Robertson OLC EOC ND - highered.mheducation.comhighered.mheducation.com/sites/dl/free/0070914176/120500/Robertson... · 2.53 Auditing Standards Case Study. Ray, the owner of a small

Robertson OLC End of Chapter Questions 1

DISCUSSION CASES

2.49 Authoritative Support. Auditors’ reports on financialstatements contain an opinion on the conformity of thestatements with generally accepted accounting princi-ples (GAAP). An audit decision on GAAP includes thedetermination of whether an accounting treatment is“generally accepted,” and this determination is made byfinding the authoritative support for the accountingtreatment.

Required:List in order of priority the sources of authoritative sup-port an auditor can consult when faced with a decisionabout GAAP.

2.50 Deficiencies and Omissions in an Audit Report. Oncompletion of all field work on September 23, 1998, thefollowing report was written by Betsy Ross to the di-rectors of Continental Corporation.To the Board of Directors.Continental Corporation:

The accompanying balance sheet of ContinentalCorporation and the related statements of income andretained earnings as of July 31, 1998, are the responsi-bility of management. In accordance with your instruc-tions, we have conducted a complete audit. We plannedand performed the audit to obtain reasonable assuranceabout whether the financial statements are free of mate-rial misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclo-sures in the financial statements. An audit also includesassessing the accounting principles used and significantestimates made by management, as well as evaluatingthe overall financial statement presentation. We believethat our audit provides a reasonable basis for our opin-ion.

In many respects this was an unusual year for theContinental Corporation. The weakening of the econ-omy in the early part of the year and the strike of plantemployees in the summer led to a decline in sales and

net income. After making several tests of the salesrecords, nothing came to our attention that would indi-cate sales have not been properly recorded.

In our opinion, with the explanation given above, andwith the exception of some minor errors we considerimmaterial, the aforementioned financial statementspresent the financial position of Continental Corpora-tion at July 31, 1998, and the results of its operations,and its cash flows for the year then ended, in conform-ity with generally accepted accounting principles.

Betsy Ross & Co., PAJuly 31, 1998

Required:List and explain the deficiencies and omissions inRoss’s audit report.

2.51 Management Fraud Conflict of Interest. Many casesof management fraud probably go undetected evenwhen competent annual audits are performed. The rea-son, of course, is that generally accepted auditing pro-cedures are not always designed and executed specifi-cally to detect executive-level management fraud.Please give your own estimate of the prevalence of ex-ecutive-level management fraud as requested below.1. Based on your perceptions of business, is the inci-

dence of significant executive-level managementfraud more than 10 in each 1,000 clients (i.e., 1 per-cent) audited by Big Four accounting firms? Answera or b.

a. Yes, more than 10 in each 1,000 Big Four clientshave significant executive-level managementfraud.

b. No, fewer than 10 in each 1,000 Big Four clientshave significant executive-level managementfraud.

2. What is your estimate of the number of Big Four clientsper 1,000 that have significant executive-level manage-ment fraud?

2.52 Investment Performance Assurance.Nancy Drew isthe president of Mystery Capital Management, Inc.Mystery manages $1.2 billion in two mutual funds, onea stock fund and the other a bond fund. Competition forinvestors’ money is fierce, and hundreds of money man-agement companies compete by advertising their funds’performance statistics. Recently, the Ontario SecuritiesCommission (OSC) has criticized the advertisementsfor misrepresenting the returns investors can actuallyearn. In addition to the investment performance statis-tics, money management firms also advertise theamounts of their fees, usually representing no-load or

low-fee arrangements, but they often do not advertisethe other expenses allowed under OSC rules.

Ms. Drew has retained your PA firm to give an opin-ion on the fair presentation of Mystery Capital Man-agement’s investment performance statistics and ex-pense ratios used in its advertisements. The plan is topresent your report in the company’s advertisements.

Required:For each of the assurance standards, state its applicabil-ity in relation to the engagement.

CHAPTER 2

2.53 Auditing Standards Case Study.Ray, the owner of asmall company, asked Holmes, PA, to conduct an auditof the company’s records. Ray told Holmes that the au-dit was to be completed in time to submit audited finan-cial statements to a bank as part of a loan application.Holmes immediately accepted the engagement andagreed to provide an auditor’s report within threeweeks. Ray agreed to pay Holmes a fixed fee plus abonus if the loan was granted.

Holmes hired two accounting students to conduct theaudit and spent several hours telling them exactly whatto do. Holmes told the students not to spend time re-viewing the controls but, instead, to concentrate on prov-ing the mathematical accuracy of the ledger accountsand on summarizing the data in the accounting recordsthat support Ray’s financial statements. The students fol-lowed Holmes’s instructions and after two weeks gaveHolmes the financial statements, which did not includefootnotes. Holmes reviewed the statements and preparedan unqualified auditor’s report. The report, however, didnot refer to generally accepted accounting principles orto the fact that Ray had changed to the accounting stan-dard for capitalizing interest.

Required:Briefly describe each of the generally accepted auditingstandards and indicate how the action(s) of Holmes re-sulted in a failure to comply with each standard.

(AICPA adapted)

2.54 Quality Control Standards. Each of the followingquality control policies and procedures is typical ofones that can be found in PA firms’ quality control doc-uments. Identify each of them with one of the elementsof quality control required by the Quality Control Stan-dards.a. Review semiannual performance reports with indi-

viduals and assess their progress in relation to job

performance, future objectives, assignment prefer-ences and career opportunities.

b. Publish guidelines for review of each audit report,including determination of the adequacy of evidenceshown in the working papers, conformity of thereport with professional standards and review of thereport by a partner not otherwise connected with theaudit engagement.

c. Maintain or provide access to adequate referencelibraries and designated experts by (1) maintainingtechnical manuals and internal technical newslettersand (2) advising staff personnel of the degree ofauthority accorded internal experts’ opinions and theprocedures to be followed for resolving disagree-ments with experts.

d. Consider the experience and training of the engage-ment personnel in relation to the complexity or otherrequirements of the engagement and the extent ofsupervision to be provided.

e. Review recruiting results annually to determinewhether goals and personnel needs are beingachieved.

f. Distribute new professional pronouncements (IAGs,EIC, others), and encourage personnel at all levels totake continuing professional education courses.

g. A special team will review a selection of completedaudits for compliance with professional standards,including generally accepted auditing standards,generally accepted accounting principles and thefirm’s quality control policies and procedures.

h. Obtain from personnel periodic, written representa-tions listing their investments, outside business rela-tionships and employment of their close relatives.

i. A firm management committee shall annually reviewclient relationships in light of changes in manage-ment, directors, ownership, legal counsel, financialcondition, litigation status, nature of client’s businessand scope of the engagement.

2 Robertson OLC End of Chapter Questions

3.52 Association with Financial Statements.This series ofquestions is a drill on the subjects of “association with”financial statements, unaudited financial statements andthe denial of opinion. What kind of report can you givein each case?a. Able Corporation engaged you to prepare financial

statements from its books and records without per-forming any audit or review procedures. Able is apublic company.

b. Baker Corporation, a public company, uses your com-puterized bookkeeping service. You deliver monthlyfinancial statements to Baker’s controller. Another PAperforms the annual audit for Baker Corporation.

c. Charlie Corporation engaged you to audit its finan-cial statements. Charlie is not a public company. Youserve as the corporation’s part-time financial vicepresident.

d. Dagmar Partnership engaged you on January 30 toaudit its financial statements for the year just endedon the previous December 31. Dagmar has neverbeen audited and has never conducted a physicalinventory. Sale of manufactured goods is the majorbusiness, and inventories amount to about 75 percentof total assets.

