedures, if he or she believes
material fraud or other irregularities could result.
The independent auditor is not an insurer or guarantor. His or her implicit obligation in
an engagement is that the examination be made with due professional skill and care in
accordance with generally accepted auditing standards. That fraud, existent during the
period covered by the independent auditor's examination, was discovered later, does
not of itself indicate negligence on his or her part.
c.
If the independent auditor's examination uncovers circumstances arousing

suspicion as to the existence of fraud, he or she should weigh their effect on the
opinion on the financial statements. When he or she believes the amount of the
possible fraud is material, the matter must be investigated before an opinion is
given.
5-6
5-17
a.
b.
Class of
Transactions
Purchase Returns
Rental Revenue
Charge-Off of
Uncollectible
Accounts
Acquisitions of Goods
and Services
Collection of GST
Adjusting Entries
Payroll Service &
Payments
Cash Disbursements
Financial Statement
Balance
Purchase ret. & allow..
Rent revenue
Bad debts or
allowance for doubtful
accounts
Repair and
maintenance
GST Payable
Accrued payroll
Sales salaries
Cash Receipts
Accounts receivable
Accounts payable
c.
Title of Journal
Transaction Cycle
Purchase Jrl
Revenue Jrl.
Adjustments Jrl.
Acquisition & Payment

Sales & Collection
Sales & Collection
Purchase Jrl.
Revenue Jrl.
Adjustments Jrl.
Payroll Jrl.

Payroll & Personnel
Payroll & Personnel
Disbursements
Jrl.
Cash Receipts
Jrl.

Sales & Collection
d.
Rental revenue is likely to be recorded in the revenue journal at the time revenue
is earned, perhaps the beginning of the month. It is therefore likely to be
recorded as a debit to accounts receivable and a credit to rental revenue. The
journal will be summarized monthly and posted to the general ledger. There will
be required adjusting entries for unearned rent and for rent receivable. A record
will be kept of each renter and a determination made whether rent is unpaid or
unearned at the end of each accounting period. The entries for recording that are
likely to be made in the adjustments journal and posted to the general ledger.
Reversing entries may be used to eliminate the adjusting entries.
5-18
(The data for this problem are available on the CD-ROM)
a.
A chart of accounts is a listing of all of the accounts that will be used to classify
balance sheet and income statement transactions during an accounting period. In
classifying any given transaction the accountant must choose from one or more of the
numbers on the chart of accounts. A general ledger trial balance is a listing of each of
the accounts and their related balance at any given point of time. It would include all
chart of account titles and numbers except those with zero balances. Financial
statements are prepared from the general ledger trial balance. Different account
balances would be combined on the financial statements. For example, in the chart of
accounts shown, all marketing expenses might be combined into one total. Similarly,
accounts 101 through 103 would likely be combined.
b.
The reason for associating general ledger trial balance accounts with transaction
cycles is to help the auditor keep closely related accounts together as the audit is
5-7
being conducted. For example, by keeping sales, sales returns, sales allowances
and accounts receivable in the same cycle, it will help the auditor keep those
closely related accounts together throughout the audit. This will help minimize the
audit work to determine whether financial statements are fairly stated and help to
more efficiently assign individuals to audit responsibilities.
c.
S - Sales and Collection
A - Acquisition and Payment
P - Payroll and Personnel
I - Inventory and Warehousing

C - Capital Acquisition and Repayment
Balance Sheet Accounts (100-299)

Assets (100-199)
Cycle
Current Assets (100-129)
SAPC 101 Cash in bank
P
102 Payroll cash
A
103 Petty cash
S
106 Notes receivabletrade
S
109 Accounts receivable
S
109.1 Allowance for doubtful
accounts
I
115 Finished goods
I
116 Work in progress
I
117 Materials
A
120 Prepaid property tax
A
121 Prepaid insurance
A
122 Miscellaneous prepaid
items
Property, Plant, and Equipment
(130-159)
A
130 Land
A
132 Buildings
A
132.1 Accum. amort.
buildings
Cycle
A
135
Machinery and equipment

factory
135.1 Accum. amort.machinery and
equipmentfactory
143 Automobiles
143.1 Accum. amort.automobiles
146 Office furniture and fixtures
146.1 Accum. amort.office furniture
and fixtures
A
A
A
A
A
Intangible Assets (170-179)

A
170 Goodwill
A
171 Patents
A
172 Franchises, licenses and other
privileges
Liabilities and Capital (200-299)

Cycle
Current Liabilities (200-219)
C
A
201
203
Cycle
C
216
Long-term debt
(due within one year)
C
218 Dividends payable
__________________________
Notes payable
Account payable
5-8
P
C
A
A
A
P
P
A
206
207
208
209
210
211
212
214
Accrued payroll
Accrued interest payable
Accrued sales tax
Other accrued liabilities
Goods and services tax payable
Employees income tax payable
Employee benefits payable
Estimated federal income tax
payable
Income Statement Accounts (300-899)

Sales (300-349)
S
301 Sales
S
301.1 Sales returns
S
301.2 Sales allowances
S
301.3 Sales discount
A
301.4 GST collected
Income Statement Accounts

Cost of Goods Sold (350-399)
I
351 Cost of goods sold
AI
353 Purchases
AI
353.1 Purchase returns
AI
353.2 Purchase allowances
AI
356 Materials price variance
AI
357 Materials quantity variance
AI
358 Purchases discount
P
366 Labor rate variance
P
367 Labor efficiency variance
API 372 Applied factory overhead
API 376 Factory overhead spending
variance
PI
422 Employee benefits
PI
425 Vacation pay
PI
427 Worker's compensation
AI
434 Fuelfactory
AI
436 Light and power
AI
438 Telephone and telegraph
AI
440 Tools
AI
442 Defective work
AI
450 Insurance expense
Long-Term Liabilities (220-229)

C
220 Bonds payable
C
222 Mortgage payable
C
224 Other long-term debt
A
226 Deferred income tax
payable
__________________________
Capital (250-299)
C
250 Common stock
C
260 Retained earnings
377
378
379
Factory overhead idle

capacity variance
Factory overhead
efficiency variance
Over- or under-applied
factory overhead
Factory Overhead (400-499)

API 400 Factory overhead control
PI
401 Salariesfactory
AI
411 Indirect materials
PI
412 Indirect labor
AI
414 Freight in
PI
417 Training
PI
420 Overtime premium
____________________________
5-9
P
A
A
A
A
A
A
A
A
522
530
534
536
538
546
548
550
560
561
Employee benefits
Supplies
Fuel
Light and power
Telephone and telegraph
Postage
Travel expenses
Insurance expense
Amortization expense
buildings
automobiles
AI
460
AI
461
AI
462
AI
463
AI
464
AI
465
AI
AI
AI
480
485
486
buildings
machinery and equipment
Repairs and maintenance of
buildings
roads
transportation facilities
machinery and equipment
Rent of equipment
Property tax
Amortization of patents
562
Repairs and
maintenance of buildings
Advertising
Display materials
Conventions and
A
565
A
567
A
568
exhibits
A
580 Rent of equipment
A
585 Property tax
_____________________________
Income Statement Accounts

Marketing Expenses (500-599)
AP
500 Marketing expenses control
P
501 Salariessales supervision
P
503 Salariessalespeople
P
504 Salariesclerical help
P
507 Sales commissions
A
515 Freight out
Administration Expenses
A
660 Amortization expense building
A
661 Amortization expense furniture
and fixtures
A
662 Repairs and maintenance of
buildings
A
670 Legal and accounting fees
A
680 Rent of equipment
A
685 Property tax
A
691 Donations
S
693 Uncollectible accounts expense
Other Expenses (700-749)
5-10
Administrative Expenses (600-699)

AP
600 Administrative expenses
control
P
601 Salaries administrative
P
604 Salaries administrative
clerical help
P
620 Overtime premium
P
622 Employee benefits
A
630 Supplies
A
634 Fuel
A
636 Light and power
A
638 Telephone and telegraph
A
646 Postage
A
648 Travel expense
A
650 Insurance expense
Other Income (800-849)
S
801 Income from
investments
S
816 Interest earned
S
817 Rental income
S
818 Miscellaneous income
Income Deductions (800-899)
C
C
C
701
703
707
Interest paid on notes payable

Interest paid on mortgage
Interest paid on bonds
890
Federal income tax
5-19
Specific Balance-related Audit
Objective
a. There are no unrecorded
receivables.
b. Receivables have not been
sold or discounted.
c. Uncollectible accounts have
been provided for.
d. Receivables that have become
uncollectible have been written
off.
e. All accounts on the list are
expected to be collected within
one year.
f. Any agreement or condition
that restricts the nature of
trade receivables is known and
disclosed.
Management Assertion
7.
Presentation and disclosure
g. All accounts on the list arose

from the normal course of
business and are not due from
related parties.
h. Sales cutoff at year end is
proper.
7.
Presentation and Disclosure
5.
Measurement
3.
Completeness
6.
Rights and obligations
4.
Valuation
1.,2.
Existence or occurrence
7.
Presentation and Disclosure
5-20 a.
Assertions are implied or expressed representations by management
about the components of financial statements. These assertions are the same for every
account balance. General audit objectives are essentially the same as management
assertions, but they are expanded somewhat to help the auditor decide which audit
evidence is necessary to satisfy the management assertions. Valuation, classification,
cutoff, and mechanical accuracy are a subset of the valuation or allocation assertion.
Specific audit objectives are determined by the auditor for each general audit objective.
These are done for each account balance to help the auditor determine the specific
amount of evidence needed for that account to satisfy the general audit objectives.
5-11
b. and c. The easiest way to do this problem is to first identify the general audit
objectives for each specific audit objective. It is then easy to determine the
management assertion using Table 5-2 as a guide.
Specific Transactionrelated Audit Objective

a. Recorded cash
disbursement
transactions are for the
amount of goods
received and are
correctly recorded.
b. Cash disbursement
transactions are
properly included in the
accounts payable
master file and are
correctly recorded.
c. Recorded cash
disbursements are for
goods and services
actually received.
d. Cash disbursement
transactions are
properly classified.
e. Existing cash
disbursement
transactions are
recorded
f. Cash disbursement
transactions are
recorded on the correct
dates.
Management Assertion
4. Valuation
General Transaction-related
Audit Objective
10. Accuracy
4. Valuation
13. Posting and summarization
1. Occurrence
8. Occurrence
4. Valuation
11. Classification
3. Completeness
9. Completeness
4. Valuation
12.Timing
5-21 a.
The first objective (existence) concerns the possibility that there are
included on the list of accounts payable, amounts that should not be included because
there is no payable to such vendor. That objective (completeness) concerns only the
overstatement of accounts payable. The second objective concerns the possibility of
accounts payable that should be included but that have not been included. This
objective concerns only the possibility of understated accounts payable.
b.
The first objective deals with existence and the second deals with completeness.
5-12
c.
For accounts payable, the auditor is usually most concerned about

understatements. An understatement of accounts payable is considered, by most
auditors, more important than overstatements because of potential legal liability.
The completeness objective is therefore normally more important in the audit of
accounts payable. The auditor is also concerned about overstatements of
accounts payable. The existence objective is also therefore important in accounts
payable, but usually less so than the completeness objective.
5-22 a.
The purposes of the general audit objectives are to provide a framework
that the auditor can use to accumulate audit evidence. Once the nine general balancerelated audit objectives have been satisfied, the auditor can conclude that the account
balance in question is fairly stated. Specific balance-related audit objectives are applied
to each account balance and are used to help the auditor become more specific as to
the audit evidence to accumulate.
There is at least one specific balance-related audit objective for each general balancerelated objective and in many cases there are several specific balance-related
objectives. There are specific balance-related audit objectives for each account balance
and specific balance-related audit objectives for an account such as capital assets
which are likely to differ significantly from those used in accounts receivable. In some
audits, the auditor may conclude that certain specific balance-related audit objectives
are not important. At the end of the audit, the auditor must be satisfied that each specific
balance-related audit objective has been satisfied. The general balance-related audit
objectives help the auditor determine the appropriate specific balance-related audit
objectives.
b.
General Balance-Related
Audit Objective
1. Existence
2. Completeness
3. Valuation
4. Accuracy
5. Classification
6. Cutoff
Specific Balance-Related Audit Objective

d. Capital assets physically exist and are being
used for the purpose intended.
a. There are no unrecorded capital assets in
use.
j. Amortization is determined in accordance
with an acceptable method and is materially
correct as computed.
k. Capital asset accounts have been properly
adjusted for declines in historical cost
e. Property, plant, and equipment are recorded
at the correct amount.
i. Expense accounts do not contain amounts
that should have been capitalized.
h. Cash disbursements and/or accrual cutoff for
5-13
7. Detail tie-in
8. Rights & Obligations
9. Presentation and
Disclosure
property, plant, and equipment items are

proper.
c. Details of property, plant, and equipment
agree with the general ledger.
b. The company has valid title to the assets
owned.
f. The company has a contractual right for use
of assets leased.
g. Liens or other encumbrances on property,
plant, and equipment items are known and
disclosed.
Cases
5-23
Memo to:
From:
Re:
Audit Partner
Leslie Donald
ABC Electronics Ltd
Several problems have come to my attention during the review of ABC audit file. I have
outlined these problems, the parties affected by the problem, my assessment of the
auditing and reporting implications of each.
Year-End Inventory adjustment
A major audit adjustment was made to reduce net income by $700,000. This may have
been an attempt by management to misinform shareholders in the financial statements
or it may indicate a deficiency in the inventory system. I suggest we recommend
improvements in their inventory system.
Payments without an invoice
During the compliance testing, 24 payments were found with incomplete documentation.
These 24 payments were payments to a management consulting firm and the rest to
Sales Promotion Enterprises Ltd.
The payments to the management consulting firm amount to $50,000. The general
manager claims to have no knowledge of the management consultants. These
payments may indicate illegal or fraudulent actions. Audit procedures will be performed
to determine the total dollar value of payments and to evaluate total dollar value with
respect to materiality. We will obtain written external confirmations from the
management consultants. If these results prove there is fraudulent activity the next step
would be to report our findings to the securities commission.
5-14
The payments to Sales Promotion Enterprises Ltd. for $85,000 were charged to
inventory on Consignment account. To verify the existence of the inventory a physical
count will be done by our staff. As well, procedures will be performed to determine the
total dollar value of payments and to evaluate the total dollar value with respect to
materiality.
The existence of these items indicates a weak internal control system. Additional audit
procedures suggested include: extend compliance testing, extrapolate errors in the
sample to total population and to obtain written external confirmation in lieu of audit
procedures previously carried out.
Reporting Problems
The results of our extended testing may prove that fraudulent or illegal acts have been
committed. If we establish that management fraud has occurred, we will be unable to
place any reliance on the internal control system and management representation. The
effects may be so pervasive as to render the financial statements meaningless, in which
case a denial of opinion is necessary.
There is evidence of over billing to Global Galaxy stores, which may require repayment.
This raises the issue of a contingent liability to Global, which would require disclosure in
the financial statements and possible restatement of prior years figures.
We should consider the following issues:
Can the contingency be isolated and quantified?
Is an unqualified opinion appropriate?
What is our exposure to legal liability as auditor of both ABC and Global?
Recommendations:
We need to determine whether it is possible to complete the audit if fraud and illegal
acts have been committed.
Seek legal counsel on our position if we are unable to complete our engagement and
carry out our statutory responsibilities. Also, seek legal counsel on our liability to
Global. It is the auditors statutory responsibility to report to shareholders. Resignation
before reporting to the shareholders is not a valid alternative.
5-24
Overstatement of inventory by:
Overstatement of footings and or extensions
Use of prices in excess of cost
Overstate net income for the year:
Inclusion of obsolete or other substandard items in inventory
Improper purchase and/or sales cutoff
Overstatement of inventory quantities
5-15
Understatement of accruals such as salaries and wages, bonuses, payroll, income tax
and other tax accruals.
Understatement of expenses through failure to charge to income deferred items such as
insurance, advertising, rent, etc.
Understatement of provisions for amortization.
Understatement of allowances for doubtful or bad debts.
Understatement of deferral of expenses such as stationery, supplies, heat, light and
power, etc. through failure to record until after year end charges for materials or
services received near the end of the period.
Failure to record in the current year commitments properly chargeable to current
expenses, such as donations approved by the board of directors for immediate payment
but whose payment was delayed until after year end.
Capitalization of items normally charged to expense of the current year such as repairs
and maintenance charges.
Charging of expenses incurred the current period to retained earnings or to reserves
created out of prior period earnings.
5-16
Chapter 6
Audit Evidence
Review Questions
6-1
Generally, it may be said that evidence is used to reach conclusions, however,
different evidence is used by auditors than in a legal case, and it is used in different
ways.
Basis of
Comparison
Use of evidence
Legal Case
Decide guilt or
innocence of
accused.
Audit of Financial Statements

Determine if statements are
fairly presented.
Nature of evidence.
Testimony by
witnesses and
party involved.
Various types of audit evidence.
Party or parties
evaluating evidence.
Jury and judge.
Auditor
Certainty of
conclusions from
evidence
Requires guilt beyond

a reasonable doubt.
High level of assurance.
Nature of
conclusions.
Innocence or guilt
of party.
Issue one of several

alternative types of
auditors reports.
Typical consequences of
incorrect conclusions
from evidence.
Guilty party is not

penalized or
innocent party is
found guilty.
Users of financial
statements make
incorrect decisions.
6-2
The four major audit evidence decisions that must be made on every audit are:
1.
2.
3.
4.
The audit procedures to use.

The sample size to select for a given procedure.
The particular items to select from the population.
The appropriate time to perform the procedure.
6-1
6-3
Audit procedures are the detailed instructions for the collection of a particular
type of audit evidence that is to be obtained. Since they are the instructions to be
followed in accumulating evidence they must be worded carefully to make sure the
instruction is clear.
6-4
An audit program section 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.
6-5
There are two primary reasons why the auditor can only be persuaded beyond a
reasonable doubt rather than be convinced that the financial statements are correct:
1.
2.
The cost of accumulating evidence. It would be extremely costly for the

auditor to be completely convinced.
Evidence is normally not sufficiently reliable to enable the auditor to be
completely convinced. For example, confirmations from customers may
come back with erroneous information which is the fault of the customer
rather than the auditor.
6-6
The three determinants of the persuasiveness of evidence are sufficiency,
appropriateness and timeliness. Sufficiency is related to sample size and items to
select. Appropriateness is related to audit procedures. Timeliness is related to timing of
the test.
6-7
Following are six characteristics that determine appropriateness and an example
of each.
Factor
Determining Appropriateness
Example of
Appropriate Evidence
Relevance
Examination of stock quotations to determine

current value of marketable securities.
Physical examination of inventory by auditor
Confirmation of a bank balance
Duplicate sales invoices for a large
well-run control company
Confirmation from a lawyer dealing with the
clients affairs
Count of cash on hand by auditor
Auditor's direct knowledge

Independence of provider
Effectiveness of client's internal
Qualifications of provider
Objectivity of evidence
6-2
6-8
Types of Audit Evidence
Examples
1.
2.
Physical examination
Confirmation
1. - count petty cash on hand

2. - confirm accounts receivable balance of a
sample of client customers
- confirm client's cash balance with bank
3. - canceled cheques, compare to bank
statement
- vendor's invoices, compare to supplier
statements
4. - observe the taking of inventory
- observe access restrictions to cash
5. - inquire of management whether there is
obsolete inventory
- inquire of management regarding the
collectibility of large accounts
receivable balances
6. - recompute invoice total by multiplying
item price times quantity sold
- foot the sales journal for a one-month
period and compare all totals to the
general ledger
7. - evaluate reasonableness of receivables
by calculating and comparing ratios
- review general ledger for reasonableness
3.
Documentation
4.
Observation
5.
Inquiries of client
6.
Reperformance
7.
Analytical procedures
6-9
The four characteristics of the definition of a confirmation are:

1.
Receipt
2.
Written or oral response
3.
From independent 3rd party
4.
Requested by the auditor
A confirmation is prepared specifically for the auditor and comes from an external
source. External documentation is in the hands of the client at the time of the audit but
was in the hands of someone outside the client's organization at one time; it may have
been prepared by the client, sent outside, and returned to the client or prepared outside
the company and sent to the client.
6-10 Internal documentation has been prepared and used within the client's
organization without its ever having gone to an outside party, such as a customer or
vendor.
6-3
Examples:
- cheque request form

- receiving report
- payroll time card
- adjusting journal entry
External documentation either originated with an outside party or was an internal

document which went to an outside party and is now either in the hands of the client or
readily accessible.
Examples:
- vendor's invoice - canceled note
- canceled cheque - validated deposit slip
6-11 Analytical procedures (comparisons and relationships) are useful in indicating

individual account balances which may appear to be correct when viewed separately
but which may appear to be questionable when viewed in the context of the other
financial statement accounts.
For example, inventory may appear to be correctly stated on the basis of evidence
collected but may appear to be questionable in the context of sales and cost of goods
sold. If inventory has increased significantly from the previous year and sales and cost
of sales have declined significantly in the same period, obsolescence and/or valuation
of inventory may be a problem.
They are also useful in reviewing accounts or transactions for reasonableness to
corroborate tentative conclusions reached on the basis of other evidence.
6-12 The decrease of the current ratio indicates a liquidity problem for Harper Ltd.
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 2.05:1 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 cut-off and possible
overstatement and to test all current liabilities for proper cut-off and possible
understatement.
6-13 Attention directing analytical procedures occur when significant, unexpected

differences between current year's unaudited financial data and other data used in
comparisons are found. If the unusual difference is large, the auditor must determine
the reason for it, and satisfy him- or herself that the cause is a valid economic event and
not an error or fraud or other irregularity.
When an analytical procedure reveals no unusual fluctuations, the implication is
minimized. In that case, the analytical procedure constitutes substantive evidence in
6-4
support of the fair statement of the related account balances, and it is possible to
perform fewer detailed substantive tests in connection with those accounts. Frequently,
the same analytical procedures can be utilized for attention direction or used to reduce
tests of details of balances, depending on the outcome of the tests. Simple procedures
such as comparing the current-year account balance to the prior-year account balance
is more attention directing (and provides less assurance) than more complex analytical
procedures; i.e., those which rely on regression analysis. More sophisticated analytical
procedures help the auditor examine relationships between many information variables
simultaneously. The nature of these tests may provide greater assurance than simple
procedures.
6-14 Gordon could improve the quality of her analytical tests by:
1.
2.
3.
Making internal comparisons to ratios of previous years.

In cases where the client has more than one branch in different industries,
computing the ratios for each branch and comparing these to the industry
ratios.
See if there is data available from industry associations that might be
helpful.
6-15 The investigation of differences discovered through analytical procedures is

affected by:
1.
The materiality of the amount. A potential material assessment will require
extensive investigation, whereas an immaterial difference will be
dismissed.
2.
The auditor's knowledge of the client's business. The auditor may know of
events that caused the change in ratio.
3.
The results of other auditing procedures. Other information obtained
during the audit may substantiate the results of the analytical procedures.
4.
The purpose of the analytical procedure. The objective of the tests will
also affect the auditor's response to his or her findings.
5.
The level of aggregation of data. If the auditor uses disaggregated data,
he or she may be able to isolate specific segments, locations, or time
periods which require further investigation.

6-16
a. (4) b. (4) c. (4) d. (1)
6-17 a. (4) b. (2)
6-5

6-18 a.
1.
2.
3.
4.
5.
6.
External
Internal
External
External
Internal*
Internal
7.
8.
9.
10.
11.
12.
Internal
Internal
External
Internal*
External
External**
13.
14.
15.
16.
17.
Internal
External
Internal
External
External
Even though these may be signed or initialed by employees, they are still internal
documents.
**
Bills of lading are ordinarily signed by the freight company. That signature will be
included on the top of the bill of lading, therefore, it is an external document.
b.
External evidence is considered to be more reliable than internal evidence

because external evidence has been in the hands of both the client and another
party, implying agreement about the information and the conditions stated on the
document.
6-19
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
(4)
(3)
(1)
(5)
(6)
(5)
(2)
(7)
(4)
(6)
(3)
(1)
(7)
(2)
(4)
(7)
(2)
(6)
(1)
(5)
inquiry of client
observation
physical examination
confirmation
reperformance
confirmation
documentation
analytical procedures
inquiry of client
reperformance
observation
documentation
inquiry of client
documentation
reperformance
confirmation
6-6
6-20
are:
Examples of audit evidence the auditor can use to support each of the functions
a.
b.
c.
d.
e.
f.
g.
6-21
Account
Name
Cash in
Bank
Examine invoice from vendor

Direct confirmation with vendor
Direct confirmation with custodian
Direct confirmation with customer
Examine cash receipts journal and bank deposits for subsequent
payments
Examine title for ownership of asset
Examine invoice from vendor
Direct confirmation with vendor
Examine client's copy of vendor's statement
Examine sales invoice of subsequent sale of goods showing marked down
sale price
Petty cash count
Direct confirmation with custodian
From Whom
Confirmed
All banks in which
Star had deposits
during the year
including those
which may have
had an account that
was closed out
during the year.
Information to be Confirmed
* Name and address of the bank.
* The account on deposit for each account
as of the balance sheet date plus the name
of each account number, whether or not the
account is subject to withdrawal by cheque
and the interest rate if the account is
interest-bearing.
*The account for which Star was directly
liable to the bank for loans, acceptances, etc.,
as of the balance sheet date plus the date of
the loan, the due date, the interest rate, the
date to which interest is paid and description of
the liability, collateral, security interest, liens,
endorsers, etc.
* The amount for which Star was contingently
liable as endorser of notes discounted and/or
as guarantors as of the balance sheet date
plus the name of the maker, the date, and the
due date of the note.
* If Star has any other direct or contingent
liabilities or open letters of credit.
6-7
* If there are any other security agreements or

agreements providing for restrictions.
* If internal controls over cash are very weak,
the auditor may wish to request that the bank
include a list of authorized signatures with the
confirmation.
Trade
A representative
Accounts sample of debtors
Receivable at a selected confirmation date which
may be either at
the balance sheet
or an interim date.
Confirmations
should also be
requested for
the following types
of accounts:
* Accounts with
large balances;
* Past-due accounts;
* Accounts with zero
or credit balances;
* Accounts written off
during the current
period;
* Accounts whose
collection is considered
questionable;
* Other accounts of
an unusual nature.
The confirmation can be either a positive

or negative form of request. The positive form
requests the debtor to directly notify the auditor
whether the information is correct and if not
correct, which items are considered incorrect.
The negative form requests a reply only if the
information is incorrect. In both cases the
information should include:
* Name and address of the debtor
* The confirmation as of date
* The aged account balance or individual
invoices included in such balance (with
invoice date).
Notes
Receivable
*Name and address of the debtor.

*Date of the note.
* Due date.
* Unpaid balance at balance sheet date.
* Payment arrangements.
* Interest rate.
* Date of last interest payment.
* Collateral, if any, to secure the note.
A selected sample
of notes receivable
outstanding at the
balance sheet
date. If a note
was written off
during the year, the
balance written off
should be confirmed
as a receivable balance.
6-8
Inventories
Public warehouses or
other outside
custodians (if any).
* Name and address of public warehouse or

other outside custodian.
* The inventory date.
* Detailed lists of inventory stored. Under
generally accepted auditing standards, direct
confirmation is acceptable provided
supplemental inquiries are made that the
inventory is the property of the company,
unless the amount is a significant percent of
current or total assets.
Trade
Accounts
Payable
Suppliers from whom

substantial purchases
have been made
during the year
regardless of the
balances of their
accounts at the
balance sheet date.
Some suppliers with
nil balances should
be confirmed as of the
year end.
* Name and address of the supplier.

* The amount due and the amount of any
purchase commitments as of the balance
sheet date. When internal control is
considered good the confirmation can be at
an interim date; however, a thorough review
must then be made of changes in the major
accounts during the intervening period
between the confirmation date and the
year-end. It should also be noted that with
interim confirmation the auditor loses a
Desirable audit procedure for disclosing
unrecorded and contingent liabilities at the
balance-sheet date.
As an alternative to confirmation letters, it is
becoming common practice to ask the vendor
to send directly to the independent auditor a
statement of his account with the client as of
the balance-sheet date rather than send an
accounts payable confirmation.
Mortgages
Payable
Mortgagee for each

mortgage which has
a balance at the
balance sheet date.
* Name and address of mortgagee.

* Original amount.
* Date of note.
* Maturity date.
* Balance due at balance sheet date.
* Payment arrangements.
* Interest rate.
* Interest payment dates.
* Date of last interest payment.
* Nature of defaults and if any events are
known to mortgagee.
* Location of mortgaged property.
6-9
Capital
Stock
If Star uses an
outside transfer
agent and registrar, confirmations
should be sent to
both.
* Name and address of transfer agent and

registrar.
* Number of shares of common stock
authorized, issued, outstanding, and held
as treasury shares for the company as of the
balance sheet date.
Legal
Fees
All of Stars major

lawyers.
Confirmations
should also be
sent to lawyers that
the independent
auditor knows the
client has used
extensively in
prior years.
The lawyers confirmation should request a

letter from each lawyer as to engagements
being handled as of and subsequent to the
balance sheet date. For each engagement,
the lawyer should give a description, report on
its status as of the balance sheet date and as
of the date of the letter, and give their opinion
as to the ultimate liability. The lawyer should
also state Stars indebtedness to him or her as
of the balance sheet date.
Sales
and
Expense
Accounts
Occasionally, confirmation may be

requested from an
outside party for
individual transactions contributing
to total expenses or
sales. This is
particularly true
where a major item
is based on a formal
contract and the auditor
wants independent
confirmation of agreement on the significant
terms of the contract
and that these terms
have been satisfactorily
completed.
* Name and address of outside party.

