Review Questions
6-1 The objective of the audit 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 cash flows in conformity with generally accepted accounting principles.
The auditor meets that objective by accumulating sufficient appropriate evidence to determine whether the financial statements are fairly stated.
6-2 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 auditing standards and report the findings of the audit in the auditor's report.
6-3 An error is an unintentional misstatement of the financial statements.
Fraud represents intentional misstatements. The auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are detected, whether those misstatements are due to errors or fraud.
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, material misstatements due to fraud are usually more difficult to uncover than errors. The auditor’s best defense when material misstatements (either errors or fraud) are not uncovered in the audit is that the audit was conducted in accordance with auditing standards.
6-4 Misappropriation of assets represents the theft of assets by employees.
Fraudulent financial reporting is the intentional misstatement of financial information by management or a theft of assets by management, which is covered up by misstating financial statements.
Misappropriation of assets ordinarily occurs either because of inadequate internal controls or a violation of existing controls. The best way to prevent theft of assets is through adequate internal controls that function effectively. Many times theft of assets is relatively small in dollar amounts and will have no effect on the fair presentation of financial statements. There are also the cases of large
6-5 True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the auditor must not accept management's representations blindly. The auditor must, whenever possible, obtain appropriate evidence to support the representations of management. As an example, if management represents that certain inventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the inventory is being sold at a price that is higher than the company's cost plus selling expenses. If management represents an account receivable as being fully collectible, the auditor should be able to examine subsequent payments by the customer or correspondence from the customer that indicates a willingness and ability to pay.
6-6
CHARACTERISTIC AUDIT STEPS
1. Management’s characteristics and influence over the control environment.
Investigate the past history of the firm and its management.
Discuss the possibility of fraudulent financial reporting with previous auditor and company legal counsel after obtaining permission to do so from management.
2. Industry conditions. Research current status of industry and compare industry financial ratios to the company’s ratios.
Investigate any unusual differences.
Read AICPA’s Industry Audit Risk Alert for the company’s industry, if available. Consider the impact of specific risks that are identified on the conduct of the audit.
3. Operating characteristics and financial stability.
Perform analytical procedures to evaluate the possibility of business failure.
Investigate whether material transactions occur close to year- end.
6-7 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
6-8
GENERAL LEDGER ACCOUNT CYCLE Sales
Accounts Payable Retained Earnings Accounts Receivable Inventory
Repairs & Maintenance
Sales & Collection Acquisition & Payment
Capital Acquisition & Repayment Sales & Collection
Inventory & Warehousing Acquisition & Payment
6-9 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 debt expense is closely related to the 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 relationships in mind.
6-10 Management assertions are implied or expressed representations by management about classes of transactions and the related accounts and disclosures in the financial statements. These assertions are part of the criteria management uses to record and disclose accounting information in financial statements. AU 326 classifies assertions into three categories:
1. Assertions about classes of transactions and events for the period under audit
2. Assertions about account balances at period end 3. Assertions about presentation and disclosure
6-11 General audit objectives follow from and are closely related to management assertions. General audit objectives, however, are intended to provide a framework to help the auditor accumulate sufficient appropriate evidence required by the third standard of field work. 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 evidence.
6-12
RECORDING MISSTATEMENT
TRANSACTION-RELATED AUDIT OBJECTIVE VIOLATED Fixed asset repair is recorded on the wrong
date.
Timing
6-13 The existence objective deals with whether amounts included in the financial statements should actually be included. Completeness is the opposite of existence. The completeness objective deals with whether all amounts that should be included have actually been included.
In the audit of accounts receivable, a nonexistent 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.
6-14 Specific audit objectives are the application of the general audit objectives to a given class of transactions, account balance, or presentation and disclosure.
There must be at least one specific audit objective for each general audit objective and in many cases there should be more. Specific audit objectives for a class of transactions, account balance, or presentation and disclosure should be designed such that, once they have been satisfied, the related general audit objective should also have been satisfied for that class of transactions, account, or presentation and disclosure.
6-15 For the specific balance-related audit objective, all recorded fixed assets exist at the balance sheet date, the management assertion and the general balance-related audit objective are both "existence."
6-16 Management assertions and general balance-related audit objectives are consistent for all asset accounts for every audit. They were developed by the Auditing Standards Board, practitioners, and academics over a period of time.
One or more specific balance-related audit objectives are developed for each general balance-related audit objective in an audit area such as accounts receivable. For any given account, a CPA firm may decide on a consistent set of specific balance-related audit objectives for accounts receivable, or it may decide to use different objectives for different audits.
6-17 For the specific presentation and disclosure-related audit objective, read the fixed asset footnote disclosure to determine that the types of fixed assets, depreciation methods and useful lives are clearly disclosed, the management assertion and the general presentation and disclosure-related audit objective are both "classification and understandability."