3.53 Errors in an Adverse Report.Brown & Brown, PAs,was engaged by the board of directors of Cook Indus-tries, Inc., to audit the financial statements for the yearended December 31, 2004. Joe Brown has decided anadverse report is appropriate. He has also become awareof a March 14, 2005, subsequent event, which the Cookfinancial vice president properly disclosed in the notesto the financial statements. Brown wants responsibilityfor subsequent events to be limited to this specific eventafter the field work was completed on March 7.

Required:Identify the deficiencies in the draft of the report pre-sented below. Do not rewrite the report.

Accountant’s ReportTo the President ofCook Industries, Inc.:We have audited the financial statements of Cook In-dustries, Inc., for the year ended December 31, 2004.We conducted our audits in accordance with generallyaccepted auditing standards. Those standards requirethat we plan and perform the audit to obtain reasonableassurance about whether the financial statements arefree of material misstatement. An audit includes exam-ining, on a test basis, evidence supporting the amountsand disclosures in the financial statements. An audit alsoincludes assessing the accounting principles used andsignificant estimates made by management, as well asevaluating the overall financial statement presentation.

We believe that our audit provides a reasonable basis forour opinion.

As discussed in Note K to the financial statements,the Company has properly disclosed a subsequent eventdated March 14, 2005.

As discussed in Note G to the financial statements,the Company carries its property and equipment at ap-praisal values, and provides depreciation on the basis ofsuch values. Further, the Company does not provide forincome taxes with respect to differences between finan-cial income and taxable income arising from the use, forincome tax purposes, of the instalment method of re-porting gross profit from certain types of sales.

In our opinion, the financial statements referred toabove do not present fairly the financial position ofCook Industries, Inc., as of December 31, 2004, and theresults of its operations and its cash flows for the yearthen ended in conformity with generally accepted ac-counting principles.

/s/ Brown & BrownPublic Accountants

March 14, 2005

(AICPA adapted)

3.54 Using the Work and Report of Another Auditor (Ap-pendix 3A).Lando Corporation is a domestic companywith two wholly-owned domestic subsidiaries.Michaels, PA, has been engaged to audit the financialstatements of the parent company and one of the sub-sidiaries and to act as the principal auditor. Thomas, PA,has audited the financial statements of the other sub-sidiary whose operations are material in relation to theconsolidated financial statements.

The work performed by Michaels is sufficient forMichaels to serve as the principal auditor and to reportas such on the financial statements. Michaels has not yetdecided whether to make reference to the part of the au-dit performed by Thomas.

Required:a. What are the reporting requirements with which

Michaels must comply if Michaels decides to nameThomas and make reference to the audit work doneby Thomas?

b. What report should be issued if Michaels can neitherassume responsibility for Thomas’s work nor divideresponsibility by referring to his work?

3.55 Reference to Another Auditor in Principal Auditor’sReport (Appendix 3A). Presented below is an inde-pendent auditor’s report that contains deficiencies. TheCorporation being reported on is profit oriented andpublishes general-purpose financial statements for dis-tribution to owners, creditors, potential investors and the


CHAPTER 3

general public. Corporation is a domestic company withtwo wholly-owned domestic subsidiaries.

Report of Independent Auditor

We have audited the accompanying consolidated bal-ance sheet of Bonair Corporation and subsidiaries as ofDecember 31, 2004, and the related statements of in-come, retained earnings and cash flows for the year thenended. These financial statements are the responsibilityof the Company’s management. Our responsibility is toexpress an opinion on these financial statements basedon our audit. We did not examine the financial state-ments of Caet Company, a major consolidated sub-sidiary. These statements were examined by other audi-tors whose report thereon has been furnished to us, andour opinion expressed herein, insofar as it relates toCaet Company, is based solely upon the report of theother auditors.

Except as stated in the paragraph above, we con-ducted our audit in accordance with generally acceptedauditing standards. Those standards require that weplan and perform the audit to obtain reasonable assur-ance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, ona test basis, evidence supporting the amounts and dis-closures in the financial statements. An audit also in-cludes assessing the accounting principles used and sig-nificant estimates made by management, as well asevaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis forour opinion.

In our opinion, except for the matter of the report ofthe other auditors, the financial statements referred toabove present fairly, in all material respects, the financialposition of Bonair Corporation and subsidiaries Decem-ber 31, 2004, and the results of their operations and theircash flows for the year then ended in conformity withgenerally accepted accounting principles.

Required:Describe the reporting deficiencies, explain why theyare considered deficiencies, and briefly discuss how thereport should be corrected. (Exclude the addressee, sig-natures and report date.) Organize your answer sheet asfollows:

Deficiencies Reason Correction

3.56 Reporting on Supplementary and Other Information(Appendix 3A). For the separate fact situations given be-low, specify the appropriate form and content of the au-dit report on the related financial statements.a. Mona Corporation voluntarily presented the interim

financial information described in Handbook,para-graph 1750.06. This year, however, time ran short,and the controller’s staff was unable to presenteverything specified by the Handbook.

b. When Kinky Korp Company presented its interimfinancial figures in a footnote to the financial state-ments, the footnote was labelled “Interim FinancialResults,” and the closing sentence of the narrative

introduction was: “Grey & Fox, CAs, reviewed theinterim financial results in accordance with standardsestablished by the Canadian Institute of CharteredAccountants.”

c. Kaviar, Inc.’s president, Sharon Kaviar, wrote a man-agement discussion and analysis section in theannual report to shareholders, in which she said:“Research and development expenses increased thisyear by 20 percent.” Consulting the R&D expensedisclosure in the financial statements, you see thatthe expense for last year is reported to be $3 millionand for this year $3.75 million.

3.57 Uncertainty and Accounting Issues.Peaco Corpora-tion builds pollution control equipment. In the year justended December 31, 2004, the company had sales of$600 million and net income of $26 million. In thefourth quarter of the year, however, reported net incomewas $7 million or $0.84 per share, exactly the same asin the fourth quarter of 2003. Company managementtakes pride in the fact that earnings have increased about10 percent each quarter of the corresponding year-ear-lier period for the last four years.

These fourth-quarter data were released January 20.It is now February 20, and you are about to completeyour audit covering the comparative 2004 and 2003 fi-nancial statements. Only one matter remains for resolu-tion.

During the fourth quarter of 2004, Peaco experi-enced difficulty with a subcontractor on a medium-sizedproject. The result was that the subcontractor was re-leased, and Peaco filed lawsuits totalling $4 million forbreach of contract, claiming that the company had in-curred additional costs of $2.5 million as a result of thesubcontractor’s actions. The subcontractor has filedcounterclaims for $6 million in damages. Peaco lawyerssay that all this litigation will take a long time to settlein court unless it is negotiated in out-of-court agree-ments.