* Other specific information would depend on
the nature of the item and the reason the
auditor feels it is necessary to confirm the
item.
6-10
6-22
1.
2.
3.
4.
5.
Audit Procedure
Test extend unit prices
times quantity on the
inventory list, test
foot the list and
compare the total
to the general ledger.
a
Type of
Audit Evidence
.
b.
General
Audit Objective
Reperformance
Detail tie-in
Trace selected
quantities from the
inventory list to the
physical inventory to
make sure it exists
and the quantities are the
same.
Existence and acuracy
Question operating
personnel about the
possibility of obsolete
or slow-moving inventory. Inquiry of the client.
Valuation
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.
Completeness
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
Accuracy
6-11
6.
7.
Examine sales invoices and

contracts with
customers to
determine if any
goods are out on
consignment.
Examine vendors'
invoices and
contracts with
vendors to
determine if any
goods on the
inventory listing are
owned by vendors.
Documentation
Send letters directly
to third parties who
hold the client's
inventory and request
they respond directly
to us.
Confirmation
Rights and Obligations
Existence, Completeness,
and Accuracy
6-23 a. An audit procedure is the detailed instruction for the collection of a particular
type of evidence that is to be obtained during the audit.
b.
Because it is an instruction for the accumulation of audit evidence, the wording

should be sufficiently precise so that the person performing the audit procedure
will understand what is expected.
c.
Type of Evidence
Confirmation
Audit Procedure
Mail 35 positive accounts receivable confirmations to
customers 10 days after the balance sheet date.
Documentation
For accounts receivable confirmations not returned, examine

shipping documents and duplicate sales invoices to
determine whether the terms of the sale were valid and billed
at the correct time.
Inquiries of the client
Inquire of the credit manager as to reasons why accounts

receivable outstanding more than ninety days have not been
collected and evaluate the reasonableness of his responses.
6-12
Reperformance
Foot the total column balance in the accounts receivable trial

balance and compare the total to the general ledger.
Calculate the ratio of allowance for uncollectible accounts to

accounts receivable as of the balance sheet date and
compare the percentage to those of previous years.
6-24
Situation Type of Evidence That is More Reliable
1
Confirmation with business organizations
2
Physically examine three-inch steel plates
3
Factor Affecting Reliability

(in this case the auditor)
Examine documents when several

competent people are checking each
other's work
Effectiveness of internal control
Examine inventory of parts for the

number of units on hand
Degree of objectivity
Confirm a bank balance
Degree of objectivity
Confirm a bank balance
Physically count the client's inventory
Auditor's direct knowledge
Physically count the inventory
and auditor's direct knowledge
6-25
a.
The use of analytical procedure in an audit has two general advantages to a
public accountant:
1)
a broad view is obtained of the data under audit,
and
2)
attention is focused on exceptions or variations in the data.
A broad view of the data under audit is needed by the public accountant to draw
conclusions about the data as a whole such conclusions cannot be drawn by merely
looking at individual transactions. The application of analytical procedures to obtain this
broad view requires a discerning analysis of the data, which results in overall
conclusions upon which the public accountant's audit satisfaction rests. The public
6-13
accountant is thus able to satisfy him- or herself as to the reasonableness, validity, and
consistency of the data in view of the surrounding circumstances.
The focusing of the auditor's attention on exceptions or variations in the data results in a
more efficient and economical audit because there is a reduction in the amount of
detailed testing which would be required in the absence of overall checks, to uncover
these exceptions or variations. Furthermore, manipulations of accounts may be
revealed because the double-entry bookkeeping system extends the effects of
manipulations to additional accounts, which will then bear a changed relationship to
other accounts.
In addition, managerial problems and trouble spots will be highlighted for the auditor
and may lead to the opportunity for the auditor to be of additional service to his or her
client.
b.
The ratios that a public accountant may compute during an audit as overall
checks on balance sheet accounts and related income accounts may include the
following:
1.
2.
3.
4.
5.
Accruals of individual expenses to related total expenses

Accounts payable to purchases (days of purchases outstanding)
Long-term debt and interest expense thereon
Return on equity (relationship of net income to ownership equity)
Return on investments (relationship of investment income to investments).
1.
The possible reasons for a decrease in the rate of inventory turnover

include the following:
a.
Decline in sales
b.
Increase in inventory quantities, intentional or unintentional
c.
Incorrect computation of inventory because of errors in pricing,
extensions, or taking of physical inventory
d.
Inclusion in inventory of slow-moving or obsolete items
e.
Erroneous cut-off of purchases
f.
Erroneous cut-off of sales under the perpetual inventory
g.
Unrecorded purchases
h.
Change in inventory valuation method.
2.
The possible reasons for an increase in the number of days' sales in

receivables including the following:
a.
Change in credit terms
b.
Decreasing sales
c.
Change in the sales mix of products with different sales terms
d.
Change in mix of customers
e.
Improper sales cut-off
f.
Unrecorded sales
c.
6-14
g.
h.
Lapping
Slower collections caused by tighter economic conditions or
lowering of the quality of the receivables.
6-26
a.
Cost of goods sold as a percent of sales for drug and nondrug sales is as follows:
2001
2000
1999
1998
Drugs
59.4%
57.8%
57.9%
57.7%
Nondrugs
68.0%
68.0%
68.1%
68.2%
The explanation given by Adams is correct in part, but appears to be overstated. Cost of
goods sold as a percent of sales for nondrugs is approximately consistent. For drugs,
the percent dropped significantly in the current year, far more than industry declines.
b.
Further investigation is required to determine if the decline is due to competitive

factors or to a misstatement of income. Examination of inventory turnover, pricing
policies and inventory obsolescence would be suitable.
6-27
a.
1.
2.
3.
4.
5.
6.
Commission expense could be overstated during the current year or could

have been understated during each of the past several years. Or, sales
may have been understated during the current year or could have been
overstated in each of the past several years.
Obsolete or unsalable inventory may be present and may require
markdown to the lower of cost or market.
Especially when combined with 2 above, there is a high likelihood that
obsolete or unsalable inventory may be present. Inventory appears to be
maintained at a higher level than is necessary for the company.
Collection of accounts receivable appears to be a problem. Additional
provision for doubtful accounts may be necessary.
Especially when combined with 4 above, the allowance for doubtful
accounts may be understated.
Amortization expenses may be understated for the year.
b. Item 1 - Make an estimate computation of total commission expense by

multiplying the standard commission rate times commission sales for each of the
last two years. Compare the resulting amount to the commission expense for that
year. For whichever year appears to be out of line, select a sample of individual
sales and recompute the commission, comparing it to the commission recorded.
6-15
Item 2 and 3 - Select a sample of the larger and older accounts receivable and have
the client prepare a schedule of subsequent payments and credits for each of these
accounts. For the larger accounts which show no substantial payments, examine credit
reports and recent financial statements to determine the ability to pay. Discuss each
account for which substantial payment has not been received with the credit manager
and determine the need for additional allowance for doubtful accounts.
Items 4 and 5
Select a sample of the larger and older accounts receivable and
have the client prepare a schedule of subsequent payments and credits for each of
these accounts. For the larger accounts which show no substantial payments, examine
credit reports and recent financial statements to determine the ability to pay. Discuss
each account for which substantial payment has not been received with the credit
manager and determine the need for additional allowance for doubtful accounts.
Item 6 - Discuss the reason for the reduced amortization expense with the client
personnel responsible for the capital assets accounts. If they indicate that the change
resulted from a preponderance of fully depreciated assets, test the detail records to
determine that the explanation is reasonable. If no satisfactory explanation is given,
expand the tests of amortization until satisfied that the provision is reasonable for the
year.
6-28
a. & b.
Ratio Number
Need for Investigation
1.
Yes
Reason for Investigation

Current ratio has decreased from previous year end is significantly lower that the
industry average. This could indicate a shortage of working capital required for
competition in this industry.
Nature of Investigation
Obtain explanation for the decrease in current ratio and investigate the effect of the
company's ability to operate, obtain needed financing, and meet the requirements of its
debt agreement.
Ratio Number
2.
Need for Investigation Yes
An 11-2/3$ increase in the amount of time required to collect receivables provides less
cash with which to pay bills. This change could represent a change in the collection
policy which could have a significant effect on the company in the future. It may also
indicate that a larger allowance for uncollectible accounts may be needed if accounts
receivable are less collectible than in the prior year.
6-16
Determine the cause of the change in the time to collect and evaluate the long-term
effect on the company's ability to collect receivables and pay its bills. The difference
between company's and industry's days to collect could indicate a more strict credit
policy for the company. The investigation of this possibility could indicate that the
company is forfeiting a large number of sales and lead to a recommendation for a more
lenient credit policy.
Ratio Number
3
Yes

The difference in the company's days to sell and the industry is significant. This could
indicate that the company is operating with too low an inventory level causing stock-outs
and customer dissatisfaction. In the long term, this could have a significant adverse
effect on the company.
Investigate the reasons for the difference in the days to sell between the company and
the industry. Determine the effect on the company in terms of customer dissatisfaction
and lost customers due to stockouts or long waits for delivery.
Ratio Number
4
NO
N/A
N/A
Ratio Number
7
NO
N/A
N/A
Ratio Number
8
Yes

The company appears to have raised prices during the past year to achieve the gross
margin of the industry. However, it appears that the industry's gross margin have been
reduced from either increased cost of goods which could not be passed on to customers
in price increases or reduction in selling prices from competition, decreased demand for
product, or overproduction. The result of these changes could be significant to the
company's ability to produce a profit on its operations.
6-17
Determine the reason for the change in the industry's gross margin percent and the
effect this might have on the company.
Ratio Number
9
NO
N/A
N/A
c.
Mahogany Products operations differ significantly from the industry. Mahogany
has operated in the past with higher turnover of inventory and receivables by selling at a
lower gross margin and lower operating earnings. However, the company has changed
significantly during the past year. The days to convert inventory to cash have increased
7% (11 days), while the current ratio has decreased by 15%. The company was able to
increase its gross margin percent during the year when the industry was experiencing a
significant decline in gross margin.
6-29 a.
The company's financial position is deteriorating significantly. The
company's ability to pay its bills is marginal (quick ratio = 0.97) and its ability to generate
cash is weak (days to convert inventory to cash = 280.8 versus 179.9 in the prior year).
The earnings per share figure is misleading because it appears stable while the ratio of
net earnings to common equity has been halved in two years. The accounts receivable
may contain a significant amount of uncollectible accounts (accounts receivable
turnover reduced 25% in four years), and the inventory may have a significant amount
of unsalable goods included therein (inventory turnover reduced 40% in four years). The
company's interest expense has become a significant expense (29% of earnings before
taxes) and burden for the company as increased inventory and accounts receivable
levels have required additional borrowings. The company may experience problems in
paying its operating liabilities and required debt repayments in the near future.
b.
Additional Information
Reason for Additional Information
1.
Debt repayment requirements,

lease payment requirements,
and preferred dividend
requirements
1. To project the cash requirements

for the next several years
in order to estimate the company's
ability to meet its obligations.
2.
Debt to equity ratio
2. To see the company capital

investment and ability of the company
to exist on its present investment.
6-18
3.
Industry average ratios
3. To compare the company's ratios to

those of the average company in its
industry to identify possible problem
areas in the company.
4.
Aging of accounts receivable,

bad debt history, and analysis
of allowance for doubtful accounts
4. To see the collection potential and

experience in accounts receivable.
To compare the allowance provided
doubtful accounts to the collection
experience and determine the
reasonableness of the allowance.
5.
Aging of inventory and history

of markdown taken
5. To compare the age of the

inventory to the markdown
experience since the turnover has
decreased significantly. To evaluate
the net realizable value of the
inventory.
6.
Short- and long-term liquidity

trend ratios.
6. To indicate whether the company

may have liquidity problems within the
next five years.
c.
Based on the ratio shown, the following aspects of the company should receive
special emphasis in the audit:
1.
2.
3.
4.
Ability of the company to continue to purchase inventory, replaced obsolete

or worn-out capital assets, and meet its debt obligations based on its current
cash position.
Reasonableness of the allowance for doubtful accounts based on the
reduction in accounts receivable turnover and increase in days to collect
receivables.
Reasonableness of the inventory valuation based on the decreased inventory
turnover and increased days to sell inventory.
Computation of the earnings per share figure. It appears inconsistent that
earnings per share could remain relatively stable when net earnings dividend
by common equity has decreased by 50%. This could be due to additional
stock offerings during the period, or a stock split.
6-19
Cases
6-30
REPORT TO LAWYER ON THE CHARACTERISTICS OF GOOD
PROFESSIONAL JUDGEMENT
Since absolute assurance about the accuracy of the financial statements is
unattainable, professional judgment must be applied in three areas:
Determine the nature and timing of audit tests
Evaluate the results of those tests
Assessing the determinations and assertions made by management
Good professional judgment would include:
Maintaining objectivity (CA has no personal interest in the outcome of a problem)
Exercising due care in discharging the responsibilities of an engagement
Be careful about his or her role in any situation. A CA ,as auditor is not engaged
to take responsibility for a disclosure decision. which are the managements to
make.
Keeping his or her knowledge up to date.
Following the provincial institutes rules of ethics and conduct in dealing with the
client company.
Maintaining a professional skepticism and a willingness to question a clients
explanations
Professional judgment is developed with experience and training.
When dealing with financial reporting issues, CAs must be aware of the standards
pertaining to each issue:
Knowledge of what the CICA handbook has to say.
Knowledge of other relevant accounting and reporting standards
Some relevant audit standards that a CA is expected to follow:
Adhering to the examinations standards
Following the reporting standards
Gaining sufficient knowledge of the clients business to permit adequate exercise
of professional judgment
Documenting the work, in particular the work behind professional judgments that
are in question
Other general characteristics of professional judgment:
Analyzing the situation systematically, including identification of alternatives,
analysis of the alternatives the testing of the chosen situation against the facts of
the case.
Consulting with other knowledgeable people.
Demonstrating consistent judgment and reasoning from client to client.
6-20
Review financial statements as a whole looking for management bias. In

addition, critique the fairness and overall presentation of the statements from a
users perspective.
An analytical review of the financial statements as a whole should have been
performed to test the going concern assumption.
I hope that this discussion provides sufficient information to help you in your preparation
of the case.
6-31
1
DH Evidence
Compliance testing
Evidence Appropriateness
Compliance testing performed in the first half
of the year could not be relied on for the last
six months.
Analytical
Observation, Physical
Examination, Enquiry
Analytical
Analytical
Documentation, enquiry
Reperformance, enquiry
Analytical procedures, enquiry
In the first half of the year, collectibility of

receivables from government was reasonably
assured. After the contract ended,
collectibility of accounts from the newly
established dealer was less certain.
Confirmation response may be better from
dealers. Confirmations should have been
sent.
Management enquiry is not a sufficient
procedure for testing the valuation of WIP
inventory
There was more overhead to allocate after
Jan 1st therefore the overhead application
rate should have increased
Testing performed at the end of the previous
year is not sufficient. Actual costs should
have been verified.
Warranty costs will be higher for goods
manufactured for general resale than they
were for goods manufactured under
government contract. Accruals should have
been made.
Some procedures should have been carried
out to determine whether the costs would
result in a future benefit. This deferred cost is
not GAAP. A future benefit is not guaranteed.
Procedures were carried out to substantiate
the design costs, but these costs should not
have been included in inventory. Violates
GAAP.
6-21
No evidence
10
Reperformance
11
Enquiry
12
Reperformance
13
Conclusion of report
14
Enquiry
15
Documentation, Enquiry
16
Documentation
Incomplete. Nothing is noted as to whether

the covenants were satisfied, or the nature of
the field work.
Insufficient procedures were carried out to
substantiate the overhead balance.
Management not the bookkeeper should be
consulted. Some allocation to cost of goods
sold may be needed.
Interest is a period expense and should not
be included in inventory. The interest on
machinery installations can be capitalized
Insufficient, should do cut off procedures for
December 31. No indication of effect on bad
debt allowance.
Insufficient evidence to warrant issuing an
unqualified audit report.
Further analysis required to determine if lack
of liquidity related to the new business
environment. May be a going concern
problem.
More analysis was required for the difference
between years 1999 and 2000.
Managements explanations may not be
plausible. As not all costs change with
volume.
Related test of revenue cut off were not done
6-22
Chapter 7
Audit Planning and Documentation
Review Questions
7-1
There are three primary benefits from planning audits: it helps the auditor obtain
sufficient appropriate audit evidence for the circumstances, helps keep audit costs
reasonable, and helps avoid misunderstandings with the client.
7-2
Seven major steps in planning audits are:

1.
2.
3.
4.
5.
6.
7.
Pre-plan the audit

Obtain background information
Obtain information about client's legal obligations
Perform preliminary analytical procedures
Set materiality and assess audit risk
Understand internal control and assess control risk
Develop an audit plan and audit program
7-3
The new auditor (successor) is required by the Canada Business Corporation Act
(Section 162) to communicate with the predecessor auditor. This enables the successor
to obtain information about the client so that he or she may evaluate whether to accept
the engagement. Permission must be obtained from the client before communication
can be made because of the confidentiality requirement. The predecessor is required to
respond to the successor's request for information; however, the response may be
limited to stating that no information will be given. The successor auditor should be wary
if the predecessor is reluctant to provide information about the client.
7-4
Prior to accepting a client, the auditor should investigate the client. The primary
purpose is to ascertain the integrity of the client and the possibility of management
fraud. The auditor should be especially concerned with the possibility of management
fraud since it is difficult to uncover. The auditor does not want to needlessly expose himor herself to the possibility of a lawsuit for failure to detect such fraud.
7-5
An engagement letter is an agreement between the public accounting firm and
the client concerning the conduct of the audit and related services. It should state what
services will be provided, whether any restrictions will be imposed on the auditor's work,
deadlines for completing the audit, and assistance to be provided by client personnel.
The engagement letter also informs the client that the auditor is not responsible for the
discovery of fraud.
7-1
7-6
The four types of information the auditor should obtain or review as part of
gaining background information for the audit and an example of how the information will
be useful in conducting the audit are:
Type of Information
1. Knowledge of the client's industry and
general information about client's business
2. Tour of plant and offices.
3.
Identification of related parties.
4.
Evaluation of need for outside specialists.
Example of How Information Is Useful

Determination of obsolete inventory for an
apparel manufacturer
Review of labor make-up in standard inventory
costs will be facilitated by seeing that the
manufacturing process is "labor intensive."
The auditor's knowledge of an affiliated
company will help the auditor evaluate the
existence of related party transactions.
Early recognition that the client has material
amounts of chemical inventories permits the
auditor to engage a specialist to help evaluate
the valuation of the chemicals.
7-7
During the course of the plant tour the public accountant will remember that an
important aspect of the audit will be an effective analysis of the cost system. Therefore,
he will observe the nature of the company's products, the manufacturing facilities and
processes, and the flow of materials so that the information thus obtained can be
related later to the functions of the cost system.
The nature of the company's products and the manufacturing facilities and processes
will reveal to the public accountant the features of the cost system that will require close
audit attention. For example, the audit of a company engaged in the custommanufacture of costly products such as yachts would require attention to the correct
charging of material and labor to specific jobs, whereas the allocation of material and
labor charges in the audit of a beverage-bottling plant would not be verified on the same
basis. The auditor will note the stages at which finished products emerge and where
additional materials must be added. He will also be alert for points at which scrap is
generated or spoilage occurs. He may find it advisable, after viewing the operations, to
refer to auditing literature for problems encountered and solved by other auditors in
similar audits.
His or her observation of the manufacturing processes will reveal whether there is idle
plant or machinery that may require disclosure in the financial statements. Should the
machinery appear to be old or poorly maintained, the auditor might expect to find heavy
expenditures in the accounts for repairs and maintenance. On the other hand, if he or
she determines that the company has recently installed new equipment or constructed a
new building, he or she will expect to find these new assets on the books.
In studying the flow of materials, the auditor will be alert for possible problems that may
arise in connection with the observation of the physical inventory, and he or she may
7-2
make preliminary estimates of audit staff requirements. In this regard, he or she will
notice the various storage areas and how the materials are stored. He or she may also
keep in mind for further investigation any apparently obsolete inventory that is seen on
the tour.
His or her study of the flow of materials will disclose the points at which various
documents such as material requisitions arise. He or she will also meet some of the key
manufacturing personnel who may give him or her an insight into production problems
and other matters such as excess or obsolete materials, and scrap and spoilage. The
auditor will be alert for the attitude of the manufacturing personnel toward accounting
controls. The auditor may make some inquiries about the methods of production
scheduling, timekeeping procedures and whether work standards are employed. As a
result of his or her observations, the internal documents that relate to the flow of
materials will be more meaningful to the auditor as accounting evidence.
The public accountant's tour of the plant will give him or her an understanding of the
plant terminology that will enable him or her to communicate fluently with the client's
personnel. The measures taken by the client to safeguard assets, such as protection of
inventory from fire or theft, will be an indication of the client's attention to internal control
measures. The location of the receiving and shipping departments and the procedures
in effect will bear upon the auditor's evaluation of the client's shop housekeeping and
modernity of the plant will suggest the accuracy and adequacy of the accounting
records which will be audited.
7-8
One type of information the auditor obtains in gaining knowledge about the
client's industry is the nature of the client's products, including the likelihood of their
technological obsolescence and future saleability. This information is essential in
helping the auditor evaluate whether the client's inventory may be obsolete or have a
market value lower than cost.
7-9
A related party is defined in Section 3840.03 of the CICA Handbook as a party
that has the ability to exercise, directly or indirectly, control or significant influence over
the operating and financial decisions of another party. Two or more parties are also
considered to be related when they are subject to common control or significant
influence.
Related party transactions must be disclosed in the financial statements by
management. Therefore, the auditor must identify related parties and make a
reasonable effort to determine that all material related party transactions have been
properly disclosed in the financial statements.
7-10 Jennifer Bailey's practice of ignoring prior year working papers and permanent
files is improper. Though it is wise not to rely completely on the prior year's audit
7-3
program and to set the current year's scope independent of the prior year, consideration
must be given to problem areas of the previous year and to information contained in the
permanent files in order to properly understand the client and wisely set the scope for
the current engagement. Failure to examine prior-year working papers will probably lead
to inefficiencies in the current year's audit. This would prove costly to the public
accounting firm in which Jennifer is employed.
7-11 In the audit of a client previously audited by a different public accounting firm, it
would be necessary to obtain a copy of the articles of incorporation and by-laws for the
permanent files and to read these documents and prepare a summary abstract of items
to test for compliance. In an on-going engagement, this work has been performed in the
past and is unnecessary each year. The auditor's responsibility is to determine what
changes have been made during the current year and to update and review the
summary abstract prepared in previous years for compliance with the articles of
incorporation and by-laws.
7-12 Information in the client's minutes that is likely to be relevant to the auditor
includes:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Declaration of dividends
Authorized compensation of officers
Acceptance of contracts and agreements
Authorization for the acquisition of property
Approval of mergers
Authorization of long-term loans
Approval to pledge securities
Authorization of individuals to sign cheques
Reports on the progress of operations
It is important to read the minutes early in the engagement to identify items that need to
be followed up as a part of conducting the audit. For instance, if a long-term loan is
authorized in the minutes, the auditor will want to make certain that that loan is recorded
as a part of long-term liabilities.
7-13 Working papers should include the following:

NAME OF CLIENT - Enables the auditor to identify the appropriate file in which to
include the working paper if it is removed from the file.
DESCRIPTION OF THE CONTENTS - A list of the contents enables the reviewer to
determine whether all important parts of the working paper have been included. The
contents description is also used as a means of identifying working papers in the same
manner that a table of contents is used.
7-4
PERIOD COVERED - Enables the auditor to identify the appropriate year to which a
working paper for a particular client belongs if it is removed from the file.
INITIALS OF THE PREPARER - Indicates who prepared the working paper in case
there are questions by the reviewer or someone who wants information from the papers
at a later date. It also clearly identifies who is responsible for preparing the working
papers if the audit must be defended.
DATE OF PREPARATION - Helps the reviewer to determine the sequence of the
preparation of the working papers. It is also useful for the subsequent year in planning
the sequence of preparing working papers.
INDEXING - Helps in organizing and filing working papers. Indexing also facilitates in
searching between related portions of the working papers.
7-14 Unanswered questions and exceptions may indicate the potential for significant
misstatements or omissions in the financial statements. These should be investigated
and resolved to make sure that financial statements are fairly presented.
The working papers can also be subpoenaed by courts as legal evidence. Unanswered
questions and exceptions may indicate the lack of due care by the auditor.
7-15 The client can prepare any type of working paper for the auditor that he or she is
competent to prepare as long as it is not of a confidential nature and does not enable
the employee to change sample data before the auditor can audit it.
Examples of working papers that can be prepared by a client are the general ledger trial
balance, a list of accounts payable, analyses of expense accounts, a schedule of fixed
asset additions and a schedule of the calculation of various ratios. It would be
inappropriate to have the client prepare a list of accounts receivable for confirmation
unless careful control is maintained, even if the auditor selects the accounts for
confirmation, because the client could change the sample data before the confirmations
are mailed. This may result in an incorrect inference about the population.
Whenever the auditor lets the client prepare working papers, the data must be traced
back to the original records to test for omissions, duplications and incorrect amounts,
dates, names or descriptions. In many cases, the tracing can be limited to a sample. If
the client has made calculations, these must also be rechecked. When the auditor has
the client list sample data, such as accounts receivable confirmations, it should be done
under the auditor's supervision and observation.
7-5
When the internal auditor assists, then the scope of the work provided could expand to
a much broader range of working papers and more reliance, depending on the
qualifications of the internal auditor and the reporting lines.
7-16
Working papers are owned by the auditor. They can be used by the client if the
auditor wants to release them after a careful consideration of whether there might
be confidential information in them. The working papers can be subpoenaed by a
court and thereby become the property of the court. They can be released to the
professional accounting body of which the public accountant is a member without
the client's permission if they are being reviewed as a part of a practice
inspection program or are needed for the disciplinary process. The working
papers can be sold or released to other users if the auditor obtains permission
from the client.

7-17
a.
(2)
b.
(4)
c.
(3)
7-18
a.
(4)
b.
(2)
c.
(1)
7-19
a.
(3)
b.
(4)
c.
(4)
7-20
a.
(4)
b.
(2)
d.
(1)
e.
(1)

7-21 The decision to continue as auditor for a client is as important as the decision
whether to accept a new client because the auditor must determine whether to continue
to do the audit. A number of reasons may prompt the auditor to discontinue association
with the client.
1.
Previous conflicts over such things as the appropriate scope of the audit,
the type of opinion to issue, the appropriateness of accounting principles
selected by the client, the time required for a proper audit or fees.
2.
A determination that the client lacks basic integrity.
3.
A lawsuit against the public accounting firm by the client or against the
client by the public accounting firm (potential impairment of
independence).
7-22 Generally, the first step in preparing to supervise and plan the field work for an
audit examination is to review and/or study current and background information on the
client and industry. The most important sources in this preparatory stage are as follows:
7-6
1.
2.
3.
4.
5.
6.
7.
8.
Engagement letter
Audit permanent file
Last year's working papers
Client correspondence files
Last year's reports, including management letter and/or internal control
memorandum
Last year's in-charge auditor
Industry and governmental publications
Industry audit guides or firm audit guides
The purpose of this preparatory review and study is to become familiar with such things
as:
1.
2.
3.
4.
5.
The client's organizational structure, including key personnel.

Business activities and special problems of the client or industry in
general.
Recent financial data or other important activities such as new security
offerings or bond financing.
The client's records and procedures especially as they relate to internal
control.
Reports that are anticipated for this engagement
After the above review, the in-charge accountant should make preliminary plans for the
field work. He or she needs to determine what audit tests can be done on an interim
basis and what must be done on or after the balance-sheet date, including tests which
should be done on a surprise basis. He or she must plan for what work can be done by
the client's accounting and/or internal audit staff. He or she should schedule critical
dates for such things as cash counts, inventory observations, and confirmations. A
detailed time budget should be developed and specific areas of the audit assigned to
each staff member on the engagement. Additionally, he or she should consider whether
special expertise is needed, e.g., a computer specialist.
Audit programs should be prepared based on the prior year's assessment of internal
control and any related current correspondence, as well as suggestions in last year's
working papers. It is often possible to use last year's programs with revisions for
changed conditions or desired audit emphasis.
If possible, visit the client to meet the appropriate officers and employees and discuss
arrangements for the engagement.
After completing the preliminary preparation and planning as outlined above, it is wise to
schedule a conference with all staff members assigned to the audit. The agenda would
include a review of the engagement letter, estimate of the scope of the work, review of
reports to be issued, review of the primary business operations of the client, assignment
of audit areas to the staff, and review of specific problems or difficulties that are
7-7
anticipated for this engagement. After this meeting, it is important to ensure that each
staff member has adequate time to review and prepare for his or her assigned area of
the audit.
A final step is to ensure that the necessary work bags, supplies, permanent files, and
prior year's working papers are carefully packed and prepared for transport to the
client's office. If there is still time before starting the work at the client's office, the staff
can be assigned preliminary work of setting up working paper analysis and lead
schedules.
7-23
a.
First the minutes of each meeting refer to the minutes of the previous meeting.
The auditor should also obtain the next year's minutes, probably for February
2001, to make sure the previous minutes referred to were those from September
15, 2001.
Additionally the auditor will obtain a letter from management stating that all
minutes were provided to the audit.
b.
Information Relevant to
2001 Audit
Feb 16
1.
Approval for increased distribution
costs of $50,000
2.
Unresolved tax dispute.
3.
Computer equipment donated.
4.
Annual cash dividend.
5.
Officer's bonus.
Sept 15
1.
2001 officers.
2.
Officer salary information.
3.
Pension plan.
Audit Action Required
During analytical procedures an increase

of $50,000 should be expected for
distribution costs.
Evaluate resolution of dispute, or
possibility of a subject to qualification.
Determine that old equipment was
correctly treated in 2000 in the statements
and that an appropriate deduction was
taken for donated equipment.
Calculate total dividends and determine
that dividends were correctly recorded.
Determine whether bonus had been
accrued at 2000 year end and was paid in
2001, considering the tax implications of
an unpaid bonus to officers.
Inform staff of possibility of related party
transactions.
Note information in working papers for
2001 audit.
Determine if the pension plan was
approved. If so, make sure all assets and
liabilities have been correctly recorded.
7-8
4.
Acquisition of new computer.
Determine that there is appropriate

accounting treatment of the disposal of the
1-year-old equipment. Also trace the cash
receipts to the journals and evaluate
correctness of the recording.
Examine supporting documentation of loan
and make sure all provisions noted in the
minutes are appropriately disclosed.
If it's not your firm, find out why. If it is,
thank management.
5.
Loan.
6.
Auditor selection.
c.
The auditor should have obtained and read the February minutes, before
completing the 2000 audit. Three items were especially relevant and require
follow-up for the 2000 audit: unresolved dispute with CCRA, replacement of
computer equipment, and approval for the 2000 bonuses.
7-24 a. The purpose of working papers is to aid the auditor in providing reasonable
assurance that an adequate audit was conducted in accordance with generally
accepted auditing standards. Specifically, the working papers provide:
1.
2.
3.
4.
a basis for planning the audit

a record of the evidence accumulated and results of tests
data for determining the proper audit report
a basis for review by supervisors and partners
b.
Working papers are the public accountant's records of the procedures followed,
tests performed, and conclusions reached in his examination. Working papers
may include audit programs, analyses, memoranda, letters of confirmation and
representation, abstracts of company documents and schedules or
commentaries prepared or obtained by the auditor.
c.
The factors that affect the public accountant's judgment of the type and content
of the working papers for a particular engagement include:
1.
2.
3.
4.
5.
The nature of the auditor's report