6-18 The four phases of the audit are:
1. Plan and design an audit approach.
2. Perform tests of controls and substantive tests of transactions.
3. Perform analytical procedures and tests of details of balances.
4. Complete the audit and issue an audit 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 fairly, in all material respects, the financial position, results of operations and
Multiple Choice Questions From CPA Examinations 6-19 a. (2) b. (2) c. (1)
6-20 a. (1) b. (2) c. (1) Discussion Questions And Problems
6-21 a. The purpose of the first part of the report of management is for management to state its responsibilities for internal control over financial reporting. The second part of the report states management’s responsibility for the fair presentation of the financial statements.
b. The auditor’s responsibility is to express an opinion on the fairness of the presentation of the financial statements and an opinion on the effectiveness of internal control over financial reporting.
6-22 a. Professional skepticism. Auditors are required to perform the audit with an attitude of professional skepticism as the financial
statements (F/S) may contain material misstatements which may or may not be intentional on the part of management.
b. The responsibility lies with:
i. Management. Auditors must also develop an estimate for comparison purposes, but auditors do not record their estimate on the F/S.
ii. Auditors. Management may also test the A/R Allowance as an internal audit function, but they are not required to do so.
iii. Management and Auditors. Both must evaluate the adequacy of the A/R Allowance.
iv. Management. ONLY management is responsible for the ultimate presentation of A/R Allowance on the F/S.
c. A misstatement would be considered material if it is probable that the decisions of a reasonable person relying on the information would have been changed or influenced by the uncorrected errors or fraud.
d. If the A/R Allowance estimate developed by management and the auditors is different, the auditor must determine if the amount is material. If the auditor determines the amount is material, the
auditor must ask the client to make an adjustment. If the client does not want to make the adjustment, the auditor may consider a
qualified or adverse opinion, or withdrawal from the engagement, depending on materiality.
6-23
CLASS OF TRANSACTIONS
a.
FINANCIAL STATEMENT
BALANCE
b.
TITLE OF JOURNAL
c.
TRANSACTION CYCLE PURCHASE
RETURNS
Purchase returns
& allowances
Acquisitions Journal
Acquisition
& Payment RENTAL
REVENUE
Rent revenue Revenue Journal Sales &
Collection CHARGE-OFF OF
UNCOLLECTIBLE ACCOUNTS
Bad debts Adjustments Journal
Sales &
Collection ACQUISITION OF
GOODS AND SERVICES
Repair and maintenance
Acquisitions Journal
Acquisition
& Payment RENTAL
ALLOWANCES
Rental
allowances
Adjustments Journal
Sales &
Collection ADJUSTING
ENTRIES (FOR PAYROLL)
Rental
allowances Accrued
payroll
Adjustments Journal Adjustments
Journal
Sales &
Collection Payroll &
Personnel PAYROLL
SERVICE &
PAYMENTS
Sales salaries Payroll Journal Payroll &
Personnel CASH
DISBURSEMENTS
Accounts payable
Cash Disburse- ments Journal
Acquisition
& Payment CASH RECEIPTS Accounts
receivable
Cash Receipts Journal
Sales &
Collection
d. Rental revenue is likely to be recorded in the cash receipts journal at the time the cash is received from renters. It is therefore likely to be recorded as a debit to cash receipts 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 that are likely to be made in the adjustments journal are posted to the general ledger. Then the financial statements are prepared from the adjusted general ledger.
6-24 a.
CYCLE BALANCE SHEET ACCOUNTS
INCOME STATEMENT ACCOUNTS SALES AND
COLLECTION
Accounts receivable Cash
Notes receivable—trade
Allowance for doubtful accounts Interest receivable
Sales
Bad debt expense Interest income
ACQUISITION AND PAYMENT
Income tax payable Accounts payable Unexpired insurance Furniture and equipment Cash
Accumulated depreciation of furniture and equipment Inventory
Property tax payable
Income tax expense Advertising expense Travel expense Purchases
Property tax expense Depreciation expense—
furniture and equipment Telephone and fax
expense Insurance expense Rent expense PAYROLL AND
PERSONNEL
Cash
Accrued sales salaries
Sales salaries expense Salaries, office and general
INVENTORY AND WAREHOUSING
Inventory Purchases CAPITAL
ACQUISITION AND
REPAYMENT
Bonds payable Common stock Cash
Notes payable Retained earnings Prepaid interest expense
Interest expense
b. The general ledger accounts are not likely to differ much between a retail and a wholesale company unless there are departments for which there are various categories. There would be large differences for a hospital or governmental unit. A governmental unit would use the fund accounting system and would have entirely different titles. Hospitals are likely to have several different kinds of revenue accounts, rather than sales. They are also likely to have such things as drug expense, laboratory supplies, etc. At the same time, even a governmental unit or a hospital will have certain accounts such as cash, insurance expense, interest income, rent
6-25 a. Management assertions about transactions relate to transactions and other events that are reflected in the accounting records. In contrast, assertions about account balances relate to the ending account balances that are included in the financial statements, and assertions about presentation and disclosure relate to how those balances are reflected and disclosed in the financial statements.
MANAGEMENT ASSERTION
b.
CATEGORY OF MANAGEMENT ASSERTION
c.
NAME OF ASSERTION a. All sales transactions have been
recorded.
Classes of transactions
Completeness b. Receivables are appropriately
classified as to trade and other receivables in the financial statements and are clearly described.