In the meantime, Peaco has accounted for its $4 mil-lion damage claims as an offset against the $2.5 millionactual additional cost (an amount you have found to bematerially accurate). Your problem now concerns theaccounting validity of recognizing the $4 million claim.The effect of alternative accounting is that net incomewould be $5 million in the fourth quarter (and EPSwould be 60 cents), and net income for the year wouldbe $24 million (and EPS would be $2.88 for 2004 com-pared to $2.40 for 2003).

Required:Decide what to do about the audit report and write theopinion paragraph and any explanatory or emphasisparagraphs you consider necessary. You may assume thatall matters of litigation were fully described in FootnoteL to the financial statements.

3.58 Explain Deficiencies in an Opinion Denial.The fol-lowing audit report was written by your partner yester-day. You need to describe the reporting deficiencies, ex-


plain the reasons for them and discuss with him how thereport should be corrected. This may be a hard job be-cause he has always felt somewhat threatened becauseyou were the first woman partner in the firm. You havedecided to write up a three-column worksheet showingthe deficiencies, reasons and corrections needed. Thiswas his report:

I made my examination in accordance with generallyaccepted auditing standards. However, I am not inde-pendent with respect to Mavis Corporation because mywife owns 5 percent of the outstanding common stockof the company. The accompanying balance sheet as ofDecember 31, 2004, and the related statements of in-come and retained earnings and cash flows for the yearthen ended were not audited by me. Accordingly, I donot express an opinion on them.

Required:Prepare the worksheet described above.

3.59 Evidence Required for Various Audit Reports.Audi-tors’ alternatives for reporting on financial statementsoffer many choices among unqualified, disclaimed,modified and expanded report language.

Required:a. List the reports that require fully sufficient appropri-

ate evidence.b. List the reports that result from pervasive and mas-

sive evidence deficiencies.c. List the reports that result from isolated evidence

deficiencies.

3.60 Reporting Situations.For each of the four unrelatedsituations described below:a. Specify the content of the notes, if any, you would

request the client to add to the financial statements.b. State, with reasons, whether the situation would

necessitate a qualification to the standard auditor’sreport. Specify any changes you would make to thereport.

State any assumptions inherent in your approach. As-sume all circumstances are material. Do not write outthe entire auditor’s report.a. You completed the field work for your client, Tanker

Oil, on February 23, 2002. It is now March 6, 2002,and you are in a meeting with the controller ofTanker Oil, reviewing the draft of the annual report.The controller informs you that one of the company’sships was involved in a major oil spill early thatmorning, off the Grand Banks of Newfoundland.While reading the annual report, you note that in thepresident’s message to the shareholders, she hasboasted that Tanker Oil has never been involved in amajor oil spill, and has a better safety record than anyof its major competitors.

b. Your client, Able Manufacturing, Inc., has hadsteadily increasing losses since its inception in April1999. Management feels that Able will be able to tapinto the U.S. market next year due to the scheduledremoval of tariffs in January 2003 relevant to its

industry as negotiated under the Free TradeAgreement.The owners of the company have exhausted all oftheir personal financial resources and are hoping toobtain a large increase in their corporate demandbank loans to cover operating expenses until the tar-iff reduction takes place.Able’s banker is anxiously awaiting the auditedfinancial statements to see if the results of the yearended March 31, 2002, are any better than the previ-ous two years’ results. Able has defaulted on its lasttwo monthly payments on its demand loan.Management of Able is confident the company willearn substantial profits in 2003 and is not in favourof making any disclosures that would jeopardizeAble getting the increase in bank loans that itrequires.

c. In addition to the audited consolidated financialstatements provided to the shareholders, your clientwould like to attach audited nonconsolidated finan-cial statements to its corporate income tax returns.

d. Your client, a secretarial personnel agency, has justcompleted its second year of operations. Due to itsplanned expansion in the near future, it requiresaudited financial statements. You performed a com-pilation engagement for its first year-end.

(ICAO adapted)

3.61 Departures from GAAP. On January 1, KingstonCompany purchased land (the site of a new building) for$100,000. Soon thereafter, the Highway Department an-nounced a new feeder road that would run alongside thesite. The effect was a dramatic increase in local propertyvalues. Nearby, comparable land sold for $700,000 inDecember of the current year. Kingston shows the landat $700,000 in its accounts. After reduction for implicittaxes at 33 percent, the fixed asset total is $400,000larger, with the same amount shown separately in ashareholder equity account titled “Current value incre-ment.” The valuation is fully disclosed in a footnote tothe financial statements, along with a letter from a cer-tified property appraiser attesting to the $700,000 value.

Required:a. Write the appropriate audit report, assuming you

believe the departure from GAAP is material but notenough to cause you to give an adverse opinion.

b. Write the appropriate report, assuming that youbelieve an adverse opinion is necessary.

c. For discussion: Should you (could you) issue a reportconforming to Rules of Professional Conduct orequivalent rules in other provinces (association witha false or misleading information)?

3.62 Reporting on an Accounting Change.In December ofthe current year, Kingston Company changed its methodof accounting for inventory and cost of goods sold fromLIFO to FIFO. The account balances shown in the trial bal-ance have already been recalculated and adjusted retroac-tively, as required by Handbook,paragraph 1506.11.


The accounting change and the financial effects are de-scribed in Note 2 in the financial statements.

Required:a. Assume you believe the accounting change is justi-

fied. Write the audit report appropriate in the cir-cumstances.

b. Assume you believe the accounting change is notjustified and causes the financial statements to bematerially distorted. Inventories that would havebeen reported at $1.5 million (LIFO) are reported at$1.9 million (FIFO); operating income before taxthat would have been $130,000 is reported at$530,000; current assets are revised upward 17 per-cent and total assets 9 percent; shareholder equity is14 percent greater. Write the audit report appropriatein the circumstances.

3.63 Financial Difficulty—The “Going-Concern” Prob-lem. The Kingston Company has experienced signifi-cant financial difficulty. Current liabilities exceed cur-rent assets by $1 million, cash is down to $10,000, theinterest on the long-term debt has not been paid, and acustomer has sued for $500,000 on a product liabilityclaim. Significant questions concerning the going-con-cern status of the company exist.

Required:a. Write the appropriate audit report, assuming you

decide that an audit opinion instead of a disclaimeris appropriate in the circumstances.

b. Write the appropriate audit report, assuming that youdecide the uncertainties are significant and that theclient fails to disclose properly.

3.64 Late Appointment of Auditor. Dalton Wardlaw, PA, hascompleted the field work for the audit of the financialstatements of Kingston Company, for the year ended De-cember 31, and is now preparing the audit report. Ward-law has audited the financial statements for severalyears, but this year Kingston delayed the start of the au-dit work, and Wardlaw was busy anyway, so he was notpresent to observe the taking of the physical inventory onDecember 31. However, he performed alternative proce-dures, including (1) examination of shipping and re-ceiving documents with regard to transactions since theyear-end, (2) extensive review of the inventory countsheets, and (3) discussion of the physical inventory pro-cedures with responsible company personnel. He alsosatisfied himself about the propriety of the inventoryvaluation calculations and the consistency of the valua-tion method. Kingston determines year-end inventoryquantities solely by means of physical count.

Required:Write Wardlaw’s audit report on the balance sheet at theend of the current year under audit, and on the state-ments of operations, retained earnings and cash flowsfor the one year then ended.