The nature of the client's business
The nature of the financial statement, schedules or other information upon
which the public accountant is reporting and the materiality of the items
included therein
The nature and condition of the client's records and internal controls
The needs for supervision and review of work performed by assistants
7-25 In general, the working paper is not set up in a logical manner to show what the
auditor wants to accomplish. The primary objective of the working paper is to verify the
7-9
ending balance in notes receivable and interest receivable. A secondary objective is to

account for all interest income, cash received and cash disbursed for new notes,
collateral as security, and other information about the notes for disclosure purposes.
Specific deficiencies of the working paper presented in the question are:
a.
b.
Deficiency
Improvement
Tick mark explanation "tested" does not
Should have separate tick marks meaning:
indicate specifically what was done.
a)
Agreed to confirmation;
b)
Footed;
c)
Agreed to canceled cheque;
d)
Recomputed; etc.
Tick mark is not explained
Show explanation "Footed" or whatever it
represents.
Explanation of all tick marks is not given.
Explain all tick marks on the same page of
the working paper.
-0- balances for P. Smith and Tent Co.
Same.
notes should also be agreed to prior year
workpapers.
Classification of long-term portion
Recompute portions of notes which are
indicates no verification.
long-term.
Paid-to-date row entries are consistent.
Same.
c.
Computer Solution This problem will give the student some experience in
preparing a simple working paper using an electronic spreadsheet software
program. It should be explained to students that this particular type of working
paper may or may not be so prepared in actual practice, and that often templates
are used to save a lot of the more time-consuming aspects. Also, whether or not
tick marks are computerized is a matter to be decided. The advantage is that the
completed audit work can then be stored and reviewed electronically, a direction
some firms are going. On the other hand, it may be more efficient to indicate
audit work manually as it is performed, and a contrast in the color of the tick
marks through use of a colored pencil may be desirable.
The solution was prepared with Excel. The formulas used are self-evident, so no listing
is provided, although it is available on the diskette that accompanies the instructor
materials (filename P725.XLS). Two particular items deserve comment:
1.
2.
An advantage of using a spreadsheet program for these types of analyses

is that footing and crossfooting are done automatically.
When auditor tick marks are done by computer, a problem arises as to
how to place them on the worksheet. One could use narrow columns
inserted between the scheduled client data, or, as done here, the tick
marks are placed in blank rows beneath the related data.
7-10
ABC COMPANY,
INC.
A/C #110 - NOTES
RECEIVABLE
Schedule
Prepared by
12/31/01
Approved by
Account #110 - Notes Receivable
Maker
Apex Co.
c*
Ajax, Inc.
c*
J.J. Co.
c*
Date
Interest
Made/
Rate/
Due
Date Paid to
6/15/00 /
5% /
6/15/02 /
None pd.
11/21/00 /
5% /
Demand
Value of
Balance
Amount
Security
12/31/00
Additions
5000
4000
tp
0
3591
13180
24000
12780
12/31/01
11/1/00 /
Interest
Face
3591
5% /
Balance
Receivable
Payments
12/31/01
12/31/00
Earned
1000
3000
104
175
tp
<
102
tp
<
10380
24
577
tp
<
468
r
0
3591
2400
tp
12/31/01
PP
tp
Receive
10
60
($200/Mo.)
P.Smith
c*
7/26/01 /
5% /
8/1/01
25000
50000
25000
5000
2100
12000
1600
22471
37000
15691
43780
128
1589
f, cf
wtb
tb
op
9/30/01
20000
20
<
($1000/Mo.)
Martin-Peterson c *
5/12/00 /
Tent Co.
9/3/01 /
5% /
Demand
c*
2100
12000
10000
2100
12/31/01
6% /
tp
0
11/30/01
r
10400
105
tp
<
162
10
10
<
($400/Mo.)
tp
7-11
111
Legend of Auditor's Tick Marks

f Footed
cf Crossfooted
tp Traced to prior year working papers
w
tb Traced total to working trial balance
o
p Traced total to operations working paper - OP6
* Examined note for payee, made and due dates,
interest rate, face amount, and value of
security. No exceptions noted.
c Received confirmation, including date interest paid to,
interest rate, interest paid during 1998, note
balance, and security. No exceptions noted.
r Traced to cash receipts journal
< Recomputed for the year
7-12
7-26 a.
The presidents salary is a significant item this year and therefore should
be included in the financial statements as information which should be disclosed to the
shareholders.
b. 1. Management is primarily responsible for financial statement presentation. The
auditor has the responsibility of determining whether the president's salary, which
is apparently material in amount, is adequately disclosed in the financial
statements. The president's salary would be adequately disclosed if it were
shown as a separate item in the income statement and if the increase in salary
were also readily apparent because of the use of comparative statements. The
president's salary could be adequately disclosed also by a footnote which gave
the prior year's salary for comparison purposes. Should the client object to the
disclosure of the president's salary as a separate item in the income statement or
as a footnote, the auditor would be compelled to decide whether to qualify his or
her opinion because the financial statements failed to disclose information of
material importance or to render an adverse opinion because the financial
statements are not a fair presentation.
c. 1. The auditor would be concerned with the fairness of the presentation of the
financial statements because of the need for disclosure.
2.
The consistency of the application of accounting principles has not been

disturbed by the use of a different basis for determining the president's salary.
The change in the method of computing the president's salary does not require
disclosure in the notes as an inconsistent application of GAAP because it is not a
change in accounting methods.
Cases
7-27 This case illustrates the common problem of an audit partner having to allocate
his/her scarcest resource - his/her time. In this case, Winston Black neglects a new
client for an existing one and causes himself several serious problems.
a.
For prospective clients that have previously been audited by another public
accounting firm, the new (successor) auditor is required by the rules of conduct
of the institutes and the ordre of chartered accountants and by the rules of
conduct of CGA-Canada and by incorporating acts such as the Canada Business
Corporations act, to communicate with the predecessor auditor. The purpose of
the requirement is help the successor auditor evaluate whether to accept the
requirement. The burden of initiating the communication rests with the successor
auditor.
In this case, Sarah Beale initiated a communication, but then left it incomplete
when the predecessor auditor did not return her call. She rationalized this away
by accepting representations from her new client. Of course, the predecessor
7-13
auditor may be able to offer information that conflicts with the new clients best
interest. It is not appropriate nor in accordance with GAAS to consider
managements representations in lieu of a direct communication with the
predecessor auditor. The client should not have been accepted until a sufficient
communication occurred.
Can this be remedied ? Yes and no. A communication with the predecessor
auditor can still be conducted presumably by Black. However, if alarming
information is obtained, Henson, Davis would find itself in the awkward position
of having accepted a client it might not want. In that case, if it decides to
withdraw from the engagement, it may be breaching a contractual obligation. If it
continues, it may taking an unwanted level of business and/or audit risk.
A related implication is the wisdom of Blacks assumption about Beales
competence and how that affects her performance on the engagement. Black
relied on Beale extensively, yet Beales performance on the new client was
deficient. Does this mean that Beales performance in other areas was deficient
as well ? certainly, Black can do a thorough review of Beales work, but may or
may not reveal all engagement deficiencies.
Blacks handling of this engagement also implies something about his attitude
and objectivity. This was an initial engagement, yet he delegated almost all
responsibility up to the final review to Beale. He got credit for bringing in a new
client, which directly benefited him in terms of his compensation. It would be
against his best interest to not accept (withdraw from) this client. If he is
unwilling to do the right thing here, how will he handle other difficult audit
problems ?
b.
In the audit of long-term contracts, it is essential to obtain assurance that the

contract is enforceable so that income can be recognized on the percentage-ofcompletion basis. It is also important to consider other aspects of the contract
that relate to various accounting aspects, such as price and other terms,
cancelation privileges, penalties, and contingencies. In this case, Beale has
concluded that the signed contract, written in French, is Gallivans standard
contract, based on client representation. Of course, GAAS require that
managements representations, a weak form of evidence, be corroborated with
other evidence where possible. Beale might argue that the confirmation obtained
constitutes such evidence.
Beales argument may seem logical with regard to enforcement, however ,the
confirmation form refers to existing disputes. It says nothing about contractual
clauses that may foreshadow enforceability. For that reason, the audit program
requires the contract to be read. How would an auditor know whether the
contract form was that of a standard contract without reading it ? Furthermore, it
may be unrealistic to assume there is such a thing as a standard contract in the
7-14
first place. Long-term and short-term contracts are the result of negotiation and
often contain special clauses and changed language.
In this case, not reading the contract was an insufficiency and the Frenchlanguage copy should be translated by an independent translator and read by the
auditors.
c.
Compliance with GAAS is a matter that is always subject to professional

judgment. One professional auditor may conclude that he or she has complied
with GAAS, and another may conclude that GAAS has been violated, so these
matters are seldom clear cut. However, in this case, it appears that Black and
Beale may have violated GAAS in the following ways:
Examination Standard: (i) The work should be adequately planned and
properly executed. If assistants are employed they should be properly
supervised. The audit partner should therefore participate in the planning, at
least with a timely review. This would be more important than otherwise in the
situation of a first-time engagement, as we have here. Similarly, some level of
on-going partner supervision would seem prudent and logical. Black, apparently,
did not really participate at all until the final review.
Examination Standard: (iii) Sufficient appropriate audit evidence should be
obtained, by such means as inspection, observation, inquiry, confirmation,
computation, and analysis, to afford a reasonable basis to support the
content of the audit report. As discussed above, the work on the Montreal
contract was deficient and further evidence is required.
In addition, whenever the examination standards are violated there are implied
violations of other standards. It might be argued that Beale was not proficient as
an auditor because of her failures with the new client acceptance procedures and
the Montreal contract. Similarly, it might be argued that due professional care
was not taken both by Beale and by Black for delegating so much to Beale.
7-15
Chapter 8
Materiality and Risk
Review Questions
8-1
Materiality is defined as: A misstatement or the aggregate of all misstatements in
financial statements is considered material if, in light of the surrounding circumstances,
it is probable that the decision of a person who is relying on the financial statements,
and who has reasonable knowledge of business and economic activities would have
been changed or influenced by such misstatement or the aggregate of all
misstatements.
"Present fairly," as used in the auditors report, means that the auditor believes that
there are no material misstatements in the client's financial statements. If the auditor
concludes that there is a material misstatement, the use of an unqualified opinion, with
respect to "present fairly," would not be appropriate.
8-2
Materiality is important because if financial statements are materially misstated,
users' decisions may be affected, and they may thereby suffer financial loss. It is difficult
to apply because there are often many different users who use the financial statements
for different decisions. The auditor must therefore make an assessment of the likely
users and the decisions they will make. Materiality is also difficult to apply because it is
a relative concept. The professional auditing standards offer little specific guidance
regarding the application of materiality. The auditor must, therefore, exercise
considerable professional judgment in the application of materiality.
8-3
The preliminary judgment about materiality is the dollar amount the auditor
believes the financial statements could be misstated and still not affect user's decisions.
Several factors affecting the preliminary judgment about materiality are as follows:
1.
2.
3.
4.
5.
Materiality is a relative rather than an absolute concept.

Bases are needed for evaluating materiality.
Qualitative factors may affect materiality decisions.
Expected dissemination of the financial statements will affect the
preliminary judgment of materiality. If the financial statements are widely
distributed to a large number of users, the preliminary judgment of
materiality will probably be set lower than if the financial statements are
not expected to be widely disseminated.
The level of audit risk which the auditor considers acceptable will also
affect the preliminary judgment of materiality.
8-1
8-4
The following qualitative factors are likely to be considered in evaluating
materiality:
a.
b.
Amounts involving fraud or other irregularities are usually considered more

important than unintentional errors of equal dollar amounts.
The potential users of the financial statements.
8-5
Identified misstatements are misstatements that are actually discovered by the
auditor and not corrected by management. Their existence is not in doubt because the
auditor has observed them directly.
Likely misstatements include misstatements that, while not conclusively proved, most
likely exist, based on the audit evidence examined, and for which no provision has been
made by management. The most common example is the projection of sample results
to the population by the auditor.
Further possible misstatements are misstatements that while not probable are possible.
The most common example is the misstatement that results from examining a sample
and not the whole population, that is a sampling error.
The auditor has discovered identified misstatement in the sample examined. The
misstatement in the sample must be extrapolated to the population to determine the
likely misstatements in the population. And since the auditor examined only a sample
from the population, further possible misstatement exists also.
8-6
If an audit is being done on a medium-sized company that is part of a
conglomerate, the auditor must make a materiality judgment based upon the
conglomerate. Materiality may be larger for a company that is part of a conglomerate
because even though the financial statements of the medium-sized company may be
misstated, the large conglomerate statements might still be fairly stated. If, however, the
auditor is giving a separate opinion on the medium-sized company, the materiality
would be lower for the medium-sized company than for the audit of a conglomerate.
8-7
The audit risk model is as follows:

PDR =
Where PDR
AR
=
IR
=
CR =
AR / IR x CR
=
Planned detection risk
Acceptable Audit risk
Inherent risk
Control risk
8-2
Planned detection risk - a measure of how willing the auditor is to accept that the audit
evidence to be obtained for a segment will fail to detect misstatements exceeding a
tolerable amount, should such misstatements exist.
Audit risk - a measure of how willing the auditor is to accept that the financial
statements may be materially misstated after the audit is completed and an unqualified
opinion has been issued.
Inherent risk - a measure of the auditor's expectation that a misstatement exceeding a
tolerable amount exists in a segment before considering the effectiveness of internal
accounting control.
Control risk - a measure of the auditor's expectation that misstatements exceeding a
tolerable amount in a segment will not be prevented or detected by the clients' internal
control.
8-8
An increase in planned detection risk may be caused by an increase in audit risk
or a decrease in either control risk or inherent risk.
8-9
Inherent risk is set for segments rather than for the overall audit because
misstatements occur in segments. By identifying expectations of misstatements in
segments, the auditor is thereby able to modify audit evidence by searching for
misstatements in those segments.
When inherent risk is increased, the auditor should increase the audit evidence
accumulated to determine whether the expected misstatement actually occurs. For
planned detection risk, evidence is decreased as the desired audit risk is increased;
whereas, as inherent risk is increased the amount of evidence is also increased.
8-10 Extensive errors in the prior year's audit would cause inherent risk to be set at a
high level (maybe even 100%). An increase in inherent risk would lead to a decrease in
planned detection risk, which would require that the auditor increase the level of
planned audit evidence.
8-11 When the auditor is in a situation where he or she believes that there is a high
exposure to legal liability, the audit risk would be set lower than when there is little
exposure to liability. Even when the auditor believes that there is little exposure to legal
liability, there is still a minimum audit risk that should be met.
8-12 The first category of circumstances that determine audit risk is the degree to
which users rely on the financial statements. Several factors are indicators of this:
8-3
1.
2.
3.
Client size
Distribution of ownership
Nature and amount of liabilities
The second category of circumstances is the likelihood that a client will have financial
difficulties after the audit report is issued. Factors affecting this are:
1.
2.
3.
4.
5.
Client's liquidity position

Profit (or losses) in previous years
Method of financing growth
Nature of the client's operations
Competence of management
8-13 Exact quantification of all components of the audit risk model is not required to
use the model in a meaningful way. An understanding of the relationship between
model components and the effect which changes in the components have on the
amount of evidence needed will allow practitioners to use the audit risk model in a
meaningful way.
It is possible to think of audit risk in terms of high, moderate or low risk. Even that
measurement method is subjective, but there are differences in meanings of those three
risk levels.

8-14
a. (4) b. (4)
8-15
a. (1) b. (1) c. (3) d. (2) e. (2) f. (3)

8-16 a.
4.
This item is intentional and would therefore be concealed. It would only be

discovered if a confirmation were sent and returned as undeliverable or
with an exception reported or the auditor requested a bill of lading
covering the shipment. In the case of the confirmation, the client may
supply a customer whom he or she knows will respond appropriately. The
client may also simply state that the bill of lading was lost, if a fictitious one
is requested.
3.
Would be discovered only if the specific repair and maintenance costs

were selected for the vouching of permanent asset additions.
8-4
b.
2.
Would be detected if the lawyer mentioned the infringement in his or her

reply to the request for a lawyer's letter or if the item were shown on an
invoice for legal services which the auditor examines. Both of these are
likely.
1.
Would be detected if the auditor tested the method of valuing inventory,

which is a normal procedure.
For auditors to accept the same responsibility for uncovering errors or fraud
regardless of the difficulty of discovering them would require the expansion of
audit procedures far beyond the requirements of generally accepted auditing
standards and would require an audit fee considerably in excess of that presently
required for an audit.
8-17 a. The profession has not established clear-cut guidelines as to the appropriate
preliminary estimates of materiality. These are matters of the auditor's professional
judgment.
To illustrate, the application of the illustrative materiality guidelines shown in Figure 8-2,
are used for the problem. Other guidelines may be equally acceptable.
b.
Statement Component
Percent Guidelines
Earnings from continuing

operations before taxes
5 - 10%
Dollar Range
(In Thousands)
$ 20.9 - $ 41.8
Total assets
- 1%
$ 19.3 - $ 38.6
Shareholders Equity
- 5%
$ 8.2 - $ 81.3
It is necessary for the auditor to be satisfied that the actual estimate of errors is
less than the preliminary judgment about materiality for all of the bases. First the
auditor would reevaluate the preliminary judgment for earnings.
Assuming no change is considered appropriate the auditor would likely require
an adjusting entry or an expansion of certain audit tests.
c.
The auditor is concerned with misstatements in the revenue and expense

accounts. Income tax is calculated on the basis of those balances therefore
materiality is calculated on the pre income tax net income figure.
8-5
8-18 a.
A public accounting firm should attempt to have used reasonable
uniformity from audit to audit when circumstances are similar. The only reasons for
having a different acceptable audit risk in these circumstances are the lack of
consistency within the firm, different audit risk preferences for different auditors, and
difficulties of measuring audit risk.
b.
Users who rely heavily upon the financial statements need more reliable
information than those who do not place heavy reliance on the financial
statements. To protect those users, the auditor needs to be more sure that the
financial statements are fairly stated. That is equivalent to stating that audit risk is
lower. Consistent with that conclusion, the auditor is also likely to face greatest
legal exposure in situations where external users rely heavily upon the
statements. Therefore, the auditor should be more certain the financial
statements are correctly stated.
c.
Reasoning for c is essentially the same as for b.
d.
The audit opinion issued by different auditors conveys the same meaning
regardless of who signs the report. Users cannot be expected to evaluate
whether different auditors take different risk levels. Therefore, for a given set of
circumstances, every public accounting firm should attempt to obtain
approximately the same audit risk.
8-19 a.
False. The audit risk, inherent risk, or control risk may all be different. A
change of any of these factors will cause a change in audit evidence accumulated.
8-20
b.
False. Inherent risk and control risk may be different. Even if acceptable
audit risk is the same, those two factors will cause audit evidence
accumulation to be different.
c.
True. These are the primary factors determining the evidence that should
be accumulated. Even in those circumstances, however, different auditors
may choose to approach the evidence accumulation differently. For
example, one firm may choose to emphasize analytical procedures
whereas other firms may emphasize tests of control.
a.
1.
The auditor may set inherent risk at 100% because of lack of prior year
information, and because of the expectation of misstatement due to
internal control. If the auditor believes there is a reasonable chance of a
material misstatement, 100% risk is appropriate. Similarly, since the
auditor does not plan to test internal controls due to the ineffectiveness of
internal control, a 100% risk is appropriate for control risk.
8-6
2.
Audit risk and planned detection risk will be identical. Using the formula:
PDR = AR (CR x IR), if CR and IR equal 1, then PDR = AR.
3.
If detection risk is smaller, the auditor must accumulate more audit

evidence than if detection risk were large. The reason is that the auditor is
willing to take only a small risk that substantive audit tests will fail to
uncover existing misstatements in the financial statements.
1.
The auditor should be conservative in estimates of the likelihood of

misstatements in the financial statements, because the costs of being
wrong are relatively high. It would be inappropriate for auditors to set low
levels of inherent and control risk without doing substantive testing to
determine if the financial statements are actually misstated. For example,
using the formula of the audit risk model shown in part a, assume inherent
and control risk are each set at 20% and desired audit risk is 4%. Using
the formula, planned detection risk would be equal to 4%. Therefore, no
substantive audit testing would be necessary. That is inconsistent with the
responsibilities of the auditor. Therefore, relatively high inherent and
control risk are used even under the most ideal circumstances.
2.
Using the formula in a, detection risk is equal to 20% [PDR = .05 / (.5 x .5)
= .2]. Notice the difference between the answer in a-2. In that case,
planned detection risk would have been 5%, because audit risk =
detection risk.
3.
Less evidence accumulation is necessary in b-2 than if detection risk were

smaller. Comparing b-2 to a-2 for an audit risk of 5%, considerably less
evidence would need to be acquired in b-2 than for a-2.
1.
The auditor might set audit risk high because Sackville is in relatively good
financial condition and there are few users of financial statements. It is
common in municipal audits for the only major users of the financial
statements to be provincial agencies who only look at them for
reasonableness. Inherent risk might be set low because of good results in
prior-year audits and no audit areas where there is a high expectation of
misstatement. Control risk would normally be set low because of effective
internal control in the past and continued expectation of good controls in
the current year.
b.
c.
8-7
2.
Using the formula in a-2, PDR = .05 / (.2 x .2) = 1.25. Detection risk is
equal to more than 100% in this case.
3.
No evidence would be necessary in this case because there is a detection

risk of more than 100%. The reason for the need for no evidence is likely
to be the immateriality of repairs and maintenance, and the effectiveness
of internal control. The auditor would normally still do some analytical
procedures, but if those are effective, no additional testing is needed. It is
common for auditors to use a 100% planned detection risk for smaller
account balances. It would ordinarily be inappropriate to use such a
planned detection risk in a material account such as normally found in
accounts receivable or fixed assets.
8-21 a.
Audit risk: the risk the auditor is willing to accept that a given segment will
be materially misstated after the audit is completed. This is the risk that the auditor will
give an incorrect audit opinion.
Inherent risk: the measure of the auditor's expectation that material misstatements exist
in a segment before considering the effectiveness of internal accounting control. This
risk relates to the auditor's expectation of misstatements in the financial statements,
ignoring internal control.
Control risk: the measure of the auditor's expectation that material misstatements in a
segment will not be prevented or detected by internal control. This risk is related to the
effectiveness of a client's internal control.
Detection risk: a measure of the auditor's expectation that material misstatements in a
segment will not be detected by audit evidence. In audit planning, this risk is determined
by using the other three factors in the risk model using the formula
PDR = AR / (CR x IR).
b.
Audit Risk
.050
.050
.050
.050
.010
.010
IR x CR
1.00
.320
.320
.200
.400
.200
AR / (IR x CR) = PDR
.050
.156
.156
.250
.025
.050
________________________________________
Planned Detection Risk

in percent
5% 15.6% 15.6%
=== ===== =====
8-8
25%
====
2.5%
====
5.0%
====
c.
1.
2.
3.
4.
d.
Decrease; Compare the change from situation 4 to 6.

Increase; Compare the change from situation 3 to 4.
Increase; Compare the change from situation 1 to 2.
No effect; Compare the change from situation 2 to 3.
Situation 5 will require the greatest amount of evidence because the detection
risk is smallest. Situation 4 will require the least amount of evidence because the
detection risk is highest. In comparing those two extremes, notice that audit risk
is lower for situation 5, and both control and inherent risk are considerably
higher.
8-22
a
b
c
d
e
f
g
h
i
j
Control
Risk
Inherent
Risk
N
N
D
N
N
D
N
I
I
D
N or I
N
N
I
N
D
I
N
N
I
Acceptable
Audit Risk
D
D
N
N
I
N
N
D
N
N
Planned
Evidence
I
I
D
I
D
D
I
I
I
C
8-23 The third examination standard states that the auditor must gain sufficient
appropriate audit evidence to support the content of the report. Because the auditor
does not examine all possible evidence doing so would be excessively costly in
relation to the benefits received the auditor necessarily assumes some risk that the
opinion on the financial statements may be in error.
The auditor's assessment of the inherent risk for individual components of the audit will
direct the planning of the appropriate evidence-gathering procedures. The greater the
risk of misstatement in the accounting process, the more extensive the testing required
to provide the desired confidence level.
The auditor evaluates the control risk by testing and evaluating the applicable internal
controls. If the auditor determines that the controls are working effectively throughout
the period to detect material errors, he or she relies on them. The extent of reliance will
affect the nature and extent of the substantive auditing procedures used.
8-9
In planning and executing the audit, the auditor attempts to reduce the risks to an
acceptable level within the constraints set by timeliness and economy.
The risks associated with issuing an incorrect audit opinion is influenced by the intended
use of the financial statements. The auditor needs to consider the users of the financial
statements and the decisions that will be made using them. The audit of a public
company is more sensitive than the audit of a private company because of the
increased exposure of the statements to a greater number of users.
The audit risk is affected by the application of sampling techniques. The sampling risk is
the risk that the conclusion derived from a test differs from the conclusion on a 100%
evaluation. Sampling risk can be reduced to an acceptably low level by ensuring that
the sample size is adequately large.
At the present time, what constitutes sufficient appropriate audit evidence is determined
by the auditor's judgment. This judgment is tempered by such factors as previous
experience, the results of testing and the relative strength of internal controls. Because
each engagement is different, it is impossible to establish a set of specific guidelines to
determine what is sufficient appropriate audit evidence.
The auditor responsible for the engagement is in the best position to judge what
evidence is necessary to substantiate an opinion . The auditor bases the decision of the
extent of testing required on his or her evaluation of the risk associated with the
engagement. It is this evaluation and the subsequent testing that allows the auditor to
state his or her opinion on the financial statements. If guidelines were to be established
defining what constitutes sufficient appropriate audit evidence, an important component
of professional judgment would be removed from the audit function.
8-24 a.
There is no information available to users as to how much or how little
work the auditors did in arriving at a decision as to the appropriate opinion to report on
the financial statements. Many or most users probably assume that all audits are the
same. In addition, users have no idea of the imprecision in the amounts on the financial
statements.
The reporting of materiality would indicate to users the imprecision and also would
indicate the degree of audit effort put forth by the auditors. If the users did not like the
materiality used (that is if they wanted more or less precision or have the auditors do
more or less work), they could request the auditors increase or decrease the materiality
used.
The students will probably have other reasons as well.
b.
The auditors opposing disclosure of materiality do so because:
8-10
i.
They think users would be upset to discover that there is a degree of

imprecision in the financial statements.
ii.
They think that if management and employees knew what materiality was,
they would know the degree of imprecision the auditors would tolerate.
They could commit fraud with no fear of being caught as long as the
amounts involved were less than materiality.
iii.
They think users would assume that the financial statements were
misstated by the amount of materiality instead of believing that materiality
represented the maximum likely misstatement and the misstatement was
probably some amount less than materiality.
iv.
They think users would misunderstand what materiality means and would
be even more confused than is presently the case.
The students will probably suggest other reasons.

c.
The students should be encouraged to discuss the pros and cons of disclosure;
they should be required to support their positions.
Some students may also suggest that audit risk should be disclosed to give a more
complete picture. They should be encouraged to explore this issue even if it wasn't
included in the question.
I find it helpful to take a vote once the subject has been fully explored.
Cases
8-25
Microcomputer prepared worksheets (using Excel) are contained on the diskette
accompanying this manual. Filenames are P825A.XLS and P825B.XLS
a.
See worksheet 8-25A It is important to recognize that there is no one solution to
this requirement. The determination of materiality and allocation to the accounts
is always arbitrary. In this illustration, the auditor makes estimated adjustments
for problems noted in analytical review. This is an important step as the potential
adjustments reduce income before taxes, and thus materiality. The illustrated
solution recognizes that with downward adjustments, actual income may be
much closer to the contractual amount required for an additional contribution to
the employees pension plan. This creates a sensitivity that will need to be
watched carefully as the audit progresses.
The allocation to the accounts is particularly arbitrary. It is noteworthy that the sum of
allocated amounts equals 1.5 times materiality. It is assumed that this is consistent with
the audit firms internal policies.
8-11
b.
The level of audit risk is based on an evaluation of three factors;
The degree to which external users rely on the statements.
The likelihood that the client will have financial difficulties after the audit report is issued.
The auditors evaluation of managements integrity.
Stanton Enterprises is a public company and therefore has a high degree of reliance by
external users on its financial statements. The companys operating results and
financial condition indicate that there is very little likelihood of financial difficulty in the
immediate future. With regard to managements integrity, although there has been
some concern with Leonard Stantons past bankruptcy, the carefully monitored
relationship has been good for the four years Stanton has been a client. On that basis,
it appears management integrity is good.
Overall then, an audit risk level of low would seem appropriate.
c.
See worksheet 8-25B that shows both horizontal and vertical analysis of the
2000 audited and the 2001 unaudited financial statements, as well as
computation of applicable ratios. Following are the key observations to be made:
Overall Results
Stanton Enterprises apparently had an extremely successful year in
2000. Sales increased by 36.4 per cent, gross margin increased by 4 absolute
percentage points, and income before taxes increased by 138.5 percent. Return on
total assets and return on equity increased and are at admirable levels. These results
allowed the company to increase its dividends by 25 percent (recognizing that more
shares were outstanding) and total stockholders equity by 101.9 percent. Furthermore,
the companys current, quick, cash, and times interest earned ratios are up, and its debt
to equity ratio is down, indicating that the company is extremely sound from a liquidity
standpoint.
Trade Accounts Receivable
In the face of such growth, trade accounts receivable
increased by 59.3 percent, and at the same time, accounts receivable turnover and
days to collect improved. However, the allowance for uncollectible accounts was only .7
percent of gross receivables at the end of 2001, down from 1.7 percent at the end of
2000. That implies that the allowance may be significantly understated for 2001 and
must be looked at very carefully during the current audit. This review would include
considering whether a liberalization of credit policies was used to help increase sales.
Property, Plant and Equipment The company made a significant additional
investment in property, plant and equipment, increasing them by 30.5 percent. These
new assets will need to be verified during the current audit. It is noteworthy that
accumulated amortization increased by only 16.1 percent. This could indicate that
amortization on the new assets was understated, but may not, depending on the dates
of acquisition and amortization method used. Amortization must be tested considering
these facts as determined.
8-12
Goodwill
Goodwill also increased significantly, by $855,000. This implies that the
company made an acquisition during the year. This could explain the increase in
operating assets, and any such transaction must be examined in detail as part of the
audit. Also, the goodwill from prior transactions must be considered during each audit
as to its amortization and recoverability.
Accounts Payable Accounts Payable went down from 2000 to 2001. This doesnt
seem reasonable at all given an increase in business activity. It is very possible there
are unrecorded liabilities at the end of 2001, and this must be an area of major
emphasis during the audit.
Bank Loan Payable It seems somewhat strange for the company to have an
outstanding balance on its bank loan payable at the end of 2001 given its admirable
results. Its possible this was the result of an acquisition, or they simply havent paid it
off. In any case, verifying this balance is a relatively easy audit procedure.
Federal Income Taxes Payable and Income Tax Expense
The companys effective
tax rate for 2000 was 34 percent. Income tax expense is only 22.5 percent of income
before taxes. Federal income taxes payable on the balance sheet is significantly lower
at 12-31-01 than would be expected based on 2000. These both indicate that the
company has not made its final tax accrual for 2001, and this area will require careful
attention during the audit.
Sales Whenever there is a drastic increase in business activity, there is an increased
risk of problems. It is possible that controls will lapse or not be carefully observed. It is
possible that transactions will not be carefully accounted for. Therefore, in a situation
such as Stantons it is important to understand the nature of the changes that took place
and to do a careful review of controls. It will be especially important to thoroughly test
cutoffs for both sales and purchase transactions.
Cost of Goods Sold and Gross Profit
Consistent with the comments under sales, the
auditors must determine why the gross profit percent has made such a significant
improvement. Tests of costs and inventories will be more extensive than on more
stable circumstances.
Pension Cost
It appears that the company exceeded the contractual amount for
additional pension contribution. Yet, pension cost is a lesser percent of sales in 2001
than in 2000. This may indicate that an accrual for additional pension cost was not
made. As pension cost is a complex and important area, it will be verified in detail
during the audit.
Detail tie-in
Existence
Completeness
ACCEPTABLE
AUDIT RISK
Low
Low
Low
INHERENT RISK
Medium
Medium
Medium
8-13
ANALYTICAL
PROCEDURES
see Note 5
see Note 5
see Note 5
Accuracy
Cutoff
Realizable value
Rights
Presentation and
disclosure
Low
Low
Low
Low
Low
Tolerable misstatement:
Trade accounts receivable
Allowance for uncollectible
accounts
Total
Medium
High
High
Medium
Medium
see Note 5
High
High
see Note 5
see Note 5
$80,000
15,000
$95,000
Rationale
Audit risk is low for engagement, therefore, it is low for accounts receivable and all of its
related objectives.
Inherent risk for the engagement would be considered medium for the following
reasons:
a. Stantons background problems.
b. Stantons autocratic management style
c. Some indication of weakness in the control environment, particularly rejection
of recommendation to establish an internal audit function.
Inherent risk for cutoff is considered high due to the companys rapid growth in 2001
and the general frequency of cutoff errors.
Inherent risk for realizable value is considered high because of the companys rapid
growth and the amount of judgment involved in establishing the allowance for
uncollectible accounts.
The analytical procedures performed are preliminary only, and dont provide substantive
evidence. However, they can indicate areas where possible problems exist. In other
words, they cant lower risk, but can increase it. In this case, they corroborate the high
inherent risk level specified for cutoff and realizable value.
8-14
Stanton Enterprises
Worksheet 8-25A
Determination of Materiality and
Allocation to the Accounts
12-31-01
DETERMINATION OF MATERIALITY
Income before taxes
Possible adjustments estimated.
See Worksheet 8-25B:
Increase allowance for
uncollectible accounts
Increase accounts payable
Pension cost
Adjusted (estimated) income
before taxes
$8,004,277.00
(60,248)
(1,069,997)
NA
$6,874,032.03
5 percent
$343,701.60
Round down to
$340,000.00
Note: A key consideration is whether the Company will be

required to make its additional pension contribution.
As more information is obtained, the amount considered
material may be reduced to assure any possible
misstatements in earnings are considered in light of
that contractual obligation.
8-15
Increase to 1.7% of trade accounts

receivable.
Reflect same increase as cost of goods sold.
Cant estimate. May or may not be required.
Stanton Enterprises
Worksheet 8-25A, cont.
Allocation to the Accounts
Preliminary
12-31-01
Cash
Accounts
Inventories
Prepaid expenses
Total current assets
Property, plant and equipment:
At cost
Tolerable
Misstatement
$243,689.0
0
3,544,009
10000 Easy to audit at low cost.