Presentation and disclosure
Classification and understandability
c. Accounts receivable are recorded at the correct amounts.
Account balances Valuation and allocation d. Sales transactions have been
recorded in the proper period.
Classes of transactions
Cutoff e. Sales transactions have been
recorded in the appropriate accounts.
Classes of transactions
Classification
f. All required disclosures about sales and receivables have been made.
Presentation and disclosure
Completeness
g. All accounts receivable have been recorded.
Account balances Completeness h. There are no liens or other
restrictions on accounts receivable.
Account balances Rights and obligations i. Disclosures related to accounts
receivable are at the correct amounts.
Presentation and disclosure
Accuracy and valuation j. Recorded sales transactions
have occurred.
Classes of transactions
Occurrence k. Recorded accounts receivable
exist.
Account balances Existence l. Sales transactions have been
recorded at the correct amounts.
Classes of transactions
Accuracy
6-26
SPECIFIC BALANCE- RELATED AUDIT
OBJECTIVE
MANAGEMENT
ASSERTION COMMENTS
a. There are no unrecorded receivables.
2. Completeness Unrecorded transactions or amounts deal with the completeness objective.
b. Receivables have not been sold or discounted.
4. Rights and obligations
Receivables not being sold or discounted concerns the rights and obligations objective and assertion.
c. Uncollectible accounts have been provided for.
3. Valuation or allocation
Providing for uncollectible accounts concerns whether the allowance for uncollectible accounts is adequate. It is part of the realizable value objective and the valuation or allocation
assertion.
d. Receivables that have become uncollectible have been written off.
3. Valuation or allocation
This is part of the realizable value objective and the valuation or allocation assertion. There may also be some argument that this is part of the existence objective and assertion. Accounts that are uncollectible are no longer valid assets.
e. All accounts on the list are expected to be collected within one year.
3. Valuation or allocation
Accounts that are not expected to be collected within a year should be classified as long-term
receivables. It is therefore being included as part of the
classification objective and consequently under the valuation or allocation assertion.
f. The total of the amounts on the accounts receivable listing agrees with the general ledger balance for accounts
3. Valuation or allocation
This is part of the detail tie-in objective and is part of the valuation or allocation assertion.
6-26 (continued)
SPECIFIC BALANCE- RELATED AUDIT
OBJECTIVE
MANAGEMENT
ASSERTION COMMENTS
g. All accounts on the list arose from the normal course of business and are not due from related parties.
3. Valuation or allocation
Concerns the classification of accounts receivable and is therefore a part of the
classification objective and the valuation or allocation assertion.
Some people believe that like item e., it is a part of presentation and disclosure.
h. Sales cutoff at year- end is proper.
3. Valuation or allocation
Cutoff is a part of the cutoff objective and therefore part of the valuation or allocation assertion.
6-27 a. Management assertions are implied or expressed representations by management about the classes of transactions and related accounts in the financial statements. AU 326 identifies five assertions about classes of transactions which are stated in the problem. These assertions are the same for every transaction cycle and account. General transaction-related 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.
Accuracy and posting and summarization are a subset of the accuracy assertion. Specific transaction-related audit objectives are determined by the auditor for each general transaction-related audit objective. These are done for each transaction cycle to help the auditor determine the specific amount of evidence needed for that cycle to satisfy the general transaction-related audit objectives.
b.
and
c. The easiest way to do this problem is to first identify the general transaction-related audit objectives for each specific transaction- related audit objective. It is then easy to determine the management assertion using Table 6-3 (p. 158 in text) as a guide.
6-27 (continued)
SPECIFIC TRANSACTION- RELATED AUDIT OBJECTIVE
b.
MANAGEMENT ASSERTION
c.
GENERAL TRANSACTION- RELATED AUDIT
OBJECTIVE a. Recorded cash disbursement
transactions are for the amount of goods or services received and are correctly recorded.
3. Accuracy 8. Accuracy
b. Cash disbursement transactions are properly included in the accounts payable master file and are correctly summarized.
3. Accuracy 9. Posting and summarization
c. Recorded cash disbursements are for goods and services actually received.
1. Occurrence 6. Occurrence
d. Cash disbursement transactions are properly classified.
4. Classification 10. Classification e. Existing cash disbursement
transactions are recorded.
2. Completeness 7. Completeness f. Cash disbursement transactions
are recorded on the correct dates.
5. Cutoff 11. Timing
6-28
SPECIFIC PRESENTATION AND DISCLOSURE-RELATED AUDIT OBJECTIVE
MANAGEMENT ASSERTION a. All required disclosures about fixed assets have
been made.
2. Completeness b. Footnote disclosures related to fixed assets are
clear and understandable.
4. Classification and understandability c. Methods and useful lives disclosed for each
category of fixed assets are accurate.
3. Accuracy and valuation d. Disclosed fixed asset dispositions have occurred. 4. Occurrence and rights and
obligations
6-29 a. The first objective concerns amounts that should not be included on the list of accounts payable because there are no amounts due to such vendors. This objective 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.
c. For accounts payable, the auditor is usually most concerned about understatements. An understatement of accounts payable is usually considered 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.