3.65 Changing the Prior Year Audit Report (Appendix3A). In November of the prior year (2003), Kingston

Company was sued by a supplier for damages and mis-representation. The supplier sought $500,000 in judge-ment. In connection with the audit of the prior year,Kingston’s lawyer submitted a letter stating that thecompany had sufficient defences to prevail in the case,and that he expected that only a minor amount wouldhave to be paid, and then only in order to avoid pro-longed and costly litigation. He estimated that no morethan $20,000 would need to be paid to settle the lawsuit.The company maintained that the probability of thisamount of loss was not even “reasonably possible” andaccrued no liability in the financial statements for theyear ended December 31, 2003. As auditors, you (An-derson, Olds & Watershed) gave an audit report contain-ing an uncertainty explanation paragraph. On July 15 ofthe current year under audit (2004), after you had deliv-ered your report dated February 10, 2004, on the prioryear financial statements, the lawsuit was settled for$5,000.

Required:Write the unqualified audit report on the comparative fi-nancial statements as of and for the years ended De-cember 31, 2004 and 2003, making your current report(dated February 4, 2005) on the prior year (2003) finan-cial statements not affected by the litigation uncertaintymentioned in the report delivered last year.

3.66 Using Work of Other Independent Auditors (Appen-dix 3A). Dalton Wardlaw is the principal auditor on theDecember 31 consolidated financial statements ofKingston Company and subsidiaries. However, otherauditors do the work on certain subsidiaries for the yearunder audit amounting to:

2004 2003Total assets 29% 31%Total revenues 36% 41%

Mr. Wardlaw investigated the other auditors, as re-quired by auditing standards, and they furnished himwith their audit reports. Wardlaw has decided to rely ontheir work and to refer to the other auditors in the auditreport. None of the audit work showed any reason toqualify any of the audit opinions.

Required:Write Wardlaw’s audit report and explain how the workand reports of the other auditors affect the audit ofKingston Company’s consolidated financial statements.

3.67 Other Information in a Financial Review Section ofan Annual Report (Appendix 3A). Mr. Lancaster(chairman of the board) and Mr. Grace (vice president,finance) prepared the draft of the financial review sec-tion of the annual report. You are reviewing it for con-sistency with the audited financial statements. The draftcontains the following explanation about income cover-age of interest expense: “Last year, operating incomebefore interest and income taxes covered interest ex-pense by a ratio of 6:1. This year, on an incremental ba-sis, the coverage of interest expense increased to a ratioof 6.588:1.”


The relevant portion of the audited financial state-ments showed the following:

Current PriorYear Year

Operating income $400,000 $360,000Extraordinary gain

from government expropriation ofland (net of taxes) 100,000

Interest expense (81,250) (60,000)Income taxes (127,500) (120,000)Net income $291,250 $180,000

Required:a. Determine whether the financial review section state-

ment about coverage of interest is or is not consistentwith the audited financial statements. Be able to showyour conclusion with calculations.

b. Assume you find an inconsistency, and the officersdisagree with your conclusions. Write the explana-tory paragraph you should put in your audit report.

3.75 Financial Statement Users’ Decisions and Material-ity. The auditor’s unqualified opinion that financialstatements are presented fairly, in all material respects,asserts that the financial statements do not contain any

misstatements that would be significant enough to affecta user’s decision or be misleading to a user.

Consider the following three misstatements for Avo-cet Limited:a. Avocet fails to record a material write-down to the

net recoverable value for one of its buildings. Thebuilding is located near to a major toxic waste spilland can no longer be used in the business for its orig-inally intended purpose.

b. A pay-equity tribunal awards Avocet’s femaleemployees a retroactive pay adjustment to make theirsalaries more comparable with those of maleemployees over the past 20 years. The company failsto accrue a material liability arising from this award.

c. Avocet fails to recognize a material estimated com-pensation expense arising from executive stockoptions granted during the year in the determinationof its net income for the year.

Required:Give examples of users whose decisions, assessments oractions could be affected by each of these misstate-ments, what kinds of decisions could be affected andwhat possible effects the misstatements could have onthese users’ decisions resulting from the misstated fi-nancial information.


3.68 Why do you think auditors are prohibited from giving a standard unqualified auditreport on condensed financial statements?

3.69 What criteria define a “primary auditor”?

3.70 Is the reference in an audit report to work performed by another auditor a scopequalification? Explain.

3.71 What is an updated audit report? a reissued audit report?

3.72 Does an audit limited by a company to the balance sheet only cause the auditor togive an audit opinion qualified for a scope limitation?

3.73 What two kinds of disclosure problems must an auditor be alert to detect when read-ing “other information” in an annual report? Explain them.

3.74 When should an auditor give a denial of opinion on supplementary information infinancial statements?

R E V I E WC H E C K P O I N T SFOR APPENDIX 3A

4.53 Auditor’s Knowledge of The Client’s Business. Theauditing guidance indicates auditors should obtain anunderstanding of the broad economic environment inwhich a client operates in order to understand theclient’s business risks and plan an effective audit. Sev-eral aspects of the client’s business and business envi-ronment are listed below.

Industry conditions:Market and competitionCyclical or seasonal activityProduct technology related to entity’s productsEnergy supply and costs

Regulatory environment:Accounting principles and specific industry prac-ticesRegulatory framework for a regulated industryTaxationEnvironmental requirements affecting industry andentity’s business

General level of economic activity (e.g., recession orgrowth)

Interest rates and availability of financingInflation, currency revaluation

Business operations:Nature of revenue sourcesProducts or services and markets for these(e.g. major customers and contracts, market share,competitors, payment terms, etc.)Conduct of operations(e.g., stages and methods of production, businesssegments, delivery methods)Alliances, joint ventures, outsourcingInvolvement in e-commerce, Internet sales andmarketing activitiesGeographic dispersion and industry segmentationLocation of production facilities, warehouses andofficesImportant suppliers of goods and services(e.g., long-term contracts, supply stability, pay-ment terms, imports, just-in-time method)Employment(e.g., supply, wages, union contracts, pensions andbenefits, bonuses, regulation)Research and development activities and expendi-turesTransactions with related parties

(Source: Exposure draft, Audit Risk: Proposed International Standardson Auditing, Oct. 2002)

Required: a. What audit relevant knowledge does the auditor

obtain by enquiring about and obtaining an under-standing of each aspect?

b. How would this knowledge affect the auditor’s plan-ning?

4.54 Change of Auditor. Auditor changes may be initiatedby the client or by the auditor. The following are somereasons for a change in auditor.1. Increase in size of business requires an audit firm

with more staff than the former auditor2. Industry specialized expertise is required to audit the

business which the former auditor does not possess3. The company has been acquired by another company

that has a different auditor4. The company and the former auditor cannot resolve

a dispute over the clients revenue recognition poli-cies

5. The former auditor reported internal control deficien-cies to management and was dissatisfied with man-agement’s actions to address their report.

Required:For each of the above reasons for an auditor change, saywhether you think it is more likely to be related to aclient-initiated auditor change or to an auditor-initiatedchange and explain why.