80000 Large tolerable misstatement because account is
large and requires extensive sampling to audit.
15000 Fairly tight TM because of inherent risk.
large and requires extensive sampling to audit.
(120,000)
4,520,902
29,500
8,218,100
12,945,255
100000 Small tolerable misstatement as a percent of acct.

bal. because most of balance is unchanged from
prior year & audit of additions is relatively low
cost.
50000 Fairly tight tolerable misstatement due to possible
risk
of misstatement. See 825B.
risk
Less, accumulated
Amortization
(4,382,990)
8,562,265
Goodwill
1,200,000
$17,980,36
5.00
Accounts payable
$2,141,552.
00
8-16
Bank loan payable

Accrued liabilities
Federal income taxes payable
Large and requires extensive sampling to audit.

risk
150,000
723,600
1,200,000
Current portion of long-term

debt
Total current liabilities
Long-term debt
Stockholders' equity:
Common stock
Additional paid-in capital
Retained earnings
240,000
4,455,152
960,000
1,250,000
2,469,921
8,845,292
12,565,213
$17,980,36
5.00

NA
$510,000.00 1.5 x $340,000
8-17
Stanton Enterprises
Worksheet 8-25B
Analysis of Financial
Statements
and Audit Planning
Worksheet
12-31-01
BALANCE SHEET
Cash
accounts
Inventories
Prepaid expenses
Total current assets
Property, plant and
equipment:
At cost
Less, accumulated
amortization
Goodwill
Accounts payable
Bank loan payable
Accrued liabilities
Federal income taxes
payable
Current portion of longterm
debt
Total current liabilities
Long-term debt
Stockholder's equity:
Common stock
Additional paid-in capital
Preliminary
12-31-01
Audited
12-31-00
%
Change
$243,689.00
3,544,009
1.4
19.7
$133,981.00
2,224,921
1.1
17.7
81.9
59.3
(120,000)
4,520,902
29,500
8,218,100
-0.7
25.1
0.2
45.7
(215,000)
3,888,400
24,700
6,057,002
-1.7
31.0
0.2
48.3
-44.2
16.3
19.4
35.7
12,945,255
72.0
9,922,534
79.1
30.5
(4,382,990)
8,562,265
1,200,000
$17,980,365.00
-24.4
47.6
6.7
100.0
(3,775,911) -30.1
6,146,623 49.0
345,000
2.7
$12,548,625.00 100.0
16.1
39.3
247.8
43.3
$2,141,552.00
150,000
723,600
1,200,000
11.9
0.8
4.0
6.7
$2,526,789.00
0
598,020
1,759,000
20.1
0.0
4.8
14.0
-15.2
-21.0
-31.8
240,000
4,455,152
1.3
24.8
240,000
5,123,809
1.9
40.8
0.0
-13.0
960,000
5.3
1,200,000
9.6
-20.0
1,250,000
2,469,921
7.0
13.7
1,000,000
1,333,801
8.0
10.6
25.0
85.2
8-18
Retained earnings
8,845,292
12,565,213
$17,980,365.00
49.2
69.9
100.0
3,891,015 31.0
6,224,816 49.6
$12,548,625.00 100.0
127.3
101.9
43.3
$43,994,931.00
24,197,212
19,797,719
100.0
55.0
45.0
$32,258,015.00 100.0
19,032,229 59.0
13,225,786 41.0
36.4
27.1
49.7
10,592,221
1,117,845
83,376
11,793,442
8,004,277
24.1
2.5
0.2
26.8
18.2
8,900,432
865,030
104,220
9,869,682
3,356,104
27.6
2.7
0.3
30.6
10.4
19.0
29.2
-20.0
19.5
138.5
Income tax expense

Net income
1,800,000
6,204,277
4.1
14.1
1,141,000
2,215,104
3.5
6.9
57.8
180.1
Beginning retained
earnings
3,891,015
2,675,911
10,095,292
(1,250,000)
$8,845,292.00
4,891,015
(1,000,000)
$3,891,015.00
1.84
0.82
0.05
12.41
1.18
0.42
0.03
14.50
29.00
5.35
67.26
96.26
0.43
1.34
24.83
4.89
73.55
98.38
1.02
1.96
Stanton Enterprises
Worksheet 8-25B, cont.
Combined Statement of
Income
and Retained Earnings
Sales
Cost of goods sold
Gross profit
Selling, general and
administrative expenses
Pension cost
Interest cost
Income before taxes
Dividends declared
Ending retained earnings
SIGNIFICANT RATIOS
Current ratio
Quick ratio
Cash ratio
Accounts receivable
turnover
Days to collect
Inventory turnover
Days to sell
Days to convert to cash
Debt to equity ratio
Tangible net assets to
equity
8-19
Times interest earned

Efficiency ratio
Profit margin ratio
Profitability ratio
Return on total assets
Return on equity
97.00
2.62
0.18
0.48
0.45
0.64
33.20
2.64
0.11
0.28
0.27
0.54
Note: Some ratios are based on year-end

balances, as 12-31-99 balances are not
provided.
8-26 a.
Factors to be considered in determining materiality
The CICA Handbook (section 5130.05) states:
A misstatement or the aggregate of all misstatements in financial statements is
considered to be material if, in the light of surrounding circumstances, it is
probable that the decision of a person who is relying on the financial statements,
and who has a reasonable knowledge of business and economic activities (the
user), would be changed or influenced by such misstatements or the aggregate
of all misstatements.
The materiality level should be determined on the basis of the needs of all users. The
CICA Handbook states that materiality is essentially a matter of the auditors
professional judgement.
In setting the level of materiality in this situation, the auditor should have included the
creditor as a user of the financial statements and assessed whether the creditor would
have changed his/her decision if there was a misstatement of $250,000. The auditor
should have weighed such a misstatement against the fact that the company had total
assets of $50 million at year end. It is possible, that given this level of total assets, a
misstatement of $250,000 would not have changed this creditors decision about the
loan.
However, the creditors loan of $100,000 was secured by inventory, and not total
assets. The auditor should have considered this fact in auditing and setting the
materiality level for inventory. For example, if inventory was valued at $2 million, then
the auditor likely would not have decreased the materiality level for inventory.
Other factors influencing the level of materiality chosen are:
Nature of the business some enterprises are in risky sectors of the economy. The
auditor should consider whether the client is in such an industry and decrease the
level of materiality if necessary.
8-20
Prior year audit experience whether or not the auditor has experienced accounting
or auditing problems in the past with this client will affect the materiality level
selected.
Prior years materiality level if the auditor is proposing a significant increase in the
materiality level in the current year but expects the level to drop to past levels in
future years, then increasing the level is not recommended. Such a step might
make it impossible to decrease the level of materiality later, due to possible
misstatements included in the companys carry-forward balances.
Normalization of assets and/or income auditor should base the preliminary

calculation of materiality on the companys assets and/or income, deducting all
unusual items that do not represent the normal course of the business.
Impact of materiality on the extent of audit testing

Materiality has a direct impact on the extent of audit testing. The higher the dollar value
of materiality, the lower the extent of audit testing. Audit testing is performed to
minimize the risk of material misstatements remaining undetected.
Other relevant matters
The Assurance and Related Services Guideline, Applying Materiality and Audit Risk
Concepts in Conducting and Audit, provides quantitative guidelines for the calculation of
materiality. It is emphasized that in no circumstance should these guidelines be
substituted for the auditors professional judgement. Professional judgement must take
into account all relevant factors. For example, the loan secured by inventory might have
been a factor in lowering the materiality level.
b.
The relationship between materiality and audit risk
Audit risk is defined as the risk of a material misstatement occurring in the financial
statements. The CICA Handbook (section 5130.23) states that there is a direct
relationship between materiality and audit riskIf, in the circumstances, a reduction in
materiality or audit risk level is appropriate, the auditor will be required to obtain further
audit evidence by increasing the extent of his/her procedures or by modifying their
nature or timing.
Consideration of concepts
In this situation, the quantitative guidelines the auditor has used are generally accepted
guidelines. The auditor chose the more conservative figure as the materiality level this
choice seems to be in the right direction. Whether the audit work was appropriate
depends largely on the level of testing performed on inventory and its value.
8-21
Chapter 9
The Study of Internal Control and Assessment of Control Risk
Review Questions
9-1
There are seven parts of the planning phase of audits: preplan, obtain
background information, obtain information about the client's legal obligations, perform
preliminary analytical procedures, assess materiality and risk, understand internal
control and assess control risk, and develop an audit plan and audit program.
Understanding internal control and assessing control risk is therefore part six of
planning. Only developing an audit plan and audit program follow understanding internal
control and assessing control risk.
9-2
Management and the auditor are both concerned that internal control provides
reliable data and safeguards the company's assets and records. Their concerns differ in
that the auditor is primarily interested in the effect of the controls on the financial
statements, whereas management is also concerned that internal control optimizes the
use of resources and ensures timely preparation of reliable information.
9-3
The independent auditor should point out to management that without reliable
financial data many of management's critical business decisions may be based on
erroneous information. Such decisions might be inappropriate and could prove costly to
the company. In addition, without proper controls over assets, the company's resources
may be drained by employee defalcation or theft by outsiders without subsequent
detection.
9-4
The control environment consists of the actions, policies and procedures that
reflect the overall attitudes of top management, the directors, and the owners of an
entity about control and its importance to the entity. The nine factors listed are those
which individually and collectively enhance or diminish internal control:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Management Philosophy and Operating Style

The functioning of the board of directors and its committees, particularly
the audit committee
Organizational Structure
Methods of Assigning Authority and Responsibility
Management Control Methods
Systems Development Methodology
Personnel Policies and Procedures
Management Reaction to External Influences
Internal Audit
9-1
9-5
A company's internal control includes two basic categories of policies and
procedures that management designs and implements to provide reasonable assurance
that its control objectives will be met. These are called the elements of internal control,
and are (1) the control environment and (2) control systems. Control systems have two
components: the accounting system; the control procedures.
The control environment is the broadest of the three and deals primarily with the way
management implements its attitude about internal controls. The accounting system is
the way accounting information is assembled, recorded and analyzed. The quality of the
accounting system will depend heavily on the control environment. The control
procedures are those policies and procedures a company implements to make sure that
assets are safeguarded and accounting information is reliable. It depends heavily on the
control environment and is a primary determinant of the accuracy of accounting
information recorded in the accounting system.
9-6
Separation of operational responsibility from record-keeping is intended to

reduce the likelihood of operational personnel biasing the results of their
performance by incorrectly recording information.
Separation of the custody of assets from accounting for these assets is intended to
prevent fraud. When one person performs both functions, the possibility of the
employee's disposal of the asset for personal gain and adjustment of the records to
relieve him or herself of responsibility for the asset without detection is increased.
9-7
General authorizations refer to management-established policies that the
organization is to follow. Subordinates are instructed to implement these general
authorizations by approving all transactions within the limits set by the policy. Examples
of general authority include the issuance of fixed price lists for the sale of products,
credit limits for customers, and fixed automatic reorder points for purchases.
Specific authorization relates to individual transactions for which management is
unwilling to establish a general policy of authorization. Instead, they prefer to make
authorizations on a case by case basis. Examples are the authorization of a sales
transaction by a sales manager for a used car dealer or loan approvals over a specific
limit in a bank.
9-8
Internal checks on performance (computer-generated or manual verification of
performance and the accuracy of recorded amounts) provide a careful and continuous
review of the other four internal control procedures by employees independent of the
employee performing the original task.
Examples of independent checks include:
1.
Preparation of the monthly bank reconciliation by an individual with no
responsibility for recording transactions or handling cash.
9-2
2.
3.
4.
5.
6.
Recomputing inventory extensions for a listing of inventory by someone

who did not originally do the extensions.
The preparation of the sales journal by one person and the subsidiary
accounts receivable ledgers by a different person and a reconciliation of
the control account to the master file.
The counting of inventory by two different count teams.
The existence of an effective internal audit staff.
Automatic balancing by computer systems.
9-9
The purpose of understanding internal control is to find out how the client
believes internal control operates. Assessing control risk means to state the degree to
which the auditor intends to depend on internal control to reduce substantive
procedures. For example, the auditor might assess control risk much below maximum
or low.
The understanding of the internal control is done by interviewing client personnel,
examining procedures manuals, describing the flow of documents and records by the
use of flowcharts and narrative descriptions, and using an internal control questionnaire.
Assessing control risk is done judgmentally, based upon the findings in the
understanding of internal control and the results of the tests of controls. It is an auditor's
decision using professional judgment.
9-10 A control is an existing procedure in internal control that aids in the prevention of
erroneous entries or omissions in the accounting system. A weakness describes a
situation where controls are inadequate for a given transaction-related objective.
Controls
1.
2.
3.
4.
5.
6.
Sales invoices are independently checked to customers' orders for prices,

quantities, extensions, footings, credit discount, and freight terms.
The management of the credit department operates completely
independent of the sales department.
The billing department is completely separated from accounts receivable
and shipping functions.
All discounts given other than those in the normal course of the company
policy require the approval of a responsible official.
Detailed customers' ledgers are maintained for all receivable accounts by
personnel entirely separated from all cash functions.
Cash receipts are entered in the books of original entry by persons
independent of the mail opening and receipt listing function.
Weaknesses
1.
The absence of any of these controls, if there were not compensating
controls would constitute a weakness.
9-3
9-11 The most important internal control weakness which permitted the defalcation to
occur was the failure to adequately segregate the accounting responsibility of recording
billings in the sales journal from the custodial responsibility of receiving the cash.
Regardless of how trustworthy James had appeared, no employee should be given the
combined duties of custody of assets and accounting for those assets.
9-12 The flowchart provides an overview of the workings of the client's internal control,
while the internal control questionnaire is a checklist reminder of many different types of
controls.
Advantages of flowcharting:
1.
Provides concise overview of client's entire internal controluseful as a
tool to aid in identifying inadequacies.
2.
Superior to written descriptioneasier to follow the diagram than to read a
description. Also easier to update a flowchart than a narrative.
Disadvantages of flowcharting:
1.
Tendency for confusion if every processing detail is shown.
Advantages of internal control questionnaire:
1.
A good questionnaire can give relatively complete coverage of each audit
area.
2.
Can usually be prepared easily at the beginning of an audit engagement.
Disadvantages of internal control questionnaire:
1.
Individual parts of the internal control are examined without providing an
overall view of the client's internal control.
2.
A standard questionnaire is often inapplicable to some audit clients
especially smaller ones.
3.
In danger of being prepared in a mechanized fashion without carefully
interviewing personnel and evaluating the implication of "no" responses.
9-13 "Significant deficiencies" are significant weaknesses in the design or operation of

internal control; they represent an absence of adequate controls and likely increase the
risk of misstatements in the financial statements. Section 5220 recommends that they
should be reported by the auditor to the audit committee or an appropriate
representative of management.
9-14 Tests of controls are procedures performed to ensure that key controls have
been operating efficiently throughout all or most of the period under audit. There are
four procedures for tests of controls:
9-4
1.
2.
3.
4.
Inquiries of client personnel

Inspection of documents and records
Observation
Reperformance
An inspection of documents test of controls would be: examine time cards for initials
which indicate that hours were re-added by an independent payroll clerk.
A reperformance test of control would be: read the hours on a sample of time cards and
compare the totals with the original calculations.
9-15 Both approaches are defined in Section 5205 of the CICA Assurance Handbook.
The substantive approach is used when the auditor does not intend to rely on the
internal controls; either because the auditor has assessed the control risk for a
particular assertion as being too high, or because it is not cost-effective to rely on the
controls for that assertion. The combined approach is used when the auditor assesses
control risk below maximum and does intend to rely on the internal controls with respect
to a particular assertion.

9-16
a.
(3)
b.
(4)
c.
(4)
9-17
a.
(3)
b.
(4)
c.
(3)
9-18
a.
(2)
b.
(4)
c.
(4)
d.
(4)

9-19
1.
a.
b.
c.
1)
Adequate documents and records.
2)
Independent checks on performance.
Transactions are stated at the correct amounts.
1)
All master file changes should be checked by a second person.
2)
Periodic review of the master file by an independent person.
2.
a.
b.
c.

Recorded transactions exist.
1)
Require that payments only be made on original invoices.
2)
Require a receiving report be attached to vendor's invoice before a
payment is made.
3.
a.
1)
9-5
b.
c.
2)
Physical control over assets.
3)
Recorded transactions exist.
1)
Fence in the physical facilities and prohibit employees from parking
inside the fencing.
2)
Require the accounting department to maintain perpetual inventory
records and take physical counts of actual sides of beef
periodically.
4.
a.
b.
c.

Transactions are stated at the correct amounts.
Counts by qualified personnel and independent checks on performance.
5.
a.
b.
c.
Proper procedures for authorization.

Recorded transactions are stated at the correct amounts.
1)
Make sure the salesman has a current price list.
2)
Require independent approval of all transactions including the price
before shipment is made.
6.
a.
1)
2)
Transactions are recorded at their proper time.
Carefully coordinate the physical count of inventory on the last day of the
year with the recording of sales to make certain counted inventory has not
been billed and billed inventory has not been counted.
b.
c.
9-2o The criteria for dividing is to keep all asset custody duties with one person
(Smith). Document preparation and recording is done by the other person (Wong). Chiu
will perform independent verification. The two most important independent verification
duties are the bank reconciliation and reconciling the receivables master file with the
control account, therefore they are assigned to Chiu. The duties should be divided
among the three as follows:
Robert Smith:
Karen Wong: *2
Barbara Chiu:
9-21
*1
*4
15
*3
5
18
*7
*6
*9
*8
10
*11
*12
13
*16
14
17
a.
Three basic controls are established by this procedure:
1.
The server, who records the sale, is not the same individual who takes the
money. In this way he is prevented from not recording the sale of a certain
item and keeping the money.
9-6
2.
3.
By recording on the tape the number of people in the party, the cashier is
able to check to see that additional people are not leaving with another
party and avoiding paying their bill.
By stapling the second tape to the first tape, the customer is prevented
from merely presenting the smaller tape as payment and leaving without
paying the larger amount.
b.
The manager can make an evaluation of these control procedures by comparing

the totals on the cash register to those on the adding machine tapes, and
comparing that to the cash received. Also, he can compare this amount to the
amount of food used to see if the cash total is appropriate.
c.
The usual fast food outlet has the customer pay prior to receiving food. This
prevents a customer from leaving without paying. However, there may be an
insufficient check on the cashier to insure he or she is not keeping the cash and
failing to record the sale. A control to help prevent this type of fraud is a visual
display on the cash register showing the amount of the sale and a cash register
receipt given to the customer.
d.
The benefit of this system is a prevention of the theft of cash by the cashier, a
prevention of customers from leaving without paying and a faster handling of
customers on the cafeteria line. The cost of this system is the salary of the extra
server.
9-22 a.
The size of a company has a significant effect on the nature of the controls
likely to exist. A small company experiences difficulty in establishing appropriate
segregation of duties and justifying an internal audit staff. However, a major type of
control available in a small company is the knowledge and concern of the top operating
person, who is frequently an owner-manager. His or her ability to understand and
oversee the entire operation of the company is potentially a significant compensating
control. His or her interest in the organization and close relationship with the personnel
enable him or her to evaluate the competence of the employees and the effectiveness
of internal control.
While some of the five internal control procedures are unavailable in a small company,
especially segregation of duties, it is still possible for a small company to have proper
procedures for authorization, adequate documents, records and reports; physical
controls over assets and records; and, to a limited degree, checks on performance.
b.
Phersen and Violette take opposite and extreme views as to the credence to be
given internal control in a small firm. Phersen seems to treat a small firm in the
same manner he would a large firm which is inefficient. Because many types of
controls are usually lacking in a small firm, assessed control risk should be
increased and more extensive substantive procedures must be utilized. Because
9-7
assessed internal control is higher, less emphasis is needed to identify the

internal controls.
Violette is not meeting the standards of the profession in that she completely
ignores the possibility of severe weaknesses in the system. She must obtain an
understanding of internal control to determine whether it is possible to conduct an
audit at all.
Auditing standards require, at a minimum, an understanding of internal control.
The auditor must understand the control environment and flow of transactions. It
is not necessary, however, for the auditor to prepare flowcharts or internal control
questionnaires. The auditor is not required to identify weaknesses if he or she
does not plan to reduce control risk below maximum (that is, rely only on
substantive procedures), as would be common on many small audit clients.
9-23
1.
a.
1)
The payroll cheques should not be returned to the supervisor but
should be distributed by persons independent of those having a part in making up the
payroll data.
2)
There is a lack of internal verification of the hours, rates, extensions
or employees by above.
b.
1)
Padding of payroll with fictitious names and extracting the cheques
made out to such names when they are returned after they have been signed.
2)
There may be errors in hours, rates, extensions, and the existence
of non-working employees.
c.
1)
Have the cheques handed out by an independent person and not
returned to Strode.
2)
Internal verification of that information by Webber or someone else.
2.
a.
The bank statement and cancelled cheques should not be reconciled by
the manager but should be sent by the bank directly to the home office, where the
reconciliations should be made against the manager's report of reimbursements.
b.
The manager may draw cheques to herself or others for personal
purposes and omit them from her list of disbursements or inflate other
reported disbursement amounts.
c.
Have all bank statements sent directly to the home office and have
Cooper report directly to the home office by use of a list of expenditures
and all supporting documentation.
9-24
Section 5220.07 of the CICA Assurance Handbook states that the auditor should
report weaknesses in internal control to the audit committee. Also, they should be
made aware of the significance of the weaknesses in internal control that the
auditor has found.
9-8
In summary, while a letter is not required under GAAS, it is good practice to provide
one. There is definite value in that the auditor has made management aware of the
weakness(s) should a problem later develop and the letter is a good public relations
gesture.
Cases
9-25
Memo to:
Partner in charge of the audit
From:
CA
Subject:
Campbells Toy Store (CTS) year-end audit
Below I have outlined the audit implications and have recommended internal control
procedures with regard to the virus that infected CTSs microcomputer system.
Audit implications of virus
Interim audit testing
The most important factor in determining the impact on our audit is the extent of
damage done to the integrity of the computer applications and data. A virus could be
benign, which would have little impact on our audit, or it could be malignant,
necessitating a change in our approach to this years audit.
Because of CTSs obvious vulnerability to viruses, we must question the reliability of the
conclusions we reached at the interim audit date in January.
Year-end audit procedures
Our audit procedures can no longer rely on CTSs computerized data. To regain our
confidence in the system we will have to retest the data.
The successful infiltration of the virus could indicate weak computer internal controls,
which means that the control risk is higher than originally anticipated. Since our risk is
increased, we will probably need to rely on a substantive approach.
We must find out what procedures CTS carried out to remove the virus and determine
whether we can rely on them. We must also complete procedures to ensure that the
virus was eliminated from the system. CAATs or virus detection program may be
sufficient.
We must assess the integrity of the financial results before the detection of the virus, as
the virus might have been active before it was detected.
9-9
Keeping a clean system from becoming infected

The following internal control procedures that will make CTSs system more virus
resistant:
Only source code should be shared, not object code, since it is harder to hide a virus
in source code.
Only the network administrator should be allowed to install new software.
Never boot a hard drive-based system from a floppy disk since many viruses are
transmitted to the hard drive only when an infected external disk is used to boot the
system.
Install up-to-date virus detection packages and update them regularly.
The system should log any access attempt: unsuccessful attempts should be
investigated.
Password security should be strictly enforced to prevent the loading of untested
software onto the system. Passwords should be updated and kept confidential.
Access to programs should be restricted to authorized users.
Access to modems should be restricted by means of passwords, callback and any
other methods of limiting access.
Employees should be notified that unauthorized programs are disallowed.
Testing of new software and information

All new software should be checked for the presence of viruses before it is installed.
System software should be write-protected so that if a virus tries to update the disk it will
be clocked and an error message will appear, thus uncovering the virus.
Hidden messages should be searched for, since the character string will reveal
malicious intent.
Different system dates should be used. If tests fail to detect a virus, it will be caught by
the change in update time. (date/time)
General environmental controls
The company should document and enforce backup policies and procedures. Backups
on all files should be made daily or at key points in time. Backups should be dated and
kept for years since the virus may be active for a long period before it is discovered.
A disaster recovery plan should be in place in case of an event that causes irreparable
damage.
9-10
Chapter 10
Overall Audit Plan and Audit Program
Review Questions
10-1 The four types of tests used by auditors to determine whether financial
statements are fairly stated are;
1.
2.
3.
4.
procedures to obtain an understanding of internal control

tests of controls
tests of details of balances
The first two types are performed to assess control risk, and the last two types are
performed to achieve planned detection risk. All audit procedures fall into one or more
of these four categories.
10-2 Tests of controls are audit procedures designed to verify whether the client's
controls are being applied in the manner described in the flowchart and internal control
questionnaire. Examples include:
1.
2.
3.
4.
The examination of vendor invoices for indication that they have been
clerically tested, compared to a receiver and purchase order, and
approved for payment.
Examination of employee time cards for approval of overtime hours
worked.
Examination of journal entries for proper approval.
Examination of approvals for the write-off of bad debts.
Substantive tests are procedures designed to test for dollar errors directly affecting the
fair presentation of financial statement balances. Examples are:
1.
2.
3.
4.
Reconciliation of balances indicated in vendor statements.

Examination of vendor invoices in support of amounts recorded for
purchases of inventories.
Recalculation of payroll amounts.
Recalculation of amounts accrued for various liabilities.
10-3 A reperformance procedure is an audit procedure in which the auditor performs

the same procedure that client personnel did, to make sure that the monetary amounts
are correct. An example is to multiply unit selling prices times quantity on duplicate
sales invoices to make sure the client calculated the amounts correctly.
10-1
10-4 A test of controls audit procedure to test that approved wage rates are used to
calculate employee earnings would be to examine rate authorization forms to determine
the existence of authorized signatures.
A substantive test audit procedure would be to compare a sample of rates actually paid,
as indicated in the earnings record, to authorized pay rates on rate authorization forms.
10-5 The auditor resolves the problem by making assumptions about the results of the
tests of controls and performing both the tests of controls and substantive procedures
(dual-purpose tests) on the basis of these assumptions. Ordinarily the auditor assumes
effective internal control with few or no deviations planned. If the results of the tests of
controls are as good as or better than the assumptions that were originally made, the
auditor can be satisfied with the substantive procedures, unless the substantive
procedures themselves indicate the existence of misstatements. If the tests of controls
results were not as good as the auditor assumed in designing the original tests,
expanded substantive procedures must be performed.
10-6 When the results of analytical procedures are different from the auditor's
expectations and thereby indicate that there may be a misstatement in the balance in
accounts receivable and sales, the auditor should extend his or her tests until he or she
determines why the ratios are different from his or her expectations. Confirmation of
accounts receivable and cut-off tests for sales are two procedures that can be used to
do this. On the other hand, if the ratios are approximately what the auditor expects, the
other tests can be reduced. This says that the auditor can satisfy the evidence
requirements in different ways and that analytical procedures and confirmation are
complementary when the results of the tests are both good.
10-7 The auditor must gain an understanding of internal control sufficient to plan the
audit under either approach. In a combined audit approach, the auditor plans to assess
control risk below maximum and perform tests of controls to confirm that assessment;
reduced substantive testing will be required because of this reliance on internal control.
In a substantive audit approach, the auditor assesses control risk at maximum and
gains all his or her assurance from substantive procedures.
A combined approach would be appropriate for the acquisitions and payment cycle if
there were internal controls in place and working that provided assurance that all
purchases made by the company were recorded in accounts payable; in this case the
auditor would likely assess control risk below maximum with respect to the
completeness assertion. If, on the other hand, controls over the recording of purchases
were weak or non-existent, controls risk would be assessed at maximum and the
auditor would verify the completeness assertion by substantive procedures.
10-2
10-8
The audit of permanent asset additions normally entails the examination of
invoices in support of the additions and possibly the physical examination of the
additions. These procedures are normally performed on a test basis with a
concentration on the more significant additions. If the individual responsible for
recording new acquisitions were known to have inadequate training and limited
experience in accounting, the sample size of the audit procedures should be expanded
to include a larger sample of the additions for the year. In addition, inquiry as to what
additions were made during the year may be made by the auditor of plant managers,
the controller, or other operating personnel. The auditor should then search the financial
records to determine that these additions were recorded as permanent assets.
Care should also be taken when the repairs and maintenance expense account is
analyzed since lack of training may cause some depreciable assets to be expensed at
the time of purchase.
10-9
The following shows which types of evidence are applicable for the four types
of tests.
Type of Evidence
Confirmation
Documentation
Observation
Inquiries of the client
Reperformance
Types of Tests
Tests of details of balances
Tests of details of balances
All except analytical procedures
Procedures to obtain an understanding of
controls and tests of controls
All four types
Tests of controls, tests of details of balances,
and substantive tests of transactions
10-10
Before a reduction in substantive procedures is permitted, internal controls
must be effective and the auditor must have found the results of the tests of controls
satisfactory. Cost effectiveness of reduced assessed level of control risk should be
considered in making the decisions as to whether to test controls. The cost
effectiveness of reduced control risk is an audit efficiency issue.
10-11
The three-step approach to designing tests of transactions is as follows:
1.
Apply the detailed internal control objectives to the class of transactions being
tested.
2.
Identify specific controls that should reduce control risk for each objective.
3.
Develop tests of controls for each key control.
10-3
10-12
The approach to designing tests of transactions (Figure 10-5) emphasizes
satisfying the internal control objectives developed in chapter 9. Recall that these
objectives focus on the proper functioning of the accounting system.
The methodology of designing tests of details of balances (Figure 10-7) emphasizes
satisfying the audit objectives developed in chapter 5. The primary focus of these
objectives is on the fair presentation of account balances in the financial statements.
10-13
It is desirable to design tests of details of balances before performing tests of
controls to enable the auditor to determine if the overall planned evidence is the most
efficient and effective in the circumstances. In order to do that the auditor must make
assumptions about the results of the tests of controls. Ordinarily the auditor will assume
no significant errors or control problems in tests of controls unless there is reason to
believe otherwise. If the auditor determines that the tests of controls results are different
from those expected, the amount of testing of details of balances must be altered.
10-14
If tolerable misstatement is low, and inherent risk and control risk are high,
planned tests of details of balances which the auditor must perform will be high.
An increase in tolerable misstatement or a reduction of either inherent risk or control risk
will lead to a reduction in the planned tests of details of balances.
10-15
Auditors frequently consider it desirable to perform audit tests throughout the
year rather than waiting until year-end because of the public accounting firm's difficulty
of scheduling personnel. Due to the uneven distribution of the year-end dates of their
clients, there is a shortage of personnel during certain periods of the year and excess
available time at other periods.
The procedures that are performed at a date prior to year-end are often dependent
upon adequate internal control and when the client will have the information available.
Procedures which may be performed prior to the end of the year are:
1.
2.
3.
4.
5.
6.
7.
8.
Update permanent asset schedules.

Examine new loan agreements and other legal records.
Vouch certain transactions.
Analyze changes in the client's system.
If the client has strong internal control so that the auditor may assess
control risk at less than maximum, the following procedures may be
performed with minor review and updating at year-end:
Observation of physical inventories;
Confirmation of accounts receivable balances;
Confirmation and reconciliation of accounts payable balances.
10-4

10-16
a. (4)
b.
(4)
c.
(3)
10-17
a. (3)
b.
(3)
c.
(4)
d.
(1)

10-18
a.
1.
TD of B
Reperformance
2.
TD of B
Documentation
3.
AP
4.
Test of Controls
Inquiry and observation
5.
TD of B
Confirmation
6.
TD of B
Documentation and reperformance
7.
Test of Controls
Documentation
8.
Test of Controls
Documentation
9.
AP
10.
TD of B
Documentation
11.
Test of Controls
Documentation
10-19
a.
1
b.
b.
c.
d.
Acquisition
and payment
Reperformance
Substantive
TD
of B
Posting and
Summarization
Acquisition
and Payment
Documentation
Test of control
or Substantive
10-5
Existence Occurrence
f.
N/A
Inventory
and
Warehousing
Analytical
Procedure
Substantive
AP
N/A
N/A
Capital Acquisition and

Repayment
Confirmation Substantive
TD
of B
N/A
Existence
accuracy
Presentation and
Disclosure
Acquisition
and Payment
Reperform- Substantive
ance
TD
of B
N/A
Detail
Tie-in
Accuracy
Acquisition
and Payment
Documentation
TD
of B
N/A
Cut-off
Sales and
Collection
Observation Test of
Controls
N/A
Completeness
N/A
Sales and
Collection
Inquiry
TD
of B
N/A
Realizable value
Substantive
Substantive
10-20
a.
1. Accuracy
2. Accuracy
3. Existence
Completeness
4. Timing
b.
Examine vendors'
invoices for
indication of
recalculation
Determine
existence of
approved price lists
for acquisitions
Account for a
numerical sequence
of receiving reports
c.
An error in
calculation of
a vendor's
invoice
Unauthorized
prices could
be paid for
acquisitions
Unrecorded
acquisitions
exist
Examine vendors'
invoices for
indication of
comparison
Cutoff errors
10-6
d.
Recalculation of the
vendor's invoice
Obtain prices from

purchasing department
and compare to vendors'
invoices
Confirm accounts
payable, especially
vendors with small zero
balances
Confirm accounts
payable
5. Posting
Summarization
6. Classification
Examine indication
of reconciliation of
the subsidiary ledge
and control account
Errors in
subsidiary
records or
control
account
Examine vendors'
Account
invoices for
classification
indication of internal errors
verification
7. Existence
Examine cancelled
cheques for
signature
Invalid or
unauthorized
payment
8. Existence
Accuracy
Examine vendors'
invoices for
indication of
comparison
Examine supporting
documents for
indication of
cancellation
Observe cheque
mailing procedures
and inquire about
normal procedures
Invalid or
unauthorized
payment
9. Existence
10. Existence
Duplicate
payment for
an acquisition
Bookkeeper
takes signed
cheques and
changes
payee name
Foot subsidiary records

and compare to control
account
Compare vendors'
invoices to acquisitions
journal for
reasonableness of
account classification
Examine supporting
documents for
appropriateness of
expenditures
Examine supporting
documents for
appropriateness of
expenditures
Examine supporting
documents for every
payment to selected
vendors
Compare payee name on
cancelled cheque to
supporting documents
10-21
a. The performance of interim tests of controls is an effective means of
keeping overtime to a minimum where many clients have the same year-end date.
However, this approach requires additional start-up time each time the auditor enters
the field to perform additional tests during different times of the year. In the case of a
small client, start up costs and training time may require more total time than waiting
until after December 31.
b.
Schaefer may find that it is acceptable to perform no additional tests of controls

work as a part of the year-end audit tests under the following circumstances:
1. The results of the tests of the interim period indicate the accounting system is
reliable.
2. Inquiries concerning the remaining period may indicate there were no significant
changes in internal control and accounting procedures.
10-7
3. The transactions occurring between the completion of the tests of controls and
the end of the year are not unusual compared to the transactions previously
tested and to the normal operations of the company.
4. Other tests performed at the end of the year do not indicate that internal control
is less effective than the auditor has currently assessed.
5. The remaining period is not too long in the circumstances. (Some consensus
exists in the profession requiring the remaining period to be three months or
less, depending upon the circumstances.)
6. Other matters of concern to the auditor indicate that the limitation of tests of
controls is appropriate (i.e., risk of exposure to legal sanction is not too great;
the auditor will probably be familiar with the client's operations and will
determine that a reduced control risk is justified; the auditor has appropriate
confidence in the competence of personnel and the integrity of management).
c.
If Schaefer decides to perform no additional tests of controls, depending upon the

circumstances, she may wish to perform analytical procedures, such as reviewing
interim transactions for reasonableness or tracing them to their source, comparing
balances to previous periods, or other such procedures, for the remaining period
to year end.
10-22
Audit
Tests of
Controls
Analytical
Procedures
Substantive
Tests of
Balances
1
E
E
S
2
N
M
E
3
E
E
S, E*
E = Extensive amount of testing.
M = Medium amount of testing.
S = Small amount of testing.
N = No testing done.
S,E* = Small amount of testing for the gross balance in accounts receivable; extensive
testing done for the collectibility of the accounts.
a.
For audit 1 the recommended strategy is to maximize the testing of internal

controls and minimize the testing of the details of all ending balances in inventory.
The most important objective would be to minimize the number of locations that
need to be visited. The justification for doing this is the quality of internal control
and the results of prior year audits. Assuming that some of the locations have a
large portion of the ending inventory balance and others smaller portions, the
auditor can likely completely eliminate tests of physical counts of some locations
and emphasize the locations with larger dollar balances. The entire strategy is
oriented to minimizing the need to visit locations.
10-8
b.
Audit risk for this audit should be low (that is, assurance because of the plans to
sell the business, severe under-financing and a first year audit.) The lack of
controls over accounts payable and the large number of adjusting entries in
accounts payable indicate the auditor cannot consider internal control effective.
Therefore the plan should be to do extensive tests of details of balances, probably
through accounts payable confirmation and other end of year procedures. No tests
of controls are recommended because of the impracticality of reduced assessed
control risk. Some analytical procedures are recommended to verify the
correctness of acquisitions and to obtain information about the reasonableness of
the balances.
c.
The most serious concern in this audit is the evaluation of the allowance for
uncollectible accounts. Given the adverse economic conditions, significant
increase of loans receivable, the auditor must be greatly concerned about the
adequacy of allowance for uncollectible accounts and the possibility of
uncollectible accounts being included in loans receivable. Given internal control,
the auditor is not likely to be greatly concerned about the gross accounts
receivable, except for accounts that need to be written off. Therefore, for the audit
of gross accounts receivable there will be a greatly reduced assessed control risk
and relatively minor confirmation of accounts receivable. In evaluation of the
allowance for uncollectible accounts the auditor should test the controls over
granting loans and follow up on collections, however given the changes in the
economy it will be necessary to do significant additional testing of the allowance
for uncollectible accounts. Therefore an S is included as a test of details of
balances for gross accounts receivable and an E for the tests of net realizable
value.
10-23
a. The balances in the accounts included in the income statement and
statement of changes in financial position result from the transactions during the period
which affect the asset and liability accounts. If the beginning balances are not audited,
the auditor cannot be sure that the intervening transactions are correct. A qualified
opinion on the income statement and statement of changes in financial position will be
required, though an unqualified opinion for the balance sheet is possible.
b.
To verify the beginning balance in accounts receivable, Jackson could:

1.
2.
c.
Confirm the balance directly with customers (although most customers

may not have sufficient records to reply).
Examine supporting documents for the beginning balances. These would
include verifying shipments by examining bills of lading and payments by
tracing to the cash receipts journal and bank statement showing deposits.
Beginning balances on continuing audit engagements have been verified as
ending balances during the previous audit.
10-9
10-24
a. Factors which could explain the difference in the amount of evidence
accumulated in different parts as well as the total time spent on the engagement are:
a.
Internal control;
b.
Materiality of the account balance;
c.
Size of the populations;
d.
Make-up of populations;
e.
Initial vs. repeat engagement;
f.
Results of the current and previous audits;
g.
Existence of unusual transactions;
h.
Motivation of the client to misstate the financial statements;
i.
Degree of client integrity.
For an example, in the first audit, the auditor has apparently made the decision to
emphasize tests of controls and minimize substantive procedures. That implies effective
internal control and a low expectation of misstatement (low inherent and control risk.) In
the third audit, the auditor apparently has a high expectation of misstatements, and
therefore believes it is necessary to do both extensive tests of controls and substantive
procedures. Audit two is somewhere between.
b.
The audit partners could have spent time discussing the audit approach and
scope with Bryan prior to the beginning of the field work.
c.
The nature of these three engagements and the different circumstances

appear to be excellent examples of the tailoring of audit procedures to
appropriate levels considering the circumstances.
10-25
a. The following is a time line for the audit procedures, showing the
sequence of the parts of an audit in a typical audit.
July 31
Audit Report Date
______________________________________________________________________
5, 9, 7, 2
8
1
3
4
6
Parts 5, 9, and 7 are all a part of planning and are therefore done early. These are in
the sequence shown in chapter 5.
As part of planning the audit, the auditor obtains an understanding of internal control
and initially assesses control risk. The auditor then tests the internal controls and
confirms or disconfirms his or her assessment of control risk.
Ideally most analytical procedures are performed after the client has prepared financial
statements, but before tests of details of balances are performed. Therefore, they
should be done before confirmation of accounts payable, to provide information about
the expectation of misstatement.
10-10
Confirmation of accounts payable should be done as early after the balance sheet date
as possible to facilitate getting responses back, performing alternative procedures for
non- responses and reconciling differences before the audit is completed.
Tests for review of subsequent events is normally the last thing done on the
engagement before the auditor's report date. The audit report is issued after the
auditor's report date.
b.
The time line shows that 5, 9, 7 and 2 are frequently done before the balance
sheet date.
Cases
10-26
a.
Further information required:
1. The names and relationships of related parties, either individuals or corporations, in
order to:
!
Identify any intercompany transactions and balances that should be

eliminated on consolidation
Identify related party transaction so that the disclosure requirements

related to the transaction, balances and other matters may be considered
Enable Fairly, Small & Co to report on its independence to Giant and Co.
2. Additional information regarding the accounting policies and other matters that
would affect YPL. To identify differences, if any, and adjust the financial statements.
3. General information regarding the business philosophy and other business matters
that would affect YPL. This would gain an insight into the operations and its overall
philosophy. General business information would provide data on product lines and
transfer prices.
4. Information regarding the requirements for nine month statements. This would be
necessary for consolidation purposes.
5. Information on Many Conglomerate Limiteds income tax classification to verify if
YPL has lost its small business deduction and is therefore required to pay Part VI
income tax on previous small business deduction credits.
10-11
6. Whether Giant and Co. require any particular information, such as a special
presentation of fixed assets, the salaries of executives or analyses of certain
accounts.
b.
Memorandum to audit senior
General matters
1.
An introduction outlining the change in control including the date of change,

name of and general information about the acquiring company and an indication
of how this change in control will specifically affect the audit as to related party
transactions.
2.
The new reporting package with which YPL must now comply.
Internal control
1.
The early reporting deadline for the financial statements, and the earlier
attendance at inventory. The audit senior will have to evaluate the new internal
control system to determine whether it is possible to rely upon it.
2.
The early inventory attendance will necessitate reliance on the new inventory
system and on the accounts receivable and accounts payable systems as well.
3.
The review procedures for the evaluation of internal control and the compliance
procedures of the system should include tests to examine:
Payroll and purchase entries to inventory accounts

Cost of goods sold entries
Transfers between inventory accounts
Physical controls that safeguard the inventories
The recording of sales, including shipping and billing procedures
Control over cash receipts and deposits
Cut-off
Because the inventory count date has been moved forward, certain cut-off procedures
must now be completed.
1.
Verify that the client has instituted effective procedures with his staff for this early
cut-off.
2.
To ensure an effective cut-off, the interrelated accounts of inventory, receivables

and payables will have to be verified.
10-12
3.
The sending of accounts receivable and accounts payable confirmations should

be completed at the time of attendance at the inventory count.
Post cut-off
1.
For transactions between November and December it will be necessary to carry

out analytical review and substantive tests to ensure that accounts receivable,
accounts payable and inventories are properly recorded.
2.
For November and December procedures should include:
A comparison of results with budgets and with previous years results

Testing of entries to the various related accounts.
Other important matters

1.
Certain aspects of the year-end audit involving prepaid expenses, fixed assets,
capital stock and goodwill can be carried out in October.
2.
Other confirmation letters, such as lawyers letters and long-term debts, should
be prepared in January.
3.
The reporting package for YPL should be reviewed as soon as possible and
problem areas highlighted.
The reporting package should be reconciled to the statutory financial statements as

soon as the statements are prepared.
10-27
Memo to:
From:
Subject:
Partners in charge
CA
Audit planning for Canadian Chocolate Company (CCC)
Inherent audit risk is high and is affected by the following factors:

Both auditors are new to this client and therefore have no previous experience to
rely on.
CCC has a number of locations, some of them foreign, with their own accounting
system and has intercompany transactions among locations.
CCC has had some financial problems such as a shrinking market and
unsuccessful new product launching. It is also facing major lawsuits, from the
extortion attempt. These increase the risk of manipulation by management of the
financial results.
10-13
Inventory prices are volatile, and the nature of the inventory makes its existence
difficult to audit. CCC relies on perpetual records and does not perform a physical
count.
New product line

The introduction of the new product lines has several audit implications, as follows:
1. Product 4 will not recover all development costs until at least the seventh year.
There are two alternative accounting treatments that may be considered.
a. In Canada and on consolidation of the U.S. subsidiary, it may be appropriate to
defer only the amount of development costs considered recoverable in a
reasonable period. (5 years)
b. If the four new items are considered collectively as a single new product, all
development costs can be recovered in a shorter period.
2. Outstanding contracts for advertising the new products should be properly accrued
and disclosed.
3. The costs associated with obtaining the market research data can be deferred, as
party of the development costs, but advertising costs cannot.
4. The development costs will have to be examined in detail to ensure that they are
costs that qualify for capitalization.
5. In the U.S. development costs must be expensed. For consolidation purposes, the
information from the U.S. auditors is needed to adjust development costs to
Canadian GAAP.
6. The coupon campaign will create a liability and CCC should accrue these liabilities
as it makes sales to retailers.
7. The capitalization of development costs and the accrual of the coupon liability will
result in deferred taxes, as the tax treatment of these items is not the same as the
accounting treatment.
Extortion loss
The net book value of the equipment taken out of service, the cost of the destroyed
products, and the public relations cost do not represent future benefits so they should
not be capitalized. CCC should recognize them as extraordinary losses.
It is necessary to review the insurance claim for reasonableness and confirm with the
insurance company the amounts paid and due to the company.
10-14
A letter is required from CCCs lawyers concerning the outstanding lawsuit, to decide
whether CCC should accrue a liability or merely disclose the fact that liability may exist.
CCCs insurance coverage should be checked to se if any of the costs of this lawsuit will
be covered by insurance.
Product discontinuance costs
Ensure that any capital items or inventory supplies that will no longer be used are
valued at no more than net realizable value. Any related deferred costs should be
written off and adequate provision made for any other related disposition costs that may
be incurred.
Inventories
The potential inventory problems can be segregated under physical existence and
valuation.
1. Physical existence
A physical count of the main raw materials, cocoa beans and sugar, stored at each
subsidiary should be conducted. It will be necessary to ascertain the degree of accuracy
of the perpetual records because they are the basis on which the year-end balances will
be determined.
The only significant audit problem posed by work in process might be obtaining
satisfaction about semi-process chocolate in transit between subsidiaries. Finished
goods do not appear to present any problems.
If a specialist is required to aid in the audit, the provisions of Handbook Section 5360
must be followed.
2. Valuation
Valuation of sugar and cocoa beans could be difficult; they are valued at the lower of
cost and replacement cost. Any valuation problem with regard to semi-processed
chocolate transferred from another company should be eliminated on consolidation, as
any intercompany profits must be eliminated.
Purchase contract losses
Review all outstanding purchase contracts at year-end for disclosure in the notes to the
financial statements. Ascertain whether any contract might lead to a loss that should be
accrued at the year-end in accordance with Section 3290 of the Handbook.
10-15
Segment information
CCC only operates in one industry segment (chocolate); the company cannot present
information on an industry-segment basis. Disclosure of the fact that dominant segment
exists will be required.
The major audit problems will be in obtaining satisfaction that all inter-segment transfers
have been appropriately priced and that such transfers reflect any consolidated profit
eliminations. Ensure that all common costs have been allocated on a reasonable basis.
Reliance on other auditors
Use the Handbook Section 6930 to determine if the auditing procedures performed by
the foreign auditors is acceptable.
Reliance on internal auditors
Use CCCs internal audit team when doing the annual audit. Their participation should
result in a more effective and efficient audit.
Transfer pricing
CCC does not have a formal policy for transfer pricing. A formal policy should be issued
using either a cost or a market-based approach to eliminate the problem of determining
a price for each shipment.
Research and Development cost allocation
Research, development and other common costs are being allocated among the
subsidiaries on the basis of asset values. This basis is not reasonable, especially in
cases where the subsidiary is not manufacturing or marketing the bar. For the new
product line, costs should be shared between the two subsidiaries that have been
created to manufacture the line.
Taxation issues
Ensure that cross-border transfer-pricing is at fair market value to satisfy Canada
Customs and Revenue Agency.
10-16
Chapter 11
Audit Sampling Concepts
Review Questions
11-1
A representative sample is one in which the characteristics of interest for the
sample are approximately the same as for the population (that is, the sample accurately
represents the total population). If the population contains significant errors, but the
sample is practically free of errors, the sample is non-representative, which is likely to
result in an improper audit decision. The auditor can never know for sure whether he or
she has a representative sample because the entire population is ordinarily not tested,
but certain things, such as the use of random (probabilistic) selection, can increase the
likelihood of a representative sample.
11-2
Statistical sampling is the use of mathematical measurement techniques to
calculate formal statistical results. The auditor therefore quantifies sampling risk when
statistical sampling is used. In nonstatistical sampling, the auditor does not quantify
sampling risk. Instead, conclusions are reached about populations on a more
judgmental basis.
For both statistical and nonstatistical methods, the three main parts are:
1. Planning the sample
2. Selecting the sample and performing the tests
3. Evaluating the results
11-3
In replacement sampling, an element in the population can be included in the
sample more than once if the random number corresponding to that element is selected
from a random table more than once. In nonreplacement sampling, an element can be
included only once. If the random number corresponding to an element is selected more
than once, it is simply treated as a discard the second time. Although both selection
approaches are consistent with sound statistical theory, auditors rarely use replacement
sampling; it seems more intuitively satisfying to auditors to include an item only once.
11-4
In systematic sampling, the auditor calculates an interval and then
methodically selects the items for the sample based on the size of the interval. The
interval is set by dividing the population size by the number of sample items desired.
To select 35 numbers from a population of 1750, the auditor divides 35 into 1750 and
gets an interval of 50. He or she then selects a random number between 0 and 49.
Assume the auditor chooses 17. The first item is the number 17. The next is 67, then
117, 167, and so on.
11-1
The advantage of systematic sampling is its ease of use. In most populations a

systematic sample can be drawn quickly, the approach automatically puts the numbers
in sequential order and documentation is easy.
A major problem with the use of systematic sampling is the possibility of bias. Because
of the way in which systematic samples are selected, once the first item in the sample is
selected, all other items are chosen automatically. This causes no problems if the
characteristics of interest, such as compliance exceptions, are distributed randomly
throughout the population; however, in many cases they are not. If all items of a
particular type are processed at a certain time of the month or with the use of certain
document numbers, a systematically drawn sample has a higher likelihood of failing to
obtain a representative sample. This shortcoming is sufficiently serious that some public
accounting firms do not permit the use of systematic sampling.
11-5
A block sample is the selection of several items in sequence. Once the first
item in the block is selected, the remainder of the block is chosen automatically. Thus,
to select 5 blocks of 20 sales invoices, one would select one invoice and the block
would be that invoice plus the next 19 entries. This procedure would be repeated 4
other times.
11-6
The sampling unit is the population item from which the auditor selects sample
items. The major consideration in defining the sampling unit is making it consistent with
the objectives of the audit tests. Thus, the definition of the population and the planned
audit procedures usually dictate the appropriate sampling unit.
The sampling unit for verifying the validity of recorded sales would be the entries in the
sales journal since this is the document the auditor wishes to validate. The sampling
unit for testing the possibility of omitted sales is the shipping document from which sales
are recorded because the failure to bill a shipment is the exception condition of interest
to the auditor.
11-7
Sampling error is an inherent part of sampling that results from testing less
than the entire population. Sampling error simply means that the sample is not
representative of the entire population.
Non-sampling error occurs when audit tests do not uncover errors which exist in the
sample. Non-sampling error can result from:
1.
The auditor's failure to recognize exceptions, or
2.
Inappropriate or ineffective audit procedures.
There are two ways to reduce the risk of sampling error:
1.
Increase sample size.
2.
Use an appropriate method of selecting sample items from the
population.
11-2
Careful design of audit procedures and proper supervision and instruction are ways to
reduce the risk of non-sampling error.
11-8
Tests of controls include looking for deviations from clients established
controls, and monetary errors or fraud and other irregularities in populations of
accounting data. Attribute sampling works well for these types of tests because it is
estimating the proportion of items that contain a certain characteristic. Test of balances
require a dollar amount to determine if the difference is material.
11-9
An attribute is a statement of the condition when the control procedure is in
effect. An exception is a departure from that control condition. The exception for the
audit procedure, the duplicate sales invoice has been initialled indicating the
performance of internal control, is the lack of the attribute in question.
11-10
Stratified sampling is the technique of dividing a population into uniform

sub groups called strata. Then each of the strata can be sampled
separately. This sampling is used when items of very high or low values
or some other type of unusual characteristics exist. Accounts receivable
could be stratified into 3 strata:
All accounts over $25,000 - 5 accounts
Accounts $10,000 to $25,000 - 15 accounts
Accounts under $10,000 10 accounts
11-11
The true value of the misstatements can be determined by doing 100%

testing. To calculate the point estimate of the total misstatements an
inference is made that misstatements in the unaudited population are in
proportion to those in the audited population. A weighted average is taken
of the misstatement.
11-12
The relationship between sample size and the four factors determining
sample size are as follows:
a.
b.
c.
d.
As the ARACR increases, the required sample size decreases.

As the population size increases, the required sample size increases but
only slightly.
As the tolerable exception rate increases, the sample size decreases.
As the estimated population exception rate increases, the required sample
size increases.
11-3
11-13
Sampling risk is the risk that the auditors conclusion based on a sample
might be different from the conclusion they would reach if they examined every item in
the population. Sampling risk applies to all sampling. Selecting an appropriate type of
sampling provides a lower sampling risk. The only time you would avoid sampling risk
is if you tested the entire population, but then you would no longer have a sample.
11-14
Analysis of exceptions is the investigation of individual exceptions to
determine the cause of the breakdown in internal control. Such analysis is important
because by discovering the nature and causes of individual exceptions, the auditor can
more effectively evaluate the effectiveness of internal control. The analysis attempts to
tell the "why" and "how" of exception occurrence after the auditor already knows how
many and what types of exceptions have occurred.
11-15
A situation where an auditor would consider using discovery sampling is if they
have reasons to suspect that fraudulent activity is taking place. For example if the
suspicion is that someone is preparing fraudulent purchasing orders, receiving reports
and purchase invoices in order to send cheques to cover the fabricated transaction.
11-16
Random (probabilistic) selection is a part of statistical sampling, but it is not,
by itself, statistical measurement. To have statistical measurement, it is necessary to
mathematically generalize from the sample to the population.
Ordinarily, the auditor should not use random selection without drawing a statistical
conclusion because of the inconclusiveness of using such results. There is a statistical
inference inherent in random selection; therefore, the auditor should compute it to
consider the implications of the statistical results. It would always be inappropriate to
use statistical measurement to evaluate results when a sample is not randomly
selected.
One case when a statistical inference should not be made is when the random sample
size is too small to do so. Conversely, it would be inappropriate to ever draw a statistical
conclusion unless the sample is randomly selected.

11-17
11-18
11-19
a. (1)
a. (3)
a. (4)
b.
b.
b.
(3)
(1)
(2)
c.
(3)
d.
(3)
e.
(2)
c.
(4)
d.
(4)
e.
(3)
11-4
f.
(1)

11-20
Sampling
Unit
1.
Sale
s invoice
2.
Bill
of lading
11-21 a.
Numbering System for Correspondence Between

the Population
Random Number Tables and
Population
All invoices numbered
The four left-most digits of the
0001 to 6211
random number correspond to
the invoice number
All bills of lading

numbered 1926 through
8511 (drop the left-most
digit "2")
The following shows which are exceptions and why:

Exception ? Type of Exception
Invoice
Number
5028
6791
6810
7364
No
No
Yes
No
7625
8431
Yes
Yes
8528
Yes
8566
8780
9169
9974
Yes
Yes
Yes
Yes
b.
The fourth left-most digits of

the random number
correspond to the bill of lading
number.
First 5
Sample
Items
5018
5001
0445
5751
4337
5018
5001
6602
5751
4337
Error was detected and corrected by client.