4.55 Communication with Predecessor Auditor. MacawLimited has decided to change auditors because a dis-pute over whether fees paid to the Macaw President’smanagement company were properly authorized byMacaw’s board of directors. Macaw has engaged PA forthe current year-end audit. The Macaw company has re-fused to give its former auditor permission to providecopies of its working papers to PA, stating that the au-dit files may contain sensitive competitive information.

Required:Assume the role of the incoming auditor. What issuesdoes Macaw’s position create for you? If you accept theappointment to audit Macaw, what impact doesMacaw’s position have on your audit planning and whatactions would you take?

4.56 Engagement Letter. PA’s engagement letter for the au-dit of Nene Limited states that the 2003 audit will becompleted and the financial statements issued by March31, 2004. This reporting date is required to meet Nene’sdeadline under its agreement with its bondholders.Nene’s chief accountant provides the draft financialstatements, trial balance and account analyses to PA onMarch 24, 2004. The budgeted hours to perform the au-dit are 300 and PA firm is unable to complete the auditin time for the deadline. The client feels this is the PA’sfault and is dissatisfied with their service.

Required:Discuss the adequacy of the engagement letter used inthis situation. How could it have been done differentlyto avoid the problem that arose?


CHAPTER 4

4.57 Auditor’s Responsibility to Detect Fraud. Shortly af-ter the issue of its 2004 financial statements, OrioleLimited senior management uncovers a fraud in its op-erations. The purchasing manager was approving in-flated prices from one of the company’s suppliers andreceiving kickbacks payments from the supplier fromthese excess payments. Investigation by the presidentand CFO revealed that this swindle had been going onfor over four years. Oriole’s auditor has been engaged todo the financial statement audit since 1999, and the Ori-ole president is angry that the auditors did not uncoverthis fraud years ago. The president wants the audit firmto compensate Oriole for the losses this fraud causedthem or else it will seek legal advice on this matter. Inresponding to the president, the PA notes that the en-gagement letter, which was drawn up for the initial au-dit in 1999, states that the audit will not necessarily de-tect fraud, if it exists. The president asserts that he hasnever seen this engagement letter, only the “hefty an-nual audit bills” that they have paid over the past fouryears to the PA’s firm.

Required:Comment on the PA’s position in this situation. Is theclient justified in its position? How might this disagree-ment have been prevented?

4.58 Time Budgets. Refer to the “Audit Time Budget” givenas an example in the chapter.

Assume that this Time Budget is for the audit of anautomotive parts manufacturing, Plover Ltd. Plover isthe subsidiary of a larger company, but also requiresstand-alone audited financial statements for its minorityshareholders. You are the audit partner and have auditedPlover for the past five years. The audits have beenproblem free and have met budget. Your office has thefollowing staff available to assign to this audit:You (the partner)Manager A—a very senior manager with 10 years auditexperience with other clientsManager B—a junior manager with 4 years audit expe-rience on other clientsSenior Accountant—a highly rated staff member with 3years audit experience and 3 years on this client’s auditIntermediate Accountant—2 years experience, one yearon this client’s auditFour (4) Junior Accountants with 0 to 6 months experi-ence, none with experience on this client.

Required:Prepare a staff plan that will select staff from the avail-able pool above, assign them to various components ofthe audit shown in the budget, and will allow the interimaudit work to be completed in six working days and theyear-end audit work in four working days. Justify yourchoices and note any other factors you would considerin this staff planning exercise.

4.59 Audit Planning. PA has audited Freshstart Ltd., a smallfood processing business, since 1997. Each year PAuses his prior year’s audit working papers as a guide for

completing the current year’s audit work. After 12 yearsas a sole practitioner, during 2003, PA hired a newlygraduated PA to be his assistant. He hands her theFreshstart 2003 audit as her first assignment, and the2002 audit working paper file to use as her guide. Thenew PA is concerned because she is unable to find theaudit plan document in any of the 2002 working paperfiles. When she asks her boss, he replies, “The plan isobvious so I don’t write it down, I just look at the auditprocedures I did last year.”

Required:Comment on the deficiencies in the above situation.What actions do the PA and the new PA need to take tocorrect these deficiencies?

4.60 Audit Evidence, Observations at Planning Stage. PAaudit staff visit a new audit client’s premises to beginplanning the current year’s audit. The controller offersto take them on a tour of the warehouse, but then has totake “an important phone call that could be lengthy” sohe suggests they go on their own and points them to thedoor to the warehouse. They observe that they are ableto enter the warehouse without needing a key or otheraccess device or explaining their presence to any ware-house employee. They see boxes of inventory piled hap-hazardly in the area close to the loading bays withoutany obvious identifying labels or tags. They observe de-livery truck drivers entering the warehouse through theloading bays and picking up merchandise with no assis-tance from the client’s warehouse personnel. Eventuallythey see a person sitting at a desk in the back corner ofthe warehouse playing a video game on a companycomputer. They ask him how the inventory is managed,but he says he doesn’t know.

Required:What evidence has the audit staff obtained by their ob-servations at the client’s warehouse? How will these ob-servations affect their audit planning and procedures?

4.61 Internal Audit. PA is the auditor of Skimmer Inc., a re-tail foreign currency exchange business. Skimmer hasan internal audit staff that performs extensive controland substantive tests of the retail operations. The headof the internal audit department reports directly to theCFO. The CFO tells PA that she expects the external au-ditors will be able to rely completely on Skimmer’s in-ternal auditors’ tests and will need to perform virtuallyno work on the retail operations to support their opinionthat the financial statements are fairly stated.

Required:Comment on the CFO’s statement. To what extent canthe PA rely on the internal audit work? What factorsdoes the PA need to consider if internal audit work is tobe used as audit evidence?

4.62 Cutoff. Consider the following situations:1. Bunting Ltd. failed to record an accrual for a ship-

ment of inventory received on December 31, 2003.However, the inventory was in the warehouse and


included in the year-end inventory count onDecember 31st.

2. Wren Inc. shipped a quantity of goods to a customeron December 30, 2004 but did not record the salesinvoice in accounts receivable until January 2, 2005,after its 2004 year end.

3. On December 30, 2003, Jacana Limited transferred$3,200,000 from its current account to the account ofa related company, Jacana Properties Inc., becauseJacana Properties Inc. will be closing a real estatepurchase on January 3, 2004. The deposit wasrecorded as an outstanding deposit on the bank rec-onciliation of Jacana Properties on December 31,2004, but the cheque was not recorded in the cashaccount of Jacana Limited until January 3, 2004, thedate the cheque was deposited into the JacanaProperties Inc. bank account.

Required:For each of the above three cutoff situations above iden-tify the assertions and financial statement account af-fected by the way the company has recorded the trans-action. What procedures would an auditor use to detecteach of these cutoff errors?

4.63 Ownership Assertion. Y. Towhee is the majority share-holder and president of Willet Limited, a manufacturerof fine furniture. She authorized Willet’s accountant topay her children’s nanny and renovations to her homeout of Willet company funds. In conducting the currentyear audit of Willet, the auditor enquires about thesepayments. The president claims that the nanny is a nec-essary Willet business expense because she allows hermore time to manage the business, and the renovationsare necessary because she often entertains customers athome for promotional purposes.

Required:Discuss the audit assertions involved in the situation de-scribed above. What procedures would the PA have usedto uncover this information?

4.64 Scope Limitation, Contingency. PA’s audit client, Tro-gon Corp., is a chemical manufacturing business withone manufacturing plant. Its operations create a numberof environmentally hazardous emissions. In the currentyear, Trogon has been fined by the government for eightexcess-emissions incidents. This is a tenfold increasefrom prior years. On enquiry, the PA is told by Trogonoperating personnel that the fines are due to some ofTrogon’s pollution control equipment becoming oldand breaking down frequently. The government hasgiven Trogon notice that it must upgrade its pollutionequipment to bring its operations within acceptableemissions levels, or close its plant.

The PA asks client personnel to estimate the ex-pected cost of upgrading the pollution control equip-ment to comply with government standards. The TrogonCFO states that it would be too costly to produce suchan estimate, because outside environmental engineers

and other experts would need to be consulted. He fur-ther states that the information is not relevant to PA’saudit because, in any case, the estimate would be too un-certain to include in the year-end financial statements.

Required:Discuss the audit evidence and reporting implications inthe above situation, and recommend a course of actionfor PA.

4.65 Audit Evidence, Confirmation. Whydah Limited has amaterial amount receivable from its customer, NoddyCompany. Whydah’s auditor plans to confirm the re-ceivable as the main audit procedure for this balance.Whydah’s accountant provides the auditor with a con-firmation letter on Noddy Company letterhead. How-ever, she does not have a mailing address for NoddyCompany. She says that recently she has communicatedwith Noddy personnel primarily by e-mail and providesthe auditor with a fax number and an e-mail address([email protected]). The auditor attempts to faxthe letter and discovers the fax number is no longer inservice.

Required:Discuss the audit evidence issues raised in the above sit-uation and recommend a course of action for the auditor.

4.66 Audit Evidence, Assertions. The auditor inspects theclient’s inventory during the client’s year-end inventorycount. Explain which assertions about the year-end in-ventory balance this evidence will be relevant to, andwhy. Explain which assertions it will not be relevant to,and why.

4.67 Audit Evidence, Scanning. Give one or more examplesof items that the auditor could discover while scanningeach of the following accounting system components,which would be considered unusual and hence need tobe further investigated:1. Cash disbursements journal2. Sales journal3. Accounts payable sub-ledger4. Repairs and maintenance expense account in general

ledger5. Payroll journal6. General journal

4.68 Analysis, Revenues. Motelier Limited operates a motelin a small city, Brantville. It rents rooms mainly to trav-elers who pay by cash or credit card. Some rooms arerented to business people who charge the rooms to theircompany’s account, when their company is a regularcustomer of Motelier. Some of these companies obtainsignificantly reduced rates by paying in advance for therooms they expect their employees to require for busi-ness travel to Brantville over the next few months.Motelier also rents out meeting rooms, operates vending


machines, and rents out the restaurant located in the mo-tel to Mr. and Mrs. Sasake, who operate it.

PA is auditing Motelier for the current year.

Required:a. What are the components of Motelier’s total rev-

enues?b. Where would the auditor obtain the information

needed to prepare the “lead sheet” for revenue thatwill be used in the audit working papers?

c. What procedures would be used to audit each com-ponent of total revenue? Consider all five of the gen-eral assertions.

d. The auditor discovers that the maximum postedroom rate for the motel is $150 per night and thereare 220 rooms. The motel is open every day of theyear. The auditor’s analysis indicates that the averagerevenue per room per night is $35. What facts wouldbe reasonable explanations for this difference?Consider possible valid business reasons, auditorerrors in the analysis, and client errors. How wouldthe auditor obtain these explanations?

4.69 Documentation. Linnet Company’s bylaws require thatthe remuneration of its CEO, CFO, COO all be ap-proved each year by the board of directors. How can theauditor verify that the current year’s executive remu-neration has been properly approved? What audit docu-mentation would be used for this? What procedureswould be required if it had not been approved?


5.44 Analytical Procedures, Comparison to Industry Av-erages, Financial Ratios. In the planning stage of theFolmar limited audit, the auditor is performing analyti-cal procedures that involve comparing Folmar’s finan-cial ratios with industry averages. Folmar is in theequipment rental business, renting construction andlandscaping equipment mainly to small contractingcompanies. The auditor has obtained industry statisticsfor commercial equipment rental and leasing compa-nies. The analysis shows that Folmar’s ratios differ sub-stantially from industry averages. In particular, its re-ceivable turnover is significantly slower than average,and its ratio of rent revenue to total assets is consider-ably higher than average.

Required:a. Provide two or more possible explanations for these

findings.b. For each of the explanations you provided, indicate

whether it is reasonable or not from the auditor’s per-spective. If not, what possible errors may haveoccurred in the financial information?

5.45 Analytical Procedures, Comparison to Budgets.Storm Company has a management bonus plan that al-locates 10 percent of pre-tax profit to senior managersif the company meets its budget for the year. You are incharge of the audit for the current year. The Storm CFOinforms you that every year in the six years since thisbonus plan was implemented, the company has met itsbudget and the bonuses have been paid. In the CFO’sview, this success indicates that Storm’s budgetingprocess provides a strong control over the operation,and that an analysis of the income statement in compar-ison to the budget is strong substantive evidence for thepurpose of auditing the income statement. As a result,the CFO believes that your audit firm can lower theamount of time your staff spends on control evaluationand substantive verification of income statementamounts, and lower its audit fee accordingly.

Required:a. What factors should you take into consideration

when using comparisons to the budget as an analyt-ical audit procedure?

b. Evaluate the CFO’s suggestion. Do you agree or dis-agree? How would you respond to the CFO’s sug-gestion?

5.46 Analysis of Cash Flows, Audit Planning. Prepare acash flow statement using the information provided inExhibit 5-1 for Anycompany, Inc. Discuss the informa-tion that this statement provides about the company’scurrent situation, and how this information can be usedin planning the current year’s audit procedures.

5.47 Materiality. You are the audit manager on the currentyear audit of Kestrel Limited. The audit staff’s field

work for the Kestrel audit was completed on September2, 2004. You are reviewing the working paper files onSeptember 4, 2004. You notice an interesting commenton a payroll audit working paper prepared by the junior,Rishmi, a summer co-op student who has since returnedto university for her third year of business studies. Intesting a sample of 50 payroll transactions, Rishmifound that one payroll cheque for $2,500 was paid to aperson who was not listed as an employee in the com-pany’s personnel files. Following up on this payment,Rishmi enquired of the assistant controller and notedher reply as follows: “The assistant controller explainedthat there were many possible reasons the person wouldnot be listed in personnel files, but since the payment isonly $2,500 and our audit materiality is $100,000, it isnot significant to the audit and it would be inefficient toinvestigate the payment further.”

Required:a. Discuss the role of materiality in the above situation.

What issues does this situation raise about the use ofmateriality in performing audit procedures?

b. As the audit manager in this situation, what actionwould you take?

5.48 Inherent Risk. Auditors tend to take the view that theinherent risk of overstatements for assets and revenuesis greater than the risk of understatements, while the in-herent risk of understatements for liabilities and ex-penses is greater than the risk of overstatements.

Required:a. What factors would lead auditors to take this view? b. Do you agree or disagree with this view? Give rea-

sons that support your position.c. How does this view affect auditor’s planning and

procedures?d. Would overstatements have a different impact on

financial statement users than understatements?Provide specific examples to support your response.

5.49 Analytical Review.Kermit Griffin, an audit manager,had begun a preliminary analytical review of selectedstatistics related to the Majestic Hotel. His objectivewas to obtain an understanding of this hotel’s businessin order to draft a preliminary audit program. He wantedto see whether he could detect any troublesome areas orquestionable accounts that might require special auditattention. Unfortunately, Mr. Griffin caught the flu andwas hospitalized. From his sickbed he sent you theschedule he had prepared (Exhibit 5.49–1). He hasasked you to write a memorandum identifying areas ofpotential misstatements or other matters that the pre-liminary audit program should cover.

Required:Write a memorandum describing Majestic’s operatingcharacteristics compared to the “industry average” in-


CHAPTER 5

sofar as you can tell from the statistics. Does this ana-lytical review identify any areas that might presentproblems in the audit?

This assignment gives you some practice using thenumber 4 general type of analytical procedures dis-cussed in the chapter: “Comparison of current year ac-count balances and financial relationships (e.g., ratios)with similar information for the industry in which thecompany operates.”

5.50 Analytical Review.The use of analytical procedure is be-coming more frequent as auditors strive to improve the ef-ficiency with which they conduct their audit examinations.

Required:a. What are the two required uses of analytical proce-

dures in an audit?

b. List the basic steps in the process of performing ana-lytical procedures.

c. What is the auditor’s objective in using analyticalprocedures in each stage of the audit?

(CGAAC Adapted)

5.51 Long-term Financing, Assertions, Evidence, Min-utes. A company takes out a significant new long-termbank loan to finance the expansion of its manufacturingplant, and pledges various assets as security for thisloan. Which of the company’s financial statements andnotes will be affected by this transaction? How? Whatassertions are involved in accounting for this new loan?Describe the specific procedures the company’s auditorcan use to verify the accounting for this loan.


E X H I B I T 5 . 4 9 – 1 MAJESTIC HOTEL PRELIMINARY ANALYTICAL PROCEDURES FYE 3/31/0Y

The Majestic Hotel, East Apple, British Columbia, compiles operating statistics on a calendar-yearbasis. Hotel statistics, below, were provided by the controller, A. J. Marcello, for 200X. The parallel col-umn contains industry average statistics obtained from the National Hotel Industry Guide.

Average annual percent of rooms occupied, Majestic (percent)

Majestic (percent) Industry (percent)

Sales:Rooms 60.4% 63.9%Food and beverage 35.7 32.2Other 3.9 3.9

Costs:Rooms department 15.2% 17.3%Food and beverage 34.0 27.2Administrative & general 8.0 8.9Management fee 3.3 1.1Advertising 2.7 3.2Real estate taxes 3.5 3.2Utilities, repairs, maintenance 15.9 13.7

Profit per sales dollar 17.4% 25.4%Rooms dept. ratios to room sales dollars:

Salaries and wages 18.9% 15.7%Laundry 1.0 3.7Other 5.3 7.6

Profit per rooms sales dollar 74.8% 73.0%Food/beverage (F/B) ratios to F/B sales dollars:

Cost of food sold 42.1% 37.0%Food gross profit 57.9 63.0Cost of beverages sold 43.6 29.5Beverages gross profit 56.4 70.5Combined gross profit 57.7 64.6Salaries and wages 39.6 32.8Music and entertainment — 2.7Other 13.4 13.8

Profit per F/B sales dollar 4.7 15.3Average annual percent of rooms occupied 62.6 68.1Average room rate per day $160 $120Number of rooms available per day 200 148

5.52 Dividends, Minutes. Phoebe Company Ltd. has paidout $400,000 of dividends in the current year to com-mon and preferred shareholders. What assertions are in-volved in accounting for dividends? How does the au-ditor verify the dividends?

5.53 Cheque Signing Authorization. A. Kea is auditing thecash disbursements of Muscovy Inc. According to theprior year’s working papers, a key control in the com-pany is that all cheques for amounts greater than $5,000must be signed by two authorized officers of the com-pany, one of whom must be the CFO or the president.Cheques less than $5,000 require only the controller’ssignature.

Required:Consider the following independent situations.a. In scrutinizing the banking records, the auditor dis-

covers sixteen cheques for amounts ranging from$5,000 to $9,999 which have only one signature, thecontroller’s. What further action should the auditortake in this situation?

b. In scrutinizing the banking records the auditorobserves that the cheque signing limits have beenfollowed without exception. The auditor also notesthat a large number of cheques were written for$4,999, often to the same payee in the same month.What further action should the auditor take in thissituation?

5.54 Minutes. In her second year on the audit of AdjutantCorporation, the auditor is assigned the responsibility ofreviewing the minutes of all board of directors’ meet-ings for the current year. However, the company lawyerrefuses to allow her to see the minutes because, in thelawyer’s words, “The minutes may contain confidentialdiscussions of sensitive legal matters. Your audit work-ing papers can be subpoenaed as evidence in a legal trialand so these minutes cannot be released to you for au-dit purposes.”

Required:a. What is the purpose of reviewing the minutes in a

financial statement audit?b. What action would you recommend the auditor take

in the situation above?c. If it is not possible for an auditor to read the com-

pany’s minutes, is it possible to issue an unqualifiedaudit opinion?


6.58 Communication with Management,Handbook, Sec-tions 5220 and 5750. CICA Handbook recommenda-tions require auditors to communicate to managementregarding subject matters such as internal control weak-nesses, nontrivial misstatements, fraud, and consequen-tial illegal or possibly illegal acts.

Required:a. Discuss the CICA’s rationale for these requirements.

Do you think it is reasonable to require auditors toprovide this communication? Give the reasons thatsupport your position.

b. Critique the CICA’s position in not requiring that thiscommunication be in writing. In particular, considerwhat limitations might arise or what might go wrongif communications of such subject matters are madeonly orally and not in writing.

c. What factors would an auditor consider in choosingto communicate these matters orally rather than inwriting?

6.59 Communication with Management. R. Liu is the au-ditor of Property Solutions Inc. (PSI) for its year endedDecember 31, 2004. It is the first time C is being au-dited. R. Liu has performed a review of the financialstatements (a negative assurance engagement) everyyear since the company started in 1995. PSI is a privatecompany and the majority of its common shares areheld by three people, the PSI president, its chief operat-ing officer and an outside person not involved in the op-eration. Over the years, employees have been given theopportunity to purchase common shares and there arenow 12 current and former employees who hold in totalabout 10 percent of the outstanding PSI shares. Therehave been disputes with some minority shareholders inrecent years, so at the last annual meeting, the minorityshareholders voted to have an audit instead of a reviewengagement for the 2004 financial statements.

During the 2004 fiscal year, PSI realized some largesales of its information technology product, after yearsof costly research and development. It is now experi-encing a year of healthy profitability and has paid off allits debts.

In preparing to audit the 2004 financial statements,R. Liu makes several important findings, described be-low:

• Liu had never issued her review engagement reporton the 2003 financial statements because in her viewthey did not contain disclosure of a significant sub-sequent event that is required to comply with gener-ally accepted accounting principles. The subsequentevent was the issue of common shares to PSI’s CFO.

The president agreed that PSI would lend the CFOthe money to buy these shares, and promised theCFO that the loan would subsequently be forgiven.During the current year’s audit, Liu discovers thatthe CFO presented draft 2003 financial statements tothe shareholders at the 2003 annual shareholders’meeting which did not contain this subsequent eventdisclosure. It is not clear whether the statementswere presented as the draft statements or the finalstatements, since the CFO was not able to recall howthe statements were presented at the annual meeting,and there were no minutes taken at the meeting.

• The president engaged an independent compensationconsultant to report on what would be a reasonablebonus for PSI’s management during the currenthighly successful year, when the profit will exceed$2 million. The consultant suggested, based onindustry norms, that the president should receive a$200,000 bonus, the Chief Operating Officer (COO)a $100,000 bonus and the CFO a $20,000 bonus. InNovember 2004, the president, COO and CFOagreed on a bonus plan and cash bonuses were paidout as follows— $400,000 to the president, $400,000to the COO and $250,000 to the CFO.

• While assessing the controls in the payroll system,Liu discovers an error that resulted in the CFO beingpaid an extra $600 weekly throughout 2004.

• The CFO has recommended to the president thatinstead of paying cash bonuses to the other 30 PSIemployees, the employees should be awarded PSIshares.

• The president is the only director of PSI. There is noaudit committee or compensation committee.

Required:Advise R. Liu.

6.60 Internal Control, Internal Audit. Why do internal au-ditors’ interests in internal control differ from those ofexternal auditors? Consider this question from the per-spective of management’s internal control objectivesand the different roles of internal audit and external au-dit functions.

6.61 General categories of errors, irregularities, frauds(misstatements). Consider one or more of the busi-nesses listed below.

• Web hosting a promotional site for bed & breakfastestablishments and small hotels

• leasing automatic teller machines (ATMs) to smallconvenience stores and restaurants

• manufacturing snack foods• manufacturing automobile parts


DISCUSSION CASES

CHAPTER 6

• installing computer networks for small business cus-tomers

Required:a. Describe in detail the sales transaction stream of the

selected business. Include all the important financialand non-financial information that needs to betracked to manage this business. State any assump-tions you make.

b. Using the general categories of errors and irregularitiesand frauds (misstatements) described in Exhibit 6-3,explain how each type of misstatement might occurin the transaction stream you described in a) above.

c. Describe the kinds of control environment factorsand specific control procedures that the business canimplement to prevent, detect and correct errors,irregularities, frauds, or misstatements in this trans-action stream.

6.62 Internal Control Structure, Sales System. You havebeen invited by your friend Naseem to become a partnerin her new business. She has created a simple system forsetting up websites and e-commerce facilities for inde-pendent retailers. She has targeted award-winning re-tailers in many small towns that are within driving dis-tance of the major city where you both live. She callsthese retailers “destination shops” because they offerunique products, excellent selection and a highly enjoy-able shopping experience, thus becoming well-known“destinations” that bring visitors to their towns.

In addition to a portal where Web-browsers can viewthe whole selection of “destination” shops and locationsand find useful information links, there will also bestand-alone sites for each shop with photos, productlists, travel information and an online sales and deliverysystem. The sales and delivery system will all be onlineexcept for the payment itself, which will be done bycredit card over fax or telephone to avoid customer con-cerns about security of credit card information on theInternet. So far, she has 12 shops signed up for the serv-ice and about 20 more very close to signing. Naseem’sgenius is in Web-based design and marketing, but shethinks your genius in management and finance are crit-ical to the success of this operation. She feels your abil-ity to describe the reliability and controls in the onlinesales and delivery system design to the shop owners andmanagers will be a great help in getting more shops tosign up.

Required:Design a sales and delivery system for this business, in-cluding a description of the control environment, the ac-counting system and the control procedures. Structureyour system design in a format suitable for marketingthis system to the “destination shop” owners and man-agers.

6.63 Internal Control Objectives, Financial StatementAssertions. Exhibit 6-5 provides “Specific Examples”of internal control objectives for accounts receivableand sales. For each of the specific examples given, iden-

tify one (or more) financial statement assertion that re-lates to that control objective.

6.64 Control Procedures, Periodic Comparison. Considerthe following accounting records:1. Cash2. Accounts receivable3. Inventories4. Short term investments5. Equipment6. Accounts payable7. Long-term debt8. Share capital 9. Revenues

10. Interest payments11. Salary expense12. Repairs and maintenance expense

Required:a. Describe a periodic comparison that management

could perform for each of the above. b. Recommend whether the comparison should be done

daily, weekly, monthly, quarterly, annually or atsome other interval. State the factors and assump-tions that support your recommendation.

6.65 Phases of Internal Control Work. Consider the fol-lowing independent situations discovered during thecompany’s audit:1. Cash is received, deposited to the bank and recorded

in the accounts receivable ledger by the company’scollections supervisor.

2. Duplicate payments are made to a supplier companythat is owned by a close relative of the purchasingmanager.

3. Bank reconciliations are not performed becausethere is no one in the company assigned to performthis task.

4. The company’s new controller was formerly a bankloans officer, and is not familiar with generalaccounting principles.

5. A number of large shipments were made to a newcustomer during the year before the customer’scredit had been approved by the company’s creditmanager. None of the shipments was invoicedbecause there was no customer account number setup in the accounts receivable system.

6. The new company bookkeeper performs a monthlybank reconciliation by using the “bank reconcilia-tion” function on the accounting software package.The software function calculates the differencebetween the bank statement balance and the cashledger account balance. The bookkeeper then makesan adjusting journal entry for this difference to thecash account and a new account he created called“Reconciling items.” The year-end balance of the“reconciling items” account is material.

7. The president and majority shareholder of the com-pany is actively involved in all aspects of the busi-ness and believes that internal control procedures area waste of money.


Required:For each of the above situations, indicate in which phaseor phases of internal control work you think this situa-tion is most likely to be discovered by the company’sauditor. Give your reasons.

6.66 Controls, Revenue Completeness. The CanadianHealth Society (CHS) is a charitable organization thatraises funds to support research and community pro-grams to improve the health of Canadian residents. Itsmain fundraising effort is done by volunteers who godoor-to-door in their neighbourhoods to get donationsfrom neighbours. When her neighbourhood volunteercalls to request a donation, Sandra, who recently starteda job as a junior auditor, finds herself experiencing someprofessional scepticism. Sandra asks the neighbourwhat kind of control environment the CHS has, andwhat control procedures are in place to ensure that thedonations collected are used to promote the health ofCanadians. When the neighbour cannot answer herquestions, Sandra says that she will be happy to donateif the neighbour can find out and get back to her with an-swers to her questions.

Required:a. Assume the role of the neighbour/volunteer. What

information would you obtain about CHS to answerSandra’s questions?

b. If you were the auditor of CHS, what factors wouldyou look for to assess whether the control environ-ment is weak or strong? What control procedureswould you expect to find over donation revenue com-pleteness and how would these controls affect youraudit work and opinion on donation revenues?

6.67 Walkthrough, Capital Assets System. Sunbird Lim-ited’s system for recording capital assets is described asfollows:• Purchases of equipment, machinery, furniture, build-

ings, etc. are capitalized if they are greater than$5,000.

• Sunbird’s Building and Equipment