Sales invoice was voided.
Proof of shipment not presented.
Credit collection problem; should be noted for review
of allowance for doubtful accounts.
Duplicate sales invoice not properly filed
Invoices not recorded by proper date; represents
potential cutoff problem.
Customer orders not included in invoice package to
verify compliance with the order.
Error in pricing. No internal verification.
Duplicate sales invoice not properly filed.
Credit not authorized.
Internal verification of price extensions and postings
of sales invoices was not included.
It is inappropriate to set a single acceptable tolerable exception rate and

estimated population exception rate for the combined errors because each
attribute has a different significance to the auditor and should be considered
separately in analyzing the results of the test.
11-5
c.
For each exception, the auditor should check with the controller to determine his
explanation for the cause. In addition, the appropriate analysis for each type of
exception is as follows:
Invoice No.
6810
7625
8431
8528
8566
8780
9169
9974
11-22
Deviation Analysis
Confirm the account balances to the customer; examine the reduction in
the perpetual inventory records.
Trace the amount to the sales journal and subsidiary ledger; examine the
shipping document and recompute the sale amount.
Determine who recorded the invoice and check several others prepared
by him or her to determine if the error consistently occurs.
Examine subsidiary ledger of subsequent cash receipt; examine sales
invoices for other invoices to the same customer to determine if customer
orders were attached.
Check the price on other invoices to the same customer. Check the price
on other invoices which have the same product.
See 7625
Check credit history of customer and evaluate collectibility of the
customer's account.
Recheck actual price, extensions and postings; determine who the clerk
was and check several other invoices for proper indication of
performance.
1. (a)
2.
(d)
3.
(d)
4.
(c)
5.
(a)
11-23 a.
This nonstatistical (ie. judgmental) sample is a stratified sample. All 23
items over $10,000 ere examined 100%. The remaining 7,297 items were tested with a
sample of 77 items. Although this was not a probabilistic sample, GAAS require that in
the auditors judgment, it be a representative one. Accordingly the results must be
projected to the population and a judgment made about sampling risk, although
sampling risk and precision cannot be measured.
Projection of the total population misstatement would be as follows;
Items over $10,000
Projected Misstatement
= Audited value - Recorded value

= 432,000 -465,000
= (33,000) overstatement.
Items under $10,000
11-6
= Average sample misstatement X population size

= (4,350 / 77) X (7,320 - 23)
= 56.49 X 7,297
Items under $10,000 -- proportional amount method

= Sample misstatement ratio X population book value

= (4,350 / 19,285) X (2,760,000 - 465,000)
= .226 X 2,295,000
Where sample misstatements are;

ITEM
AUDITED VALUE
12
19
33
35
51
59
74
4,820
385
250
3,875
1,875
3,780
0
RECORDED
VALUE
5,120
485
1,250
3,975
1,850
4,200
2,405
TOTALS
14,935
19,285
MISSTATEMENT
(4,350)
(300)
(100)
(1,000)
(100)
(25)
(420)
(2,405)
Total misstatement is either:

(33,000) + (412,207) = (445,207) overstatement
or
(33,000) + (518,670) = (551,670) overstatement
In either case, the following can be said: There is a significant number of misstated
items in the sample, and the amount is quite large. Since the sample is representative,
it is clear that there is a material misstatement of the population. The amount of
misstatement is not estimable from the sample. At this point, the best course of action
would be to ask the client to make a study of their records for all population items to
identify more accurately the misstatements that exist and correct them.
11-24
Decision to Use Sampling
Generally accepted auditing standards do not require a 100% examination to

express an opinion. The standard audit report explicitly refers to such tests and
other procedures as were considered necessary in the circumstances.
11-7
Sampling allows the auditor to obtain sufficient confidence in the financial

information without examining all the underlying evidence. This reduces cost and
improves timeliness without sacrificing quality.
Planning is necessary to ensure that, within the confidence limits desired, the
sample is representative of the population and that the conclusion drawn from the
sample can be properly applied to the entire population.
The auditor would choose to sample a large sized database but may decide it is
more efficient to examine the entire population of a small number of large dollar
value transactions.
When some items in the population are high risk, or if the auditor believes they
require special attention because of a particular attribute (for example, seriously
overdue accounts receivable, slow moving inventory items or related party
transactions), those items should be specifically identified for testing.
The auditor must consider inherent risk at the time of each examination and
determine the extent of testing necessary to satisfy himself or herself that this risk
has not actually resulted in errors that would cause difficulties in the expression of
the audit opinion.
100% examination may not necessarily give complete assurance because there is
always the possibility that the assumptions were faulty or that inaccurate
observations were made.
Nonsampling risk stems from factors unrelated to the sampling process. The auditor
must recognize the possibility that the results obtained may be inaccurate because
of mistakes made in inspecting or examining the items in the sample. The risk of
nonsampling error generally is not subject to measurement, but this same risk would
exist even if the data of the entire population were to be examined 100%.
Nonsampling risk can be reduced by appropriate professional competence,

objectivity, due care and judgement. The use of sampling can actually lessen the
nonsampling risk because it reduces the repetitiveness of a 100% examination.
Because a sample is only part of the entire population, there is a possibility that the
conclusion the auditor draws from the sample will not be representative of the
population. This sampling risk can take two forms: the sample may be incorrectly
accepted as representative or it may be incorrectly rejected as unrepresentative.
11-8
Application of Sampling Techniques

Sample Size
Sample size is affected by the level of assurance desired and the level of error the
auditor can tolerate (precision). Sample size varies directly with the level of
assurance and inversely with precision. If a higher confidence level and/or smaller
precision interval is required, a larger sample is necessary.
Level of Assurance (confidence)
The confidence level is the probability that the sample results will be sufficiently
representative of the population to give the auditor the assurance he or she requires
that the population does not contain more than the specified amount of errors or
deviations.
The level of assurance required is a matter of professional judgement for the auditor.
Precision
Precision refers to the degree of accuracy in the results of a sampling application to
the indicated value of the characteristic being measured in the entire population from
which the sample is taken.
The goal is to obtain reasonable assurance that errors in the financial statements do
not exceed materiality limits. Precision limits should be set so that, at the upper level
of confidence, the upper limit of possible errors will not be material.
Sample Selection
The sample selected must be representative of the population being tested.
Otherwise, it is not possible to project conclusions from the sample to the entire
population.
Samples can be selected using manual or computerized techniques using, random
selection, systematic selection or block testing.
Sample Examination
Care must be taken to ensure audit control to avoid the possibility that, because of
client manipulation, the sample items examined are not truly representative of the
population.
Sample Evaluation
Errors discovered in the sample should be considered representative of others in the
population, and these should be projected over the entire population. The auditor
must then decide whether the achieved precision and confidence are acceptable,
Statistical versus Judgemental Sampling
Statistical sampling offers a number of advantages over nonstatistical methods.
Conclusions drawn from a statistical sample are more objective and defensible
because they are based on mathematical principles. This enables the auditor to
measure and control the risks of making incorrect projections that are inherent in all
11-9
sampling approaches; possible increase in accuracy due to a reduction in

nonsampling risk; time and cost saving; and more consistent extent of testing
decisions with respect to a client from year to year and between clients in an audit
practice.
If statistical sampling is selected, a number of sampling plans are available, such as
attribute and variables techniques. Statistical sampling requires trained and
knowledgeable personnel and costs will be incurred in development and training to
implement the statistical methods.
Cases
11-25
Points to be included in the memorandum:
1. Audit objectives of the physical count
a. to verify physical existence of the stated amount or number of securities;
b. to verify that title to the securities is correct;
c. to verify the existence of all outstanding coupons, options, etc.;
d. to verify that Bank holdings are separated from Trust holdings;
e. to verify that all securities on hand are recorded;
f. to verify that the securities are bonafide;
g. to help form an opinion on the adequacy of the system of controls by means of a
cut off check, etc.
2. Description and assessment of various statistical sampling techniques
The techniques to be assessed are as follows:
Monetary unit sampling, which allows for projection of $ amount of errors

(misstatements);
discovery sampling, which is equivalent to a 0 acceptance number in acceptance

sampling. The objective is the detection of at least one error should error exist at
some assumed level of occurrence;
attributes estimation sampling, which is used to estimate the number or percentage

of errors in a population and the related precision and reliability of the estimates.
The auditor can conclude that he is X% confident that the actual number of errors is
between Y and Z;
variables estimation sampling, which is used to estimate a variable characteristic of

an accounting population. The most important application for auditors is the
estimation of the dollar value of the population. The auditor can conclude that he is
X% confident that the total population estimated lies between Y and Z.
11-10
Assessment of alternatives:
In achieving objectives (a), (c) and (f), identified in part (i), it is likely that no
errors would be acceptable, accordingly:
discovery sampling is a possibility, since it places an acceptable error rate at

0. It has the disadvantage of not enabling a quantification of the total
probable dollar value of errors if there are any;
monetary (dollar) unit sampling and attributes estimation sampling allow for a
quantification of total probable errors, but always with workable sampling
sizes allows for some errors;
variables estimation sampling is not really appropriate because the size of the
population is already known, so there is no need to estimate it.
In achieving objectives (b), (d) and (e), what is involved is primarily a test of the
system, so some errors might be acceptable. The auditor must decide how
many or what dollar value of errors is acceptable.
discovery sampling is not appropriate because some errors can be accepted;
monetary (dollar) unit sampling and attributes estimation sampling provide a

quantification of the number of probable errors, but is costly in terms of sample
sizes;
variables estimation sampling is also costly in terms of sample sizes.
3. Recommendations
For objectives (a), (c) and (f), discovery sampling appears to be the best
technique because:
it allows 0 errors
quantification of errors that exist is probably not worth the extra work required
since, if errors are found, a 100% test could be required.
Attribute sampling could also be used to identify potential control system
deviations for objectives (b), (d) and (e).
11-11
Other considerations:
there should be a contingency plan in case a 100% count becomes

necessary;
the other audit firm must agree to this use of statistical sampling;
to make proper use of statistical sampling, discrepancies have to be clarified

immediately, requiring fairly senior audit personnel to be readily available.
11-12
Chapter 12
Audit of the Sales and Collection Cycle: Tests of Controls
Review Questions
12-1
a. The bill of lading is a document prepared at the time of shipment of goods
to a customer indicating the description of the merchandise, the quantity shipped, and
other relevant data. Formally, it is a written contract of the shipment and receipt of
goods between the seller and carrier. It is also used as a signal to bill the client. The
original is sent to the customer and one or more copies are retained.
b.
A sales invoice is a document indicating the description and quantity of goods

shipped, the price including freight, insurance, terms, and other relevant data.
It is the method of indicating to the customer the amount owed for the sale and
due date of the payments. The original is sent to the customer and one or
more copies are retained. The invoice is the basic document for recording
sales in the accounting records.
c.
The credit memo is a document indicating a reduction in the amount due from
a customer because of retained goods or an allowance granted. It takes the
same general form as a sales invoice, but it reduces the customer's accounts
receivable balance rather than increasing it.
d.
The remittance advice is a document accompanying the sales invoice mailed

to the customer for return to the seller with the cash payment. It is used to
indicate the customer name, sales invoice number, and the amount of the
invoice when the payment is received. A remittance advice is used to permit
the immediate deposit of cash as a means of improving control over the
custody of assets.
e.
The monthly statement to customers is the document prepared monthly and

sent to each customer indicating the beginning balance of that customer's
accounts receivable, the amount and date of each sale, cash payment
received, credit memo for sales returns and allowances, and the ending
balance due. It is in essence a copy of the customer's portion of the accounts
receivable master file.
12-2
Proper credit approval for sales helps minimize the amount of bad debts and
the collection effort for accounts receivable by requiring that each sale be evaluated for
collection potential.
Adequate controls in the credit function enable the auditor to place more reliance on the
client's estimate of uncollectible debts. Without these controls, the auditor would have to
make his or her own credit checks on the customers in order to assure him- or herself
that the allowance for bad debts is reasonable.
12-1
12-3
The charge-off of uncollectible accounts receivable is a process whereby the
company writes off receivables already in existence that it decides will not be collected.
This usually occurs after a customer files for bankruptcy or the account is turned over to
a collection agency. The bad debt expense is a provision for sales that the company will
be unable to collect in the future. It is an estimate used because of the matching
concept of accounting.
The uncollectible accounts write-off must be carefully audited to assure that accounts
that have been paid are not written off to cover up a defalcation. This is done by
examining the authorization for the write-off and the correspondence in the files
concerning that account, and possibly by circularizing accounts receivable
confirmations.
Bad debt expense is audited by examining past trends in uncollectibility, as it is a
projection of future uncollectibles.
12-4
Transaction-Related Audit
Objective
Key Internal Controls
1. Recorded sales are for

shipments actually made to
nonfictitious customers
(existence).
Recording of sales is supported by authorized

shipping documents and approved customer orders.
Monthly statements are sent to customers;
complaints receive independent follow ups.
Authorization of credit before shipment takes place.
Only customer numbers existing in the computer data
files are accepted when they are entered.
Shipping documents (that is, bills of lading) are
prenumbered and accounted for.
2. Existing sales transactions

are recorded
(completeness).
Sales invoices are prenumbered and accounted for.

Shipping documents are prenumbered and accounted
for.
3. Recorded sales are for the

amount of goods shipped
and are correctly billed and
recorded (accuracy).
Determination of prices, terms, freight, and discounts

is properly authorized.
Internal verification of invoice preparation.
Approved unit selling prices are entered into the
computer and used for sales.
Batch totals are compared with computer summary
reports.
4. Sales transactions are

properly classified
(classification).
Use of adequate chart of accounts.

Internal review and verification.
12-2
5. Sales are recorded on the

correct dates. (timing).
Procedures require billing and recording of sales on a

daily basis.
Internal verification.
6. Sales transactions are

subsidiary records and are
correctly summarized
(posting and
summarization).
Regular monthly statements to customers.

Internal verification of accounts receivable master file
or trial balance with general ledger balance.
12-5 The most important duties that should be segregated in the sales and collection
cycles are:
1.
Receiving orders for sales
2.
Shipping goods
3.
Billing customers and recording sales
4.
Maintaining inventory records
5.
Maintaining general accounting records
6.
Maintaining detailed accounts receivable records
7.
Processing cash receipts
8.
Granting credit and pursuing unpaid accounts
Segregation of duties should be used extensively in the sales and collection cycle for
two reasons. First, cash receipts are subject to easy manipulation. Second, the large
number and nature of transactions within the cycle makes the procedure of crosschecking, where one employee's duties automatically serve to verify the accuracy of
another's, highly desirable.
If the asset-handling activities (shipping goods and processing cash receipts) are
combined with their respective accountability activities (maintaining inventory, accounts
receivable, and general accounting records), a serious weakness with respect to
safeguarding those assets exists. It would be very easy for an employee, by either
omitting or adding an entry, to use the company's assets for his or her own purpose. If
the credit granting function is combined with the sales function, a weakness as to
adherence to management's policies exists, as the credit function checks the natural
tendency of sales to optimize volume even at the expense of high bad debt write-offs.
12-6
The use of prenumbered documents is meant to prevent the failure to bill or
record sales as well as to prevent duplicate billings and recordings. An example of a
useful control to provide reasonable assurance that all shipments are billed, is for the
billing clerk to file a copy of all shipping documents in sequential order after a shipment
has been billed. Periodically, someone can account for all numbers in the sequence and
investigate the reason for missing documents. The same type of control is also useful
for duplicate sales invoices. An example of a useful test in this area is to account for the
sequence of duplicate sales invoices in the sales journal, watching for omitted numbers,
12-3
duplicate numbers, or invoices outside the normal sequence. This test simultaneously
provides evidence of both the "existence" and "completeness" objectives.
12-7
1. Credit must be properly authorized before a sale takes place.

Test:
Analyze the allowance for doubtful accounts and writeoffs of
accounts receivable during the period to determine the effectiveness of the
credit approval system.
2. Goods should be shipped only after proper authorization.
Test: Review physical inventory shortages to determine the effectiveness of
inventory control.
3. Prices, including payment terms, freight, and discounts, must be
authorized.
Test: Compare actual price charged for different products, including freight
and terms, to the price list authorized by management.
12-8
The purpose of footing and crossfooting the sales journal and tracing the
posting to the general ledger is to determine that all transactions are included in the
sales journal from which the auditor will make his or her sample selection for testing the
transactions and to determine that the general ledger balance results from the sales and
collection cycle.
12-9
The verification of sales returns and allowances is quite different from the
verification of sales for two primary reasons:
1.
Sales returns and allowances are normally an insignificant portion of

operations and therefore receive little attention from the auditor.
2.
The primary emphasis the auditor places on sales returns and

allowances is to determine that returns and allowances are properly
authorized and that sales are not overstated at year-end and
subsequently reversed by the issuance of returns.
12-10
Cash is the most liquid asset that the company owns and thus is the most
likely target of a fraud. The emphasis the auditor places on the possibility of fraud in
cash is not inconsistent with this responsibility, which is to confirm the fairness of the
presentation of the financial statements. If material fraud has occurred, and it is not fully
disclosed in the financial statements, those statements are not fairly presented.
12-4
12-11
Transaction -Related Audit
Objective
Key Internal Controls
1.
Recorded cash receipts
are for funds actually received
by the company. (existence)
Separation of duties between handling

cash and record keeping.
Independent reconciliation of bank

account.
2.
Cash received is
recorded in the cash receipts
journal. (completeness)
Separation of duties between handling

cash and recordkeeping.
Use of remittance advices, or a prelisting

of cash.
Immediate endorsement of incoming

cheques.
Internal verification of the recording of

cash receipts.
Regular monthly statements to

customers.
3.
Recorded cash receipts
are deposited and recorded at
the amount received.
(accuracy)
Same as 2 above.
Regular reconciliation of bank accounts.
Batch totals are compared with computer

summary reports.
4.
Cash receipts are
properly classified.
(classification)
5.
Cash receipts are
recorded on the correct dates.
(timing)
Procedure requiring recording of cash

receipts on a daily basis.
Internal verification.
6.
Cash receipts are
subsidiary records and are
correctly summarized. (posting
and summarization)
Regular monthly statements to

customers.
Internal verification of accounts receivable

master file contents.
Comparison of accounts receivable

master file or trial balance totals with general
ledger balance.
Use of adequate chart of accounts.

Internal review and verification.
12-5
12-12
Audit procedures the auditor can use to determine whether all cash receipts
were recorded are:
1.
2.
3.
4.
5.
Confirmation of accounts receivable.

Gain an understanding of and test internal controls over cash.
Reconciliation of bank account.
Tracing receipts listed by person opening mail to the deposit slip
validated by the bank.
Trace credits in accounts receivable to their source (i.e., cash receipts,
sales return, uncollectible account).
12-13
Proof of cash receipts is a procedure to test whether all recorded cash
receipts have been deposited in the bank account. In this test, the total cash receipts
recorded in the cash receipts journal for a period of time, such as a month, are
reconciled to the actual deposits made to the bank during the same time period. The
procedure is not useful to discover cash receipts that have not been recorded in the
journals or time lags in making deposits, but it is useful to discover recorded cash
receipts that have not been deposited, unrecorded deposits, unrecorded loans, bank
loans deposited directly into the bank account, and similar errors or fraud.
12-14
Lapping is the postponement of entries for the collection of receivables to
conceal an existing cash shortage. The fraud is perpetrated by someone who records
cash payments in the cash receipts journal and then enters them into the computer
system. He or she defers recording the cash receipts from one customer and covers the
shortage with receipts from another customer. The shortage is in turn covered by the
receipts from a third customer a few days later. The employee must either continue to
cover the shortage through lapping, replace the stolen money, or find another way to
conceal the shortage.
This fraud can be detected by comparing the name, amount and dates shown on
remittance advices to cash receipts journal entries and related duplicate deposit slips.
Since the procedure is relatively time-consuming, auditors ordinarily perform the
procedure only where there is a specific concern with fraud because of a weakness
discovered in internal control.
12-15
The audit procedures most likely to be used to verify accounts receivable
charged off as uncollectible and the purpose of each procedure are as follows:
1.
Examine approvals by the appropriate persons of individual accounts

charged off. The purpose is to determine that charge-offs are approved.
12-6
2.
Examine correspondence in client's files that indicates the

uncollectibility of the accounts for a selected number of charge-offs.
The purpose is to determine that the account appears to be
uncollectible.
3.
Consider the reason for the charge-off as compared to the company

policy for writing off uncollectible accounts. Purpose is to determine
whether or not company policy is being complied with.
12-16
It is always acceptable to perform tests of controls at an interim date. The
auditor may decide it is necessary to test the untested period at year end especially if
the period is longer than a month or two. It is acceptable to perform tests of controls for
sales and cash receipts at an interim date and not perform additional tests of the system
at year end under the following circumstances:
The auditor feels internal control over the accounting system is effective.
1.
The auditor does not anticipate significant changes in internal control
during the remaining period.
2.
The transactions normally occurring between the completion of the
tests of controls and the end of the year are similar to the transactions
prior to the test date.
3.
The remaining period is not too long in the circumstances; conventional
wisdom suggests three months or less.
4.
Other matters of concern to the auditor indicate that the limitation of
transactions testing is appropriate.
Note that if the auditor decides not to test the controls for the interim period and there
are problems (for example, a material error or fraud) arising from transactions that took
place during that period, the onus would be on the auditor to prove that he or she was
not negligent by not testing for the interim period. The auditor must consider the
potential impact of such decisions in making the decisions.
12-17
Generally, a successful test of controls allows for a reduction of tests of details
of balances at year end. However, Deidre Brandt chose the month of March, which only
represents one-twelfth of the year, as her test period. With such a short test period,
Deidre cannot conclude that she has selected a representative sample from the total
population; therefore, without testing additional months (consensus of coverage), Deidre
cannot change the scope of her tests of details of financial balances at year end. By any
standard, she is being negligent in adopting such an audit approach.
12-18
a. In considering the appropriate TER the auditor uses judgement to determine
what exception rate would be material. It is deciding how important each
12-7
attribute is. A tolerable exception rate of 3% leads to a larger sample size than a
6% TER.
b. In deciding the ARACR the auditor is considering if there are other controls in
place for this attribute that he/she may rely upon. A sample size based on a 10%
ARACR will be smaller than a sample size based on a 5% ARACR.
c. A sample of 100 invoices, an ARACR at 5% and three exceptions found would
indicate a CUER of 7.6. This is the computed upper exception rate based on the
actual number of deviations found in the sample. If this number exceeds the
TER then more deviations were found than the auditor decided was appropriate.

12-19
12-20
12-21
a. (2)
a. (1)
a. (1)
b.
b.
b.
(3)
(3)
(1)
c.
c.
c.
(1)
(1)
(3)
d.
(1)

12-22
1.
2.
a.
Recorded sales are for the amount of goods ordered and are correctly
billed and recorded. (Accuracy)
b.
Examine indication of internal verification on sales documents.
c.
Incorrect prices may be charged, the customer may be billed for the wrong
quantity, or the total amount may be computed incorrectly.
d.
Recompute information on the sales invoices. Trace details on sales

invoices to shipping records, price lists, and customers' orders.
a.
Recorded sales and credit transactions are for shipments actually made
and existing sales transactions are recorded. (Existence and
Completeness)
b.
Account for the numerical sequences of sales orders, invoices, and credit
memoranda.
c.
Shipments or returns are not recorded. Orders from customers are

misplaced and not filled.
12-8
3.
4.
5.
6.
d.
Examine correspondence concerning credit memoranda to assure that

they were properly issued. Trace shipping documents to resultant sales
invoice and entry into sales journal and accounts receivable master file.
Send accounts receivable confirmations.
a.
Existing transactions are recorded; recorded transactions are valid.

(Completeness and Existence)
b.
The auditor should observe the employees and discuss the procedures
with personnel.
c.
Sales could be made and not recorded, with the employee keeping the
proceeds of the sale.
d.
Trace selected shipping documents to related duplicate sales invoices, the

sales journal, and accounts receivable master file.
a.
Existing transactions are recorded. (Completeness)
b.
The auditor should observe the activities of those employees and discuss
the procedures with personnel.
c.
These unusual sales could be made but not recorded and the proceeds
kept from the company.
d.
Examine sales documents for these sales and trace the entries into the
cash receipts books.
a.
Existing transactions are recorded and recorded sales are for the amount
of goods ordered and are correctly billed. (Completeness and Accuracy)
b.
The auditor should observe the activities of employees and discuss the
procedures with personnel.
c.
A receivable might intentionally not be recorded, allowing the cash to be

kept from the company.
d.
Trace from the shipping records to the sales invoice, to the accounts
receivable master file, and to cash receipts.
a.
Sales and collection transactions are properly included in the subsidiary

records and are correctly summarized. (Posting and Summarization)
b.
Observation of procedures and examination of indication of internal

verification.
12-9
7.
8.
c.
Unintentional misstatements could be posted in the control accounts and

left undetected for long periods of time.
d.
Perform tests of clerical accuracyfoot journals and trace postings from

journal to general ledger and accounts receivable master file.
a.
Existing cash receipts transactions are recorded. (Completeness)
b.
Observation and discussion of procedures with employees.
c.
Cash could be received, not recorded, and kept from the company by an
employee or lost prior to deposit.
d.
Trace receipts recorded on a listsuch as from a prelist of cashto the

books of original entry; send accounts receivable confirmations.
a.
Transactions are recorded at the proper time. (Timing)
b.
Compare date per books to the date the deposit appears on the bank
statement.
c.
Cash receipts might be recorded in the wrong accounting period, lost, or

stolen.
d.
Trace cash recorded on a list, such as a prelist of cash, to the cash

receipts journal and to the bank statement.
12-23
1-a
1-b
1-c
Error
Print a list of all master file changes for independent verification.
Compare approved master file change form to listing of master file.
2-a
2-b
Error
Sales invoices are prenumbered, properly account for in the sales journal, and a
notation on the invoice is made of entry into the sales journal.
2-c
Account for numerical sequence of invoices recorded in the sales
journal, watching for duplicates. Confirm accounts receivable at year-end.
3-a
3-b
Fraud
All payments from customers should be in the form of a cheque payable to the
company. Monthly statements should be sent to all customers.
12-10
3-c
Trace from recorded sales transactions to cash receipts for those
sales; confirm accounts receivable balances at year end.
4-a Fraud
4-b
The listing of cash received should be compared to the postings in the
accounts receivable master file and to the validated bank deposit slip.
4-c
Trace cash received from prelisting to cash receipts journal. Confirm
accounts receivable.
5-a
Error
5-b
Use of prenumbered bills of lading that are periodically accounted for.
5-c
Trace a sequence of prenumbered bills of lading to recorded sales transactions.
Confirm accounts receivable at year end.
6.-a
6-b
Error
No merchandise may leave the plant without the preparation of a prenumbered
bill of lading.
6-c
Trace credit entries in the perpetual inventory records to bills of
lading and the sales journal. Confirm accounts receivable at year end.
7-a
7-b
7-c
Error
Internal review and verification by an independent person.
Test accuracy of invoice classification.
12-24
Objective
1. Accuracy
2. Posting and summarization

3. Accuracy
4. Classification
5. Completeness Accuracy
Timing
6. Existence Completeness
Accuracy, Timing
7. Accuracy
Dual-Purpose Test
Match a sample of duplicate sales invoices to related
shipping documents checking quantity and
description.
Not applicable.
Compare unit selling prices on duplicate sales
invoices to the approved price list.
Not applicable.
Select a sample of customer orders and verify that
shipping documents, vendor's invoices exist for each
one and that there is an entry in the accounts
receivable master file for each one.
Procedure listed is a dual-purpose test.
Recalculate the cash discounts for a sample of
remittances and determine if each one was consistent
with company policy.
12-11
12-25
a. The lack of segregation of duties was the major deficiency that permitted
the fraud for Appliance Repair and Service Corp. Gyders has responsibility for opening
mail, prelisting cash, updating accounts receivable, and authorizing sales allowances
and charge-offs for uncollectible accounts. It is easy for Gyders to take the cash before
it is prelisted and to charge off an accounts receivable as a sales allowance or as a bad
debt.
b.
The benefits of prelisting cash are to immediately document cash receipts at the
time that it is received by the company. Assuming all cash is included on the
prelisting, it is then easy for someone to trace from the prelisting to the cash
receipts journal and deposits. Furthermore, if a dispute arises with a customer, it
is easy to trace to the prelisting and determine when the cash was actually
received. The prelisting should be prepared by a competent person who has no
significant responsibilities for accounting functions. The person should not be in a
position to withhold the recording of sales, adjust accounts receivable or sales for
credits, or adjust accounts receivable for sales returns and allowances or bad
debts.
c.
Subsequent to the prelisting of cash, it is desirable for an independent person to

trace from the prelisting to the bank statement. That can be done by anyone
independent of whoever does the prelisting, or prepares or makes the deposit.
d.
A general rule that should be followed for depositing cash is that it should be
deposited as quickly as possible after it is received, and handled by as few
people as possible. It is, ideally, the person receiving the cash that should
prepare the prelisting and prepare the deposit immediately afterward. That
person should then deposit the cash in the bank. Any unintentional errors in the
preparation of the bank statement should be discovered by the bank. The
authenticated duplicate deposit slip should be given to the accounting
department who would subsequently compare the total to the prelisting. When an
independent person prepares the bank reconciliation, there should also be a
comparison of the prelisting to the totals deposited in the bank.
Any money taken before the prelisting should be uncovered by the accounting
department when they send out monthly statements to customers. Customers are likely
to complain if they are billed for sales for which they have already paid.
12-26
a. Collections
Weakness
1. Treasurer exercises too much
control over collections.
2. Finance committee is not
exercising its assigned
responsibility for collection.
Recommended Improvement
To extent possible, treasurer's responsibilities
should be confined to record keeping.
Finance committee should assume a more
active supervisory role.
12-12
3. The auditing function has been

assigned to the finance
committee, which also has
responsibility for the
administration of the cash
function. Moreover, the finance
committee has not performed
the auditing functions.
4. The treasurer has sole access
to cash during the period of the
count. One person should not
be left alone with the cash until
the amount has been recorded
or control established in some
other way.
5. The collection is vulnerable to
robbery while it is being
counted and from the church
safe prior to its deposit in the
bank.
6. The ushers do not count
collection but simply place it in
the church safe. If the church
were to be robbed (see 5.
above), there would be no
record of the amount stolen.
7. No mention is made of
bonding.
8. Written instructions for
handling cash collections
apparently have not been
prepared.
b.
Record keeping
1. The envelope system has not
been encouraged. Control
features which it could provide
have been ignored.
Individuals should be appointed to perform

periodic auditing procedures or engage
verification procedures.
The number of counters should be increased to

at least two, and cash should remain under joint
surveillance until counted and recorded so that
any discrepancies will be brought to attention.
The collection should be deposited in the bank's

night depository immediately after the count.
Physical safeguards, such as locking and bolting
the door during the period of the count, should
be instituted. Vulnerability to robbery will also be
reduced by increasing the number of counters
The ushers should count the collection using
specially developed count sheets. One copy of
the count and the receipts should be placed in a
night depository at the bank; the second copy
should be left at the church.
Key employees and members involved in
receiving and disbursing cash should be
bonded.
Especially because much of the work involved in
cash collections is performed by unpaid,
untrained church members, often on a shortterm basis, detailed written instructions should
be prepared.
The envelope system should be encouraged.
Counters should indicate on the outside of each
envelope the amount contributed. Envelope
contributions should be reported separately and
supported by the empty collection envelopes.
Prenumbered envelopes will permit ready
identification of the donor by authorized persons
without general loss of confidentiality.
12-13
2. The church has no record of

individual givings and thus
receipts are not based on the
amounts actually given. It may
be that some members are
receiving tax receipts that are
far in excess of their actual
givings. This weakness is
especially a problem because
the tax department may revoke
the church's status as a
charitable organization.
3. Because no records of
individual givings are
maintained, the church does
not know which members are
meeting their pledges. There
would be no way of knowing
who was causing the shortfall
Members should have to document their givings

by using envelopes or cheques payable to the
church. The counters should list the givings by
envelope number every Sunday and reconcile
total to the funds (cash and cheques) received
and deposited. The treasurer should use the
same list to update the individual member's
giving record which is used to prepare the
annual tax receipt for the member.
Each member should receive a statement

quarterly from the finance committee indicating
amount pledged and amount given to the end of
the quarter; this would assist delinquent
members in meeting their pledges.
12-27
a. To test whether shipments have been billed, a random selection of
warehouse removal slips should be made and examined to see if they have the proper
sales invoice attached. The sampling unit will be the warehouse removal slip.
b.
c.
Assuming the auditor is willing to accept a tolerable exception rate of 3% at a

10% ARACR, expecting no exception in the sample, the appropriate sample size
would be 76, determined from Table 11-6:
A one-to-one correspondence is established between the warehouse removal
slip number and the 5 digits in the random number table.
The first ten random numbers selected are 30452, 35793, 21027, 29925, 31546, 17563,
34535, 35936, 28288, 24841.
d.
Other audit procedures that could be performed are:

a.
Test extensions on attached sales invoices for clerical accuracy.
(Valuation)
b.
Test time delay between warehouse removal slip date and billing date
for timeliness of billing. (Timing)
c.
Trace entries into perpetual inventory records to determine that
inventory is properly relieved for shipments. (Posting and
summarization)
e.
The test performed in part c cannot be used to test the existence of sales
because the auditor already knows that inventory was shipped for these sales.
To test the validity of sales, the sales invoice entry in the sales journal is the
12-14
sampling unit. Since the sales invoice numbers are not identical to the
warehouse removal slips it would be improper to use the same sample.
12-28
a. It would be appropriate to use attributes sampling for all audit procedures
except audit procedure 1. Procedure 1 is an analytical procedure for which the auditor is
doing a 100% review of the entire cash receipts journal.
b.
The appropriate sampling unit for audit procedures 2-5 is a line item, or the date
the prelisting of cash receipts is prepared. The primary emphasis in the test is the
completeness objective and audit procedure 2 indicates there is a prelisting of
cash receipts. All other procedures can be performed efficiently and effectively by
using the prelisting.
c.
The attributes for testing are as follows:
Audit Procedure
Procedure 2
Attribute
Cash receipts in the prelisting are recorded in the
cash receipts journal.
Procedure 3
Customer name, date, and amount are equal to the

prelisting and cash receipts journal.
Procedure 4
Cash discounts were approved on the related

remittance advice.
Procedure 5
Cash included in the prelisting has been included on

the deposit slip.
d.
The sample sizes for each attribute are as follows:
Sample Size
Sample
Audit
Procedure
Size
ARACR
TER
EPER
2
5%
8%
2%
77
3
5%
8%
2%
77
4
5%
8%
2%
77
5
5%
8%
2%
77
12-15
12-29
a. Use professional judgement to come up with a reasonable sample.
b.
1
2
3
4
Sample Size Before

Population Size
Adjustment
88
127
181
127
5
6
7
25
18
149
Population Size
Adjustment
none
none
none
n = 127 / 1 + 127
/1,000 = 112.7
none
none
none
Sample Size After

Population Size
Adjustment
88
127
181
113
25
18
149
c.
1
2
Change in
Factors
Increase in
ARACR.
Increase in
tolerable exception
rate.
Increase in
estimated
population
exception rate.
Increase in
population size.
Effect on Sample Size
Illustration in Part a
Decrease
Compare columns 2 to 1
Decrease
Increase
Increase
d.
The difference in the sample size for column 3 and 6 result from the larger
ARACR and larger tolerable exception rate in column 6. The extremely large
tolerable exception rate is the major factor causing the difference.
e.
The greatest effect on the sample size is the difference between tolerable
exception rate and estimated population exception rate. For columns 3 and
7, the differences between the tolerable exception rate and estimated population
rate were 3% and 2% respectively. Those two also had the highest sample size.
Where the difference between TER and EPER was great, such as columns 5 and
6, the required sample size was extremely small.
12-16
Population size also had a relatively small effect on sample size. The difference in
population size in columns 2 and 4 was 99,000 items, but the increase in sample size
for the larger population was only 14 items.
f.
12-30
1.
2.
3.
4.
5.
6.
The sample size is referred to as the initial sample size because it is based on an
estimate of the sample exception rate. Once the test is performed, the actual
sample exception rate is used to calculate the final upper exception rate. The
auditor can then decide whether the sample size is adequate.
a. and b. The sample sizes of CUERs are shown in the following table:
Actual
Initial Sample
Sample Size Size From Table
12-7
Sample exception Rate

(SER)
100
100
60
100
20
60
2.0%
0.0
1.7
4.0
5.0
13.3
127
99
65
93
18
60
CUER
From
Table
12-8
6.2%
3.0
6.3
8.9
18.1
>20.0
a.
The auditor selected a sample size smaller than that determined from the tables
in population 1 and 3. The effect of selecting a smaller sample size than the initial
sample size required from the table is the increased likelihood of having the
computed upper exception rate exceed the tolerable exception rate. If a larger
sample size is selected, the result may be a sample size larger than needed to
satisfy tolerable exception rate. That results in excess audit cost. Ultimately,
however, the comparison of CUER to tolerable exception rate determines
whether the sample size was too large or too small.
b.
The sample exception rate and computed upper exception rate are shown in
columns 4 and 5 in the above table.
c.
The population results are unacceptable for populations 4 and 6. In each of those
cases, the CUER exceeds tolerable exception rate.
The auditor's options are to change tolerable exception rate or ARACR, increase the
sample size, or perform other substantive tests to determine whether there are actually
material errors in the population. Increasing sample size would not likely result in
improved results for either population 4 or 6 because the CUER exceeds tolerable
exception rate by a large amount.
d.
Analysis of exceptions is necessary even when the population is acceptable

because the auditor wants to determine the nature and cause of all exceptions.
12-17
If, for example, the auditor determines that an error was intentional, additional
action would be required even if the CUER was less than tolerable exception
rate.
e.
Term
1. Estimated population
exception rate
2. Tolerable exception rate
3. Acceptable risk of assessing
control risk too low
4. Actual sample size
Nature of Term
Nonstatistical estimate made by
auditor.
Audit decision.
Audit decision.
Audit decision (determined by

other audit decisions).
5. Actual number of exceptions Sample result.
in the sample
6. Sample exception rate
Sample result.
7. Computed upper exception
Statistical conclusion about the
rate
population
Cases
12-31
(a) CA did not consider anything other than the fact that he had the time to do the audit.
Before accepting an engagement the CA should have obtained more information
about the client including reviewing a copy of the previous financial statements,
communication with the predecessor accountant, and exploring the possibility of
unusual risks. The CA did not mention checking to ensure the firm was independent
of the prospective client nor whether the firm had the expertise required to fulfill this
engagement.
(b) CAs preparation, conduct and evaluation did not comply with generally accepted
auditing standards. There is no mention of CA assessing audit risk or of doing any
verification that policies and procedures are followed. CA would need to investigate
this first before deciding and defining what test of controls or substantive procedures
were necessary and assigning someone to carry them out. CA was aware that
Smith Wholesalers Ltd. had inadequate segregation of duties; accounting duties,
data entry and handling cash all carried out by the same person. As well, the Sales
Manager was also responsible for credit approval and volume discounts, special
sales prices and the writing-off of uncollectible accounts. The receiver was in
charge of inventory control. This auditing engagement should have been assigned a
maximum risk level and the audit should have been designed accordingly. GAAS
states that a sufficient understanding of internal control should be obtained to plan
the audit. CA was aware there was a lack of controls from reading the companys
formal sales policy and the list of employees and their duties. CA did no
investigating and the audit program CA designed does not reflect this knowledge.
12-18
GAAS states that if assistants are employed they are to be properly supervised. CA
gave the assistant free reign and no supervision. As well CA did not use all the
means described in the GAAS examination guidelines to gather sufficient
information: inspection, observation, enquiry, confirmation, computation and
analysis. CAs evaluation of the results was inadequate. CA should have seen red
flags and done further investigating himself. CA knew the companys formal sales
policies and was now aware they were not always followed. GAAS states that the
examination should be performed and the report prepared by a person having
adequate technical training and proficiency in auditing and is to be performed with
due care.
(c) Investigate and confirm the aged accounts receivables.
Sales are up but cash is low could indicate that accounts receivables are not
being collected in a timely manner or at all.
Check how the company accounts for uncollectible accounts receivables. What
happens to bad debts? How many write-offs have there been?
Are bad debts, write-offs and uncollectible accounts being deducted from the
gross sales?
Check the extent of volume discounts and special discounts granted by Zee.
Overgranting discounts would decrease the profit margin, decreasing cash.

Investigate how the company calculates gross sales. Is it reasonable?
Zees bonus is based on gross sales if it is not adjusted based on GAAP then
Zee would be receiving a larger bonus that he should. Perhaps CA should
recommend Zees bonus be paid on net sales.
Investigate the controls in place with regard to cash and do substantive testing to
verify controls are working. Is all cash being deposited in the bank?
With the same person performing the accounting duties, the data entry and
handling cash, theft of cash would be relatively easy to do.
d) The principle difference between test of controls and substantive procedures is

their objective. Test of controls are used to assess and evaluate the effectiveness
of policies and procedures to prevent or detect material misstatements and to
assess the control risk range, from maximum to low for the audit. Substantive
procedures are used to acquire evidence as to the accuracy of the information
produced by the entity. Both tests of controls and substantive procedures use the
same methods to gather evidence: inspection, observation, enquiry, confirmation,
computation and analysis.
12-19
12-32
a. Programmed controls
1. Check digit on the following fields:
clerk code
stock number
2. Limit check on maximum and minimums on the following fields:
quantity sold
unit price
total sale
sales tax
amount tendered
3. Field check on the following fields:
clerk code
transaction code
stock number
quantity sold
unit price
amount tendered
4. Logical relationship
total sale cannot exceed amount tendered
return transaction should not have amount tendered
5. Programmed routine to identify error or potential error condition for the following:
Unusual transaction or large value transaction should require a correction
procedure with a restricted use clerk code. The code would be issued only to the
store manager.
A casual input error would simply be reentered by the clerk.
A limited number of reentries for the same error would require correction by the
restricted clerk.
A program routine should flag transactions left open after a certain period of time
(e.g., END key not activated).
6. Numeric test on stock number to ensure that only numeric items are processed.
7. Validity checks (program subroutine) against a table of valid codes (or against the
master inventory file for CD codes) on the following:
transaction code
clerk code
inventory master details
12-20
8. Set up control totals so that cashier can count cash at the end of the shift, enter, and
receive an error message if control does not equal cash count.
9. Anticipatory control to ensure that sequence of data entered is correct, e.g., data,
correct operation, data, etc.
10. Control to report on a sale against or generating a negative inventory quantity.
11. Other valid programmed controls.
b. Test transactions
1. Put through transactions
to test that the system correctly handles valid transactions
2. Use an invalid check digit
verify the existence of the check digit

3. Use field overflow
field check
4. Omit data in critical fields to create an incomplete transaction
field check
5. Use unreasonable data
to verify limit checks
6. Use an invalid transaction code
to verify the existence of the table of valid codes
to assess the system response to invalid codes
7. Enter several valid transactions and enter an incorrect cash count
to assess the system response to control totals being out of balance
8. Use of amount tendered less than total sale
To verify the logical relationship test and to review the system response
9. Use an alpha numeric code for the stock number
to assess the numeric test and to assess the system reaction

10. Withhold END key
to ensure that open transaction is flagged by the system
11. Enter data out of proper sequence
anticipatory control over sequence of input data
12-21
12. Enter a sale which creates a negative balance in inventory
error flag for credit balance in inventory

Note: Each transaction should contain only one error to facilitate follow-up by the
auditor.
c. Integrity of inventory master file
1. Use of copy of the clients inventory master file for processing the test transactions
Ideally, the copy should be made under conditions controlled by the auditor.
2. Create dummy stock numbers and quantities in a dummy master file and have all
test transactions processed against this dummy file.
OR
3. Use reversing transactions to remove the effects of any tests that affect the master
file (more risky and less desirable).
12-22
Chapter 13
Analytical Review and the Audit of the Sales and Collection Cycle
Review Questions
13-1 Analytical procedures are useful, by assisting in planning the nature, timing and
the extent of other audit procedures. It also points the auditors attention to areas
requiring special investigation. Client data is compared with industry data, similar prior
period data and with client determined expected results (budgets) to analyze
organization strategies, environment links and business continuity.
13-2 Even though there may be none or only a few companies in the supplies of the
same products there are many companies who supply similar products and have a
similar business therefore the analysis procedures would still be useful as compared to
other businesses.
13-3 Expected changes are those the auditor would expect to see because of a
change in the business activities during the year as well as those that should
change like amortization expense, accumulated amortization, and accruals.
Other expected changes would be if sales has increased or decreased, the cost
of sales would be expected to move accordingly. Unexpected results are those
the auditor would have expected to stay pretty much the same. A large increase
in accounts receivable would indicate that further investigation would be
appropriate.
13-4 Depending upon the results of analytical procedures, the amount and type of
substantive testing will be determined.
13-5 Analytical procedures using current and prior comparative financial statements
provide a low level of assurance. Advantages of using this type of procedures is
that it is quick and not that difficult to prepare. No specialized software or
techniques are used. A disadvantage is the low level of assurance it provides and
that the results are subjective.
Regression analysis provides a high level of assurance. Advantages include the
ability to quantify expectations, use several independent variables at the same
time to predict a dependent variable, and a disciplined approach is used.
Some disadvantages are that a minimum number of observations are required to
have an adequate base, and specialized assistance may be need to formulate the
aggression analysis.
13-1
13-6 The 12 steps required to conduct structured analytical procedures

Define results to be examined and relationship
State objectives of the review
Decide on examination methods
Define significant fluctuations
Specify intended reliance
Select the method of computation
Control nonsampling risk
Ensure audit control
Make the comparison
Identify significant fluctuations
Investigate significant fluctuations
State conclusions
13-7 When a significant fluctuation is noted during the analytical procedures, the
auditor will use the variance as a percentage to determine the dollar value. Dollar
differences greater than a certain percent of materiality could also be
investigated.
13-8 An analytical procedure that provides a:

Low level of assurance:
Compare account balances with prior years
Medium level of assurance:
Prepare ratios from previous years and extrapolate to determine expected results
for current year.
High level of assurance:
Develop an equation that provides a relationship
13-9 Additional substantive testing is required to further investigate significant

fluctuations. The auditor could also inquire of employees or management.
13-10 Spreadsheet software is used by most auditors. By entering the data once, it is
possible to prepare a variety of calculations quickly and efficiently.
13-11 Graphic presentation methods allow the auditor to observe unusual patterns while
the numeric methods in analytical procedures enable better quantification of
differences or trends.
13-2
13-12 Statistical methods

Advantages:
The ability to quantify expectations,
Use several independent variables at the same time to predict a dependent
variable,
Use a disciplined approach
Disadvantages:
A minimum number of observations are required to have an adequate
base,
Specialized assistance may be needed to formulate the aggression
analysis.
13-13
Significant fluctuations not caused by error or irregularities can be caused by a change
in business practices, such as bringing in house activities that were formerly
outsourced, by a change in the economy, or any number of variables that could affect
the accounts, such as an increase in sales.

13-14 a.
(3)
b.
(4)
c.
(1)
d.
(2)
13-15 a.
(4)
b.
(4)
c.
(2)
d.
(2)

13-16
Days sales in receivables has increased could indicate a collectibility problem
Sales have decreased could indicate cut off errors or sales not recorded
The allowance for doubtful account decreased as a percentage of sales could indicate
an error in calculation, or that the allowance is inadequate for the current year.
13-17
Inventory has increased cost of sales may not be recorded correctly. If the inventory
was not adjusted for each sale thereby, cost of sales will be low, inventory will be too
high and the gross margin will be higher than appropriate.
13-3
13-18
a) Analytical procedures are considered a substantive test because they can be
used to provide assurance levels of low, medium or high therefore changing the
amount and extent of the overall testing mix.
b) Compare customer balances current to prior; compare balances outstanding to
credit limit; compare aging on a month-to-month basis.
13-19 Analytical procedures are subjective and require judgment to link the quantitative
results to the client and its environment and organizational strategies. The partner
could be thinking that junior staff were performing the procedures and they lacked the
professional judgment gained through many years experience.
13-20
a)
Account
Capital assets
Accumulated amortization
Accounts receivable
Accrued liabilities
Shareholders Capital
Cost of goods sold
Gross profit
Advertising expenses
Salespeoples commissions
Ratio analysis
Total cost of capital assets divided by
cost of goods sold
Comparison of repairs and
maintenance expense from year to
year
Amortization expense to total cost of
capital assets
Accounts receivable days to collect, as
a percentage of sales
Compare with previous year
Shareholders capital to total assets
Profit margin ratio; inventory turnover
Profit margin ratio
Compared to previous year
As a percentage of sales
b.
If the company were experiencing gradual sales growth, the auditor would expect:
No difference anticipated
Capital assets
Difference anticipated
Accumulated amortization
Accounts receivable
Accrued liabilities
Shareholders Capital
Gross profit
Advertising expenses
Salespeoples commissions
13-4
c. The accumulated amortization account should increase whether sales is growing or

not. With increased sales the accounts receivable likely will increase due to the
increase in sales. Increased sales should bring an increase in gross profit.
Salespersons commissions would be expected to increase as commissions are usually
tied to a percentage of sales. If the company increased advertising as a means to
increase the sales then the auditor would expect to see this account increase as well.
Cases
13-21
a.
(The data for this problem is available on the CD-ROM)

Matters that the auditor would be particularly interested in investigating before
completing the audit
Each point below has two parts: matter (M) and significance (S).
More important matters
(1) M - Companys collection policies, especially as they affect the validity of the
trade receivables figure.
S - Receivable has risen much faster than have sales increased (80%in two
years vs. 24%).
(2) M -Method of computing allowance for doubtful accounts.
S - Allowance has not changed in three years even though sales, bad debts
expense and trade accounts receivable have all increased substantially.
(3) M -Validity of using companys standard cost to value finished goods on the
balance sheet.
S - In 2002, manufacturing costs were over applied by $54,000; since closing
inventories are significant in relation to annual production costs, it is
probable that closing inventories are over-valued if valued at standard cost
(though because of the depreciation change this may not be the case).
(4) M - Value of the inventory of Product Line A.
S - The sales of Product Line A have been increasing very slowly (only 6% in
three years) but the closing inventory has increased 140%; since the
companys products are susceptible to obsolescence, such a pile-up of
inventory would normally result in its value diminishing.
(5) M -The Companys amortization practices.
13-5
S - Annual amortization has dropped from $115,000 in both the previous

years to $70,000 in 2002; this is a significant decline especially in view of
the over-application of manufacturing costs.
(6) M -Health of operations identified as Product Line A.
S - Both labour and overhead costs have increased substantially even
though sales have not and so the gross profit has been cut by a third.
(7) M - Sale of land during year.
S - Land sale receivable is a significant portion of current assets and the
profit on sale is a significant portion of the years net income (in fact
creates a net income instead of a net loss).
(8) M -Inventorying of shop supplies in 2002.
S - Shop supplies were not inventoried in past years; this could mean that
either there were no such inventories in prior years or that the company
has changed its accounting practices (perhaps to improve the profit
picture).
(9) M -Increase in amount of interest expense and trade notes payable.
S - Trade notes have quadrupled since the previous year and now exceed
the value of the raw material inventory. Interest expense has gone up
50%. Do the changes in both reconcile, or might there be unrecorded
liabilities (for principal or interest)?
Less important matters
(10)
M - Companys mortgage standing.
S - According to the amounts shown as currently payable on the

mortgage the company is three months behind in its mortgage payments,
this could have serious financial consequences (or else the repayment
schedule may have changed for some reason).
(11) M - Common share capital.
S - There has been a small increase in share capital since the previous year;
has owner group altered during that time?
(12)
M - Composition of sundry expenses.
S - These have more than doubled since the previous year.
13-6
(13)
M - Decrease in raw materials inventory.
S - Since other inventories have increased, may indicate change in valuation

or reclassification of shop supplies.
(14) M - Elimination of amount due to shareholder.
S - Perhaps odd that shareholder has withdrawn his funds during two years
when most non-cash assets have greatly increased.
(15) The changes in several other account balances (such as accounts
payable, employee advances, advertising expense and cash discounts taken)
might be queried because such changes may imply policy changes,
unrecorded liabilities, etc.
b.
Comments on companys financial condition
A good answer should point out that although:

the company is showing an accounting profit;
it has a respectable working capital ratio;
working capital has increased from $240,000 to $414,000 in two years;
it is not heavily burdened with long term debt;
There are several signals that the company is in financial difficulty:
increased trade notes payable and loss of cash discounts;
receivables and some inventories are piling up;
gross profit rate is declining;
interest cost is climbing (its amount indicates that either the bank loan or the
trade notes (or both) is at a high rate);
short term creditors share of the total financing is increasing;
ratio of cash to short term debts is decreasing;
return on investment is decreasing;
without the land sale, company would have had a loss.
13-7
Chapter 14
Completing the Tests in the Sales and Collection Cycle: Accounts Receivable
Review Questions
14-1 Tests of details of financial balances are designed to determine the
reasonableness of the balances in sales, accounts receivable, and other account
balances which are affected by the sales and collection cycle. Such tests include
confirmation of accounts receivable, and examining documents supporting the balance
in these accounts.
Tests of controls for the sales and collection cycle are intended to determine the
effectiveness of internal control and to test the substance of the transactions which are
produced by this cycle. Such tests would consist of examining sales invoices in support
of entries in the sales journal, reconciling cash receipts, or reviewing the approval of
credit.
The results of the tests of controls will be used to affect the procedures, sample size,
timing and particular items selected for the tests of details of financial balances (i.e.,
effective internal control will result in reduced testing when compared to the tests of
details of balances required in the case of inadequate internal control).
14-2
The CICA Assurance Handbook Section 5303 par. 26 - 28 deals with the
confirmation of accounts receivable.
The procedures suggested in the section are both positive and negative confirmations.
Negative confirmations suffer from the fact that they do not always receive
consideration from the debtor, and consequently a failure to reply does not necessarily
signify agreement. Positive confirmations are preferred for individual balances of
relatively large amounts, when there are a few debtors, or when there is evidence or
suspicion of fraud or serious error.
Cynthia Roberts approach is questionable from the standpoint that the non-replies have
not necessarily proved that internal control is effective although replies indicating
misstatements in the account balances would be confirmation that internal control was
ineffective. Her confirmation at an interim date requires her to assume an assessed
control risk less than maximum, but she has not tested the related internal control for
the period from the confirmation date until year end.
14-3 The following are analytical procedures for the sales and collection cycle, and
potential misstatements uncovered by each procedure. Each ratio should be compared
to previous years. The question asked for five analytical procedures.
14-1
Analytical
Procedure
Potential Misstatement
1. Gross margin by
product line
2. Sales returns and
allowances as a
percentage of gross
sales by product line
or segment
3. Trade discounts
taken as a percentage
of net sales
4. Bad debts as a
percentage of gross
sales
5. Days sales in
receivables
outstanding.
6. Aging categories
as a percentage of
accounts receivable
7. Allowance for
uncollectible accounts
as a percentage of
accounts receivable
8. Comparison of the
balances in individual
customer accounts
over a stated amount
with their balances in
the previous year
Including in the physical inventory items for which the

corresponding liability had not yet been recorded.
All returns were not recorded, or shipments to customers were
not in accordance with specifications and were returned (this
could result in significant operating problems).
Discounts that were taken by customers and allowed by the

company were not recorded.
Allowance for doubtful accounts misstated.
A problem with collections, and understatement of bad debts

and allowance for doubtful accounts.
Collection problems and understatement of bad debts and
allowance for doubtful accounts.
Allowance for doubtful accounts misstated.
A problem with collections, and therefore, a misstatement of

the allowance for doubtful accounts.
14-4 The following are the nine balance-related audit objectives and related audit
procedures for the audit of accounts receivable.
Balance-related Audit
Objective
1. Accounts receivable in
the aged trial balance
agree with related
master file amounts,
the total is correctly
Audit Procedure
a.
Trace twenty accounts from the trial balance to the
related accounts on master file.
b.
Foot two pages of the trial balance, and total all
pages.
14-2
2.
3.
4.
5.
6.
7.
added and agrees with

the general ledger.
The accounts
receivable in the aged
trial balance exist.
Existing accounts
receivable are
included in the aged
trial balance.
Accounts receivable in
the trial balance are
owned.
accurately recorded.
the aged trial balance
are properly classified.
Transactions in the
sales and collection
cycle are recorded in
the proper period.
8. Accounts in the sales

and collection cycle
are properly presented
and disclosed.
9. Accounts receivable in
stated at realizable
value.
Confirm accounts receivable using positive confirmations.

Confirm all amounts over $5,000 and a nonstatistical
sample of the remainder.
Trace ten accounts from the accounts receivable master
file to the aged trial balance.
Review the minutes of the board of directors for any

indication of pledged or factored accounts receivable.
Confirm accounts receivable using positive confirmations.
Confirm all amounts over $5,000 and a nonstatistical
sample of the remainder.
Review the receivables listed on the aged trial balance for
notes and related party receivables.
Select the last 10 sales transactions from the current
years sales journal and the first 10 from the subsequent
years and trace each one to the related shipping
documents, checking for the date of actual shipment and
the correct recording.
Review the minutes of the board of directors for any
indication of pledged or factored accounts receivable.
Discuss with the credit manager the likelihood of collecting

older accounts. Examine subsequent cash receipts and
the credit file on older accounts to evaluate whether
receivables are collectible.
14-5 The most important objectives satisfied by confirmations are existence, rights,
and accuracy. In extreme cases, confirmations are also useful tests for cutoff.
Sometimes confirmations may also help the auditor satisfy the completeness objective.
14-6 The purpose of the accuracy tests of gross accounts receivable is to determine
the correctness of the total amounts receivable from customers based on total sales.
These tests normally consist of confirmation of accounts receivable or examination of
shipping documents in support of the shipment of goods to customers.
The purpose of the test of the realizable value of receivables is to estimate the amount
of the accounts receivable balance that will not be collected. To estimate this amount,
the auditor normally reviews aging of the accounts receivable, analyzes subsequent
14-3
cash payments by customers, discusses the collectibility of individual accounts with

client personnel, and examines correspondence and financial statements of significant
customers.
14-7 In most audits it is more important to carefully test the cutoff for sales than for
cash receipts because sales cutoff misstatements are more likely to affect net earnings
than are cash receipt cutoff misstatements. Cash receipt cutoff misstatements
generally lead to a misclassification of accounts receivable and cash and, therefore, do
not affect income.
To perform a cutoff test for sales, the auditor should obtain the number of the last sales
invoice issued before year-end and examine shipping documents representing
shipments before and after year-end to determine that the proper shipments were
recorded in the appropriate period. The reconciliation of the bank confirmation will
establish the propriety of the cash receipts cutoff.
14-8 It is acceptable to confirm accounts receivable prior to the balance sheet date if
internal control is adequate and can provide reasonable assurance that sales, cash
receipts and other credits are properly recorded between the date of the confirmation
and the end of the accounting period. Other factors the auditor is likely to consider in
making the decision are the materiality of accounts receivable and the auditors
experience in prior years. If the decision is made to confirm accounts receivable prior to
year end, it is necessary to test the transactions occurring between the confirmation
date and the balance sheet date by examining internal documents and performing
analytical procedures at year end.
14-9
The most important factors affecting the sample size in

confirmations of accounts receivable are:
1.
2.
3.
4.
5.
Materiality
Inherent risk (relative size of total accounts receivable, number of
accounts, prior year results, and expected misstatements)
Control risk
Achieved detection risk from other substantive tests (extent and results of
substantive tests of transactions, analytical procedures, and other tests of
details)
Type of confirmation (negatives normally require a larger sample size)
14-4
14-10 In most confirmations of accounts receivable, some type of stratification is

desirable. A typical approach to stratification is to consider both the size of the
outstanding balance and the length of time an account has been outstanding as a basis
for selecting the balances for confirmation, since large accounts and long outstanding
accounts are more likely to include a significant misstatement. It is also important to
sample some items from every material stratum of the population. Utilizing this
approach, the auditor will pay particular attention to the accounts in which errors are
most likely and will follow the guidelines set forth in chapter 11 regarding the need to
obtain a representative sample of the population.
14-11 TER = 4%, EPER 0%, ARIA 10% Sample size = 57
14-12 Alternative procedures are procedures performed on a positive confirmation not

returned by the debtor using documentation evidence to determine whether the
recorded receivable exists and is collectible. It is common to send second requests for
confirmations and sometimes even third requests. Even with these efforts, some
customers do not return the confirmation, so it is necessary to follow up with alternative
procedures. The objective of the alternative procedures is to determine by a means
other than confirmation whether the non-confirmed account existed and is properly
stated at the confirmation date. For any confirmation not returned, the following
documentation can be examined to verify the existence and accuracy of individual sales
transactions making up the ending balance in accounts receivable.
1.
Subsequent cash receipts. Evidence of the receipt of cash subsequent

to the confirmation date includes examining remittance advice, entries in
the cash receipts records, or perhaps even subsequent credits in the
accounts receivable subsidiary records. The examination of evidence of
subsequent cash receipts is a highly useful alternative procedure because
it is reasonable to assume that a customer would not make a payment
unless it was a valid receivable. On the other hand, the fact of payment
does not establish whether there was an obligation on the date of the
confirmation. In addition, care should be used to match each unpaid sales
transaction with evidence of its payment as a test for disputes or
disagreements over individual outstanding invoices.
2.
Duplicate sales invoices. These are useful to verify the actual issuance
of a sales invoice and the actual date of the billing.
3.
Shipping documents. These are important to establish whether the

shipment was actually made and as a test of cutoff.
14-5
4.
Correspondence with the client. Usually it is unnecessary to review

correspondence as a part of alternative procedures, but it can be used to
disclose disputed and questionable receivables not uncovered by other
means.
The extent and nature of the alternative procedures depends primarily upon the
materiality of the unconfirmed accounts, the nature and extent of the misstatements
discovered in the confirmed responses, the subsequent cash receipts of the
unconfirmed accounts and the auditors evaluation of the effectiveness of internal
control. It is normally desirable to account for all unconfirmed balances with alternative
procedures, even if the amounts are small, as a means of properly generalizing from the
sample to the population.
14-13 Confirmation of accounts receivable is normally performed on only a sample of

the total population. The purpose of the confirmation is to obtain outside verification of
the balance of the account and to obtain an indication of the rate of occurrence of
misstatements in the accounts. Most misstatements that are indicated by the
differences on the confirmation replies will not be material; however, each difference
must be analyzed to determine the effect of that difference and all others considered
together on the accounts receivable balance. Though the individual differences may not
be material, they may indicate a material problem when extended for the entire
population, and with regard to the internal controls over the accounts receivable.
14-14 Three differences that may be observed on the confirmation of accounts

receivable that do not constitute misstatements and an audit procedure that would verify
each difference are as follows:
1.
2.
3.
Payment has been made by the customer but not received by the client at
the confirmation date. The subsequent payment should be examined as
to date deposited.
Merchandise shipped by the client has not been received by the customer.
The shipping documents should be examined to verify that the goods were
shipped prior to confirmation date.
Merchandise has been returned but has not been received by the client at
the confirmation date. Receiving documents and the credit memo should
be examined.

14-15
a. (4)
b.
(4)
c.
(3)
14-16
a. (2)
b.
(1)
c.
(4)
d.
14-6
(2)

14-17
1. Detail tie-in
2. Detail tie-in
3. a.
Existence
b.
Accuracy
c.
Realizable value (if cash receipts relate to older accounts).
4. a.
Existence
b.
Accuracy
5. a.
Existence
b.
Accuracy
c.
Realizable value (if cash receipts relate to older accounts).
6. a.
Cutoff
7. a.
Rights
b.
Presentation and disclosure.
8. Classification
14-18
a.
b.
c.
Balance-related
Audit Objective
Preventive
Internal Control
1. Transactions
Company policy should state
are recorded in that the cash cutoff at end of a
the proper
month should be achieved by
period (cutoff)
only recording the amounts
received prior to the month
end in the current month.
2. Accounts
receivable are
stated at
realizable value
(realizable
value)
The client should perform an

analysis of the collectibility of
accounts receivable at the end
of the year and should
communicate with its
customers to determine the
likelihood of the collectibility of
individual accounts.
14-7
Test of Details of Balances Audit

Procedures
The auditor should be present at the
clients facility at the end of the last
working day of the year, should obtain
the amount of the last deposit to be
made from current year receipts, and
should determine in the audit
procedures that this was, indeed, the
last deposit recorded during the current
year.
The auditor should compare the
deposits in transit shown on the bank
reconciliation to the date that deposits
reached the bank to determine that the
lag is reasonable.
The auditor should keep informed of
current economic conditions and
consider their effect on collectibility of
accounts receivable for his or her
clients.
The auditor may compare cash
collections after year end to the
collections of the similar period of the
3. Accounts
receivable are
stated at the
correct
amounts
(accuracy)
The client should record

claims for defective
merchandise as soon as
possible after the claim is
received to keep accounts
receivable balances as
accurate as possible.
4. Accounts
The controller should maintain
receivable
a schedule containing all
presentation
required disclosure
and disclosures information. This schedule
are proper
should be updated each time
(presentation
an event occurs which affects
and disclosure) this information.
5. Transactions
are recorded in
the proper
period (cut-off)
6. Accounts
receivable are
properly
classified
(classification)
7. Accounts
receivable in
The client should follow a

policy of holding open the
books to record any returns in
the subsequent period which
apply to goods shipped and
sales recorded in the current
period.
The client should maintain

separate accounts for the
recording of receivables due
from affiliated companies.
The client should total the trial

balance of accounts
14-8
previous year and consider any

changes as to their effect on the
collectibility of the accounts receivable
The auditor should review the clients
correspondence files from customers.
The auditor should note any replies to
the confirmation of accounts receivable
confirmations which indicate disputes
between a customer and client.
The auditors standard bank
confirmation should contain an inquiry
as to assets pledged for loans from
that institution.
Where loan confirmations are sent by
the auditor, they should contain an
inquiry as to any assets pledged for the
indebtedness.
The auditor should review returns
recorded in the subsequent period to
determine if they apply to goods
shipped and sales recorded prior to
year end.
The auditor should perform an
analytical test to determine whether or
not returns in the first month of the next
year are similar in magnitude to those
experienced in the same period of
previous years.
The auditor should review the trial
balance of accounts receivable to
determine whether or not accounts
from affiliated companies are included
in the customer accounts.
The auditor should be aware of
affiliated companies and the
transactions between them and the
client, and should inquire and follow up
to determine that accounts receivable
from affiliates are not included in the
accounts receivable from customers.
The auditor should foot the trial
balance of accounts receivable and
the aged trial

balance agree
with related
master file
amounts, and
the total is
correctly added
and agrees
with the
general ledger
(detail tie-in)
14-19
receivable and reconcile the

total to the balance in the
general ledger.
a.
reconcile it to the balance per the

general ledger.
A shipment should be recorded as a sale at the date of shipment or

the passing of title, whichever occurs first. Ordinarily, a shipment is
considered a sale when it is shipped, picked up, or delivered by a
common carrier.
b. The sales invoice number can be ignored, except to determine the shipping
document number.
Invoice #
Shipping
Document #
August sales
4326
4329
4327
4328
4330
2164
2169
2165
2168
2166
September sales
4332
4331
4333
4335
4334
2163
2167
2170
2171
2172
Net understatement
Misstatement in Sales
Cutoff
Overstatement or Shipping
Error in Understatement of
Aug. 31 Sales
none
1,914.30
none
620.22
none
2,534.52
overstatement
2,641.31
106.39
none
none
none
2,747.70
213.18
understatement
understatement
14-9
overstatement
Adjusting entry
Accounts receivable
Sales
213.18
213.18
c. After making the type of cutoff adjustments shown in part b, current

year sales would be overstated by:
2168
2169
2170
2171
2172
Amount of sale
620.22
1,914.30
852.06
1,250.50
646.58
5,283.66
The best way to discover the misstatement is to be on hand on the balance sheet date
and record in the audit working papers the last shipping document issued in the current
period. Later, the auditors can examine shipping documents before and after the
balance sheet date to determine if they were correctly dated.
An alternative, if there are perpetual records, is to follow up differences between
physical inventory counts and perpetual record balances to determine if the cause was
end of the period cutoff errors. Assume, for example, that there were 626 units of part
x263 on hand August 31, but the perpetual records showed a total of 526, and a
shipment of 100 units included on the perpetual August 31, that is a likely indication of a
September shipment that had been dated August 31.
d.
The following procedures are usually desirable for sales cutoff:

1.
2.
3.
Be present during the physical count on the last day of the accounting
period to determine the shipping document number for the last
shipment made in the current year. Record that number in the working
papers.
During year-end field work, select a sample of shipping documents
preceding and succeeding those selected in procedure 1. Shipping
documents with the same or with a smaller number than the one
determined in procedure 1 should be included in current sales. Those
with document numbers larger than that number should have been
excluded from current sales.
During year-end field work, select a sample of sales recorded in the last
few days of the sales journal and a sample of those recorded for the
first few days in the subsequent period. Trace sales recorded in the
14-10
current period to related shipping documents to make sure each one

has a number equal to or smaller than the one in procedure 1.
Similarly, trace sales recorded in the subsequent period to make sure
each sale has a related shipping document number greater than the
one in procedure 1.
e. The following are effective controls to prevent cutoff errors and related tests of
controls.
Control
(1) Policy requiring the use of
prenumbered shipping documents.
Test of Controls
Examine several documents for
prenumbering
(2) Policy requiring the issuance of

shipping documents sequentially.
Observe issuance of documents, examine

document numbers and enquiry
(3) Policy requiring recording sales

invoices in the same sequence as
shipping documents are issued.
Observe recording of documents, examine

document numbers and enquiry.
(4) Policy requiring dating of shipping

documents, immediate recording of
sales, and dating sales on the same
date as the shipment.
Observe dating of shipping documents and

sales invoices, and timing of recording.
(5) Use of perpetual inventory records and

reconciliation of differences between
physical and perpetual records.
Examine worksheets reconciling physical

and perpetual counts.
14-20
a. The two types of confirmations used for confirming accounts receivable
are positive and negative confirmations. A positive confirmation is a communication
addressed to the debtor requesting him or her to confirm directly whether the balance
as stated on the confirmation is correct or incorrect. A negative confirmation requests a
response from the debtor only when he or she disagrees with the stated amount.
When deciding which type of confirmation to use, the auditor should consider the
assessed control risk in the sales and collections cycle, the make-up of the population,
cost/benefit relationship, and any information about the validity of the accounts.
Positive confirmations are more reliable but more expensive than negative
confirmations. Positive confirmations should be used for individual balances of
relatively large amounts, when there are few debtors, when there is evidence or
suspicion of fraud or serious error or when required by regulatory agencies. When
negative confirmations are used, the auditor has normally assessed control risk below
maximum and tested the internal controls for effectiveness. Negative confirmations are
14-11
often used when accounts receivable are comprised of a large number of small
accounts from the general public.
b.
When evaluating the collectibility of accounts receivable, the auditor may review
the aging of accounts receivable, analyze subsequent cash payments by
customers, discuss the collectibility of individual accounts with client personnel,
and examine correspondence and financial statements of significant customers.
Changes in the aging of receivables should be analyzed in view of any changes
in the clients credit policy and the current economic conditions.
c.
When customers fail to respond to positive confirmation requests, the public

accountant may not assume with confidence that these customers checked the
request, found no disagreement, and therefore did not reply. Some busy
customers will not take the time to check confirmation requests and will not
respond, hence obvious exceptions may exist without being reported to the
public accountant. In the case of fraud or embezzlement, the perpetrators could
perhaps prevent exceptions from being reported and prevent letters addressed to
fictitious addresses from being returned from the post office as undeliverable.
Confirmations returned as undeliverable by the post office will require appropriate
action to obtain better addresses.
Follow-up is necessary when customers do not reply because the public accountant has
selected the positive confirmation route for certain receivables, and the most logical
step to follow first is to mail second requests.
d.
When no response is received to the second request for positive confirmation,

the auditor should use alternative procedures. These normally include
examination of customers formal remittance advice and cash receipts journals.
This is often a simple and effective check where collections have been made
subsequent to the balance sheet date. Correspondence in the clients files will
also sometimes offer satisfactory evidence. The auditor should also examine
shipping documents, sales invoices, contracts, or other documents to
substantiate that the charges were proper.
In unusual cases, the public accountant should mail a third request and possibly make
telephone calls in an effort to get a reply directly from the customer. The public
accountant may find it necessary where significant amounts are involved and
circumstances are not clear to investigate the existence and/or financial status of a
customer.
14-21
a. Yes, it is acceptable for the controller to review the list of accounts the
auditor intends to confirm. The confirmations will be sent to the companys customers,
and the auditor must be sensitive to the clients concern with the treatment of their
customers. At the same time, if the client refuses permission to confirm receivables, the
14-12
auditor must consider the effect on her audit opinion. If the restriction is material, a
qualified or denial of opinion may be needed.
b.
The auditor should be willing to perform special procedures which the client
requests if the client is in agreement that these procedures may not necessarily
be considered within the scope of the auditors engagement. In the case of the
20 additional confirmations which the controller requested that the auditor send,
the auditor should be willing to send the confirmations; however, these
confirmations should not be considered in the evaluation of the results of the
accounts receivable confirmation sent by the auditor.
c.
If the auditor complies with the controllers request to eliminate six of the
accounts from the confirmation, the auditor must perform alternative procedures
on the six accounts and decide whether or not this omission is significant to the
scope of her examination. If the auditor believes that the impact of omitting these
accounts is significant, she must qualify the auditors report to indicate the
restriction of scope imposed by the client.
14-22
a.
Random Number
Table Item
Random Dollar Population

Item
1000
70,399
8
1001
51,458
8
1005
102,032
20
1006
100,596
20
1008
9,545
2
1010
101,882
20
1011
100,140
20
1012
160.232
30
1014
175,103
32
1015
133,735
27
Note:
Random dollar items are matched with population item numbers by computing
cumulative book values of the population according to the chart which follows:
Popn
Item
1
*
2
3
4
5
*
6
7
*
8
Recorded Cumulative
Amount
Amount
1,410
1,410
9,130
10,540
660
11,200
3,355
14,555
5,725
20,280
8,210
28,490
580
29,070
44,110
73,180
Popn
Item
21
22
23
24
25
* 26
27
28
14-13
Recorded Cumulative
Amount
Amount
4,865
117,385
770
118,155
2,305
120,460
2,665
123,125
1,000
124,125
6,225
130,350
3,675
134,025
6,250
140,275
9
10
11
12
13
14
15
16
17
18
19
20
825
1,155
2,270
50
5,785
940
1,820
3,380
530
955
4,490
17,140
74,005
75,160
77,430
77,480
83,265
84,205
86,025
89,405
89,935
90,890
95,380
112,520
29
30
31
32
33
34
35
36
37
38
39
40
1,890
27,705
935
5,595
930
4,045
9,480
360
1,145
6,400
100
8,435
142,165
169,870
170,805
176,400
177,330
181,375
190,855
191,215
192,360
198,760
198,860
207,295
Interval = Population total / Number of items selected

=
207,295 / 10
=
20,729
Interval
Using 1857 as a starting point, we have:
1
2
3
4
5
6
7
8
9
10
Systematic Dollar
Population Item No.
1,857
2
22,586
6
43,315
8 (counts as 2 items)
64,044
8
84,773
15
105,502
20
126,231
26
146,960
30 (counts as 2 items)
167,689
30
188,418
35
All items larger than the interval will be automatically included. If the interval is 20,729
item 30 will be included at least once, and item 8 at least twice.
b. Monetary unit sampling would be used because (1) it is efficient and (2) it
focuses on large dollar items.
14-23
a. The differences that were uncovered include only five misstatements
rather than seven misstatements. Items 2 and 7 are not misstatements, but only timing
differences. Therefore, only the five "misstatements" are summarized in order to
compute the upper and lower misstatement bounds. These misstatements are
summarized below.
14-14
_______________________________________________________________
Recorded
Audited
MisstateMisstatement /
Item
Value
Value
ment
Recorded Value
_______________________________________________________________
1
3
4
5
6
$2,728.00
3,890.00
791.00
548.00
3,115.00
$2,498.00
1,190.00
815.00
1,037.00
3,190.00
$230.00
2,700.00
(24.00)
(489.00)
(75.00)
.084
.694
(.030)
(.892)
(.024)
Upper misstatement bound before adjustment:

No. of
Recorded
Misstate- Value
ments
0
$1,975,000
1
1,975,000
2
1,975,000
CUER
Portion
x Misstatement = Misstatement Bound

%
Portion
Assumption
.023
1.000
$45,425
.015
.694
20,560
.014
.084
2,323
.052
$68,308
Lower misstatement bound before adjustment:
No. of
Recorded
Misstate- Value
ments
CUER
Portion
0
1
2
3
$1,975,000
1,975,000
1,975,000
1,975,000
x Misstatement
%
Assumption
.023
.015
.014
.014
.066
1.000
.892
.030
.024
= Misstatement Bound
Portion
$45,425
26,426
830
664
$73,345
Adjustment of upper misstatement bound:

Point estimate for understatement misstatements = sum of misstatement prorations x
recorded value / sample size
=
(.892 + .030 + .024) x (1,975,000 / 100)
.946 x 19,750
18,684
14-15
Adjusted bound = initial bound - point estimate for understatement misstatements

=
68,308 - 18,684
49,624
Adjustment of lower misstatement bound:

Point estimate for overstatement misstatements = Sum of misstatement prorations x
Recorded value / sample size
=
(.694 + .084) x (1,975,000 / 100)
.778 x 19,750
15,366
Adjusted bound = Initial bound - point estimate for overstatements

=
73,345 - 15,366
57,979
b.
The population is not acceptable as stated because the lower misstatement

bound exceeds materiality. (Note that although the upper misstatement bound
does not exceed materiality, it is quite close.)
In this situation, the auditor has the following options:

1.
2.
3.
Increase the sample size.

Segregate a specific type of misstatement and test it separately. The
sample would then not include the specified type of misstatement since it
is being tested separately.
Expand other areas in the audit of accounts receivable.
Of these options, segregating a particular type of misstatement may prove the most
beneficial. In this problem, items 3 and 5 are cut-off misstatements. Segregating these
items and eliminating them from the sample would result in the following bounds:
14-16
Upper misstatement bound:

No. of
Recorded
Misstate- Value
ments
0
1
CUER
Portion
x Misstatement
%
Assumption
$1,975,000
1,975,000
.023
.015
.038
Less adjustment [(.030 + .024) (19, 750)]
1.000
.084
Portion
$45,425
2,489
$47,914
(1,067)
$46,847
Lower misstatement bound:

No. of
Recorded
Misstate Value
-ments
0
1
2
$1,975,000
1,975,000
1,975,000
CUER
Portion
x Misstatement
%
Assumption
.023
.015
1.000
.030
.024
Less adjustment [(.084) (19, 750)]
Portion
$45,425
889
664
--------$46,978
(1,067)
$45,319
It can be seen that both misstatement bounds are now within materiality after "cut-off"
misstatements were segregated. These misstatements were significant in two ways.
Their existence increased the overall estimated misstatement rate, and their magnitude
contributed to the amount of estimated misstatements in the portion of the population
represented by the misstatements in the sample.
14-24
a. The audit approach of testing all three account balances is acceptable.
This approach is also desirable when the following conditions are present:
1.
The auditor can obtain valid, reliable information to perform the required
tests in all of the areas.
2.
Internal control for each of the three areas are comparable.
3.
Misstatements are expected to occur evenly over the entire population.

For instance, the auditor does not expect a large number of misstatements
in accounts receivable and very few, if any, in inventory.
14-17
b.
The required sample size for all three accounts is:
Tolerable misstatement / Recorded population value 100,000 / 10,000,000 = .01

From the attributes table sample size n cannot be determined, but using interpolation it
is approximately 114 + (114 - 76) = 152. (This is not an appropriate method to
determine sample size in practice. Normally, computer software would be used.)
c.
The required sample sizes if each account is tested separately are:

Approximate
Account
Factor
Sample Size
Accounts receivable
n = 100,000 \ 3,600,000 = .028
76
Inventory
n = 100,000 \ 4,800,000 = .020
114
Marketable securities
n = 100,000 \ 1,600,000 = .060
38
The important point is that sample size under b is much smaller than for the combined
samples in c.
d.
The population would be arranged so that all accounts receivable would be first,
followed by inventory and marketable securities. The items would be identified by
the cumulative totals. In the example, the number 4,627,871 would relate to an
inventory item since it is between the cumulative totals of $3,600,000 and
$8,400,000. Accordingly, for this number the inventory audit procedures would be
performed.
e.
The misstatement data are as follows:
Recorded
Amount
Audited
Amount
Difference
$987.12
$887.12
$100.00
Misstatement /
Recorded Amount
10.1%
Assuming a 100% average misstatement in the population when there are no

misstatements found and an ARIA of 10%, the misstatement bounds are:
Upper misstatement bound:
$10,000,000 x .011 x 1.0
$10,000,000 x .008 x .101
$110,000
8,080
$118,080
14-18
Lower misstatement bound:

Before adjustment:
$10,000,000 x .011 x 1.0
Adjustment:
$10,000,000 ( 200
$110,000
(5,050)
$104,950
Based on the sample results and the materiality level of $100,000, the population
should not be accepted as stated without further testing:
14-25 For all of the exceptions, the auditor is concerned about four principal things:
(a)
Whether there is a client misstatement. Many times the confirmation

response differences are due to timing differences for deposits in the mail
and inventory in transit to the customer. Sometimes customers
misunderstand the confirmation or the information requested. The auditor
must distinguish between those and client misstatements.
(b)
The amount of the client misstatement if any.
(c)
The cause of the misstatement. It could be intentional, a

misunderstanding of the proper way to record a transaction, or a
breakdown of internal control.
(d)
Potential misstatements in the sample not tested. The auditor must

estimate the misstatements in the untested population, based on the
results of the tests of the sample.
Suggested steps to clear each of the comments satisfactorily are:

1.
(a)
Examine supporting documents, including the sales invoices and

applicable sales and shipping orders, for propriety and valuation of the
sales.
(b)
Review the cash receipts books for the period after December 31, 2001,
and note any collections from Duck Lake Inc. The degree of internal
control over cash receipts should be an important consideration in
determining the reliance that can be placed on the cash receipts entries.
In addition, as there is no assurance that collections after December 31
represent the payment of invoices supporting the December 31 trial
balance, consideration should be given to requesting a confirmation from
Duck Lake Inc. of the invoices paid by their cheques.
14-19
2.
(a)
The cause should be investigated thoroughly. If the credit was posted to

the wrong account, it may indicate merely a clerical error. On the other
hand, posting to the wrong account may indicate lapping.
(b)
Such a comment may also indicate a delay in posting and depositing of

receipts. If upon investigation such is the case, the company should be
informed immediately so that it can take corrective steps.
3.
This is a confirmation of the balance with an additional comment. Since

the customer has given us the data, it is preferable to check to see that
the information agrees with the companys records. Such a procedure
may disclose misposting or delay in recording receipts.
4.
This incomplete comment should raise an immediate question: does the

customer mean paid before or paid after December 31? Because the
customers intent is unknown, this account should be reconfirmed and the
customer asked to state the exact date. Upon receipt of the second
confirmation, the information thereon should be traced to the cash receipts
book.
5.
The auditor should first evaluate how long it takes to ship goods to the
customer in question. If it ordinarily takes more than five days, there is no
indication of misstatement.
A comment of this type may indicate that the company may be recording
sales before an actual has taken place. The auditor should examine the
invoice and review with the appropriate officials the companys policy on
shipment terms and determine if sales, cost of sales, inventories and
accounts receivable need to be adjusted.
6.
7.
(a)
Determine if such advance payment has been received and that it has
been properly recorded. A review should be made of other advance
payments to ascertain that charges against such advances have been
properly handled.
(b)
If the advance payment was to cover these invoices, the auditor should
propose a reclassification of the $1,350, debiting the advance payment
account and crediting accounts receivabletrade.
(a)
Examine the shipping order for indications that the goods were shipped
and, if available, carriers invoice and/or bill of lading for receipt of the
goods.
(b)
If it appears that goods were shipped, send all available information to the
customer and ask the customer to reconfirm. If the customer still insists
that goods were never received, all data should be presented to an
14-20
appropriate company official for a complete explanation. This may

indicate that accounting for shipments is inadequate and consideration
should be given to reviewing the procedures to determine if improvements
can be made.
(c)
If the goods were not shipped, the auditor should recommend an

adjustment reducing sales, cost of sales, and accounts receivable, and
increasing inventories.
8.
This should be discussed with the appropriate officials and correspondence with
the customer should be reviewed to allow determination whether an adjustment
should be made in the amount receivable or if an allowance for doubtful accounts
should be set up.
9.
As title on any goods shipped on consignment does not pass until those goods
are sold, the sales entry should be reversed, inventory charged, and cost of sales
credited if it is actually a consignment sale. Other so-called sales should be
reviewed and company officials queried to determine if other sales actually
represent consignment shipments; if so, the adjustment set forth in the preceding
sentence should be made for all consignment shipments.
10.
This is a noncurrent asset and should be reclassified to either deposit or prepaid

rent. A review of other accounts, especially those with round numbers, may
disclose other accounts that should be so reclassified.
This may indicate a misposting of the credit or a delay in posting the credit.
Comments under 2 above would also apply to credits.
11.
14-26
Additional audit procedures necessary for testing the balances in the sales
and collection cycle from August 31 to year end are as follows:
1.
2.
3.
4.
Compare sales and accounts receivable balances at year end to the

balances at August 31 and obtain and verify an explanation for any
significant unexpected differences. If either balance appears to be
significantly out of line at year end, consider performing unexpected
confirmation procedures again at year-end.
Obtain reconciliations of the sales and accounts receivable accounts
from August 31 to year end. Trace reconciling items to supporting
journals produced by the system. Obtain explanation and verify the
explanation for any unusual transactions.
Examine the trial balance of accounts receivable at year end. Consider
confirmation of any accounts which have large balances and were not
included in the circularization at August 31.
Compute the gross margin percent on a monthly basis for the year and
determine if the ratios for the months after the confirmation are
significantly different that before.
14-21
5.
6.
Compute the ratio of sales returns and allowances to sales on a monthly

basis as in 4.
Internal controls should be tested for the period August 31 to December
31. The extent of testing should depend on the results of procedures 1
through 5.
14-27 a. If called upon to evaluate the adequacy of the sample size, the type of
confirmation used, and the percentage of accounts confirmed, the following additional
information would be required:
1.
2.
3.
4.
5.
6.
7.
The number of accounts that had positive balances at 12/31/01.

The materiality of total accounts receivable.
The distribution and size of the accounts receivable.
The assessment of control risk based on the understanding obtained of the
control structure and tests of controls.
The results of the confirmation tests in previous years.
The risk of exposure to bankruptcy and similar risks. (audit risk)
Expected misstatements.
b.
If the amounts are material, it is necessary to perform follow-up procedures for
positive confirmations not returned by the debtor. It is common to send second
requests for confirmations and sometimes even third requests. Even with these efforts,
some customers do not return the confirmation, so it is necessary to follow up on all
non-responses with a method referred to as alternative procedures.
c.
The alternative procedures used for verifying the two non- responses do not
appear to be adequate. In recording information about the subsequent cash receipts,
for confirmation request no. 9, the auditor should have indicated which invoices the
payments applied to and whether or not the invoices were included in the balance at
12/31/01. In addition, the auditor should have examined copies of cheques if they were
available or traced the amounts into the bank deposit and to the bank statement. The
cash receipts listed for confirmation request no. 9 total in excess of the balance due at
the 12/31/01. The auditor should have indicated what portion of this balance applies to
the balance at 12/31/01.
The alternative procedures for confirmation request no. 26 show a payment for which no
indication of the invoice to which it applies is given. The auditor examined a duplicate
sales invoice which may or may not support the balance at 12/31/01. The auditor must
determine which sales invoices are represented by the $2,500 balance at 12/31/01 and
then examine a shipping document to support the shipment of goods to the customer.
The even amount of the balance and periodic payments also raise a question about the
possibility of a note outstanding rather than an account receivable.
14-22
14-28
Investigation of credit and collection problems
1. Obtain:
Aged accounts receivable trial balances (current date).
Analysis of bad debt expenses.
Analysis of doubtful accounts.
2. Ascertain policies in force.
3. Obtain explanations from credit manager for unfavorable results.
4. Consider the following factors:
Economic situation
Effect of competition
Sales policies.
5. Identify variances in policies and procedures between subsidiary and parent
company.
6. Method of granting credit: Is there an acceptable credit granting system?
Outside sources (such as trade credit agencies).
Internal sources payment history.
Credit limits established.
7. Follow-up on collections: Is there an adequate system for follow-up?
Invoices and statements mailed promptly.
Aged list of accounts reviewed and old accounts contacted by

reminders, advices, correspondence, etc.
8. Are records up-to-date?
9. Check compliance with procedures.
Have there been changes?

10. Review status of overdue accounts per aged list of accounts and ascertain whether
proper action has been taken.
Follow-up by credit manager.
Approval of credit on specific sales.
Credit limit exceeded should be cut off.
Explanation of delays in payment.
Perform similar analysis of accounts written off as to causes, by checking:
original credit approval,
follow-up.
14-23
11. Determine that current allowance is adequate by reviewing collectibility of overdue

accounts.
Form opinion on written off items.

12. Ensure that write-offs are appropriate and that collection efforts are continued where
possible.
Form opinion on written off items.

13. Assess competence of credit manager.
Case
14-29
a.
Information hoped to be obtained
Independent addition of:
Amounts outstanding in total (need $
amount outstanding)
Aged totals
Total service charges
Selection of accounts for circularization:
account data that would be placed on a
confirmation: account number, name,
address, balances, open items by
transaction
Accounts lacking valid customer (credit
card) number
Accounts lacking customer name
Accounts lacking customer address
Accounts with duplicate names
Accounts where the aggregate balance
outstanding exceeds the credit limit
A list of bad debt write offs, by customer
Accounts showing balances 60 days or
older
Accounts which have been inactive for 90
days or more.
Accounts in credit balance
Accounts over stated amount
Over valid information
Reason
Mechanical accuracy
To assist in verifying the revenue figure
To establish circularization basis (for a
statistical sample, if selection is on a
random basis)
To locate invalid account, i.e., customer

could not be located.
Same as above
Same as above
To locate double active accounts
Verify similar report by credit department
and related reports
Same as above
Same as above
Same as above
Identify unusual credit balances
Identify unusual customers
Same as above
14-24
b.
Control over programmer

Obtain master file layout and relate it to the program.
Run program and compare with predetermined output.
If in doubt, have program checked by an expert.
Check constants (limit) in the program.
Check logic of program: ensure all items have an equal chance of being
drawn: ensure no specific account is mentioned in program.
Ensure with operator that proper file is used: be present when file is used:
check instructions to operate.
14-25

Audit Case Bank

Enviado por

Dados do documento

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Audit Case Bank

Enviado por

Direitos autorais:

Formatos disponíveis

Chapter 1

An Overview of Auditing and Assurance Services

Five specific examples of operational audits that could be conducted by an

The major differences in the scope of audit responsibilities are:

The existence of standards are a means of transmitting wisdom and avoiding

Organizational structure - usually a partnership employing a professional

Conduct - employs a professional staff of sufficient size to provide a broad

1-12 The CICA Handbook codifies as recommendations, generally accepted

1-18 A practice inspection is a review, by practice inspectors employed by the

Multiple Choice Questions

Discussion Questions and Problems

Virms is being asked to issue a report about qualitative and quantitative

There is no correct answer to this question. Different people reach different

1. It was inappropriate for Holmes to hire the two

1. This standard recognizes that early appointment

2. The auditor should obtain a

2. Holmes did not obtain an understanding of

1. Cannot tell from the question whether this

2. The scope of the auditors

2. The scope of the work was so limited as not

3. The report shall either

3. Although Holmes report contains an

4. Holmes report made no reference to Canadian

1-29 a) An audit would provide an independent review of EECs financial activities,

Design appropriate control systems

An unqualified report may be issued under the following five circumstances:

An audit engagement has been undertaken.

The unqualified auditors report consists of:

planned and performed in accordance with professional standards and

The auditor followed Canadian generally accepted auditing standards.

2-10 A "contingency" is an unusual uncertainty affecting an entity in which the

Recurring operating losses

The two conditions requiring a departure from an unqualified opinion are:

The financial statements have not been prepared in accordance with

2-14 The common definition of materiality as it applies to accounting and, therefore, to

The dollar amount of some measure compared to a base such as net

The three levels of materiality are:

immaterial, that is, a readers decisions are unlikely to be affected by the

A non-GAAP condition, for example, an inappropriate accounting treatment, an

Whenever there is a scope restriction, the appropriate response is to issue an

Memo to Jan de Boer

If the primary auditor decides that an unqualified opinion is appropriate,

Multiple Choice Questions

Discussion Questions and Problems

"Our audit was performed to detect material misstatements in the financial

"We conducted our audit in accordance with Canadian generally accepted

The reference to generally accepted accounting principles specifies rules which

Items that need not be included in the auditor's report are:

That Excelsior is presenting comparative financial statements.

The following deficiencies are in Roscoe's report:

failure to present a cash flow statement.

Qualified opinion or adverse opinion for failure to follow generally accepted

Unqualified opinion. The company has made a decision to follow a different

Failure to follow GAAP

(2) Qualified opinion

MATERIAL & PERVASIVE (5) Adverse

(3) Qualified scope and

MATERIAL & PERVASIVE (4) Denial

The Auditor's Report would be something like the following:

To the Shareholders of Kootenay Real Estate Holdings Limited

We conducted our audit in accordance with Canadian generally accepted auditing

the memo might take the following form:

To the Shareholders of Saskatoon Building Products Limited

Operating losses in the past three years totaled $700,000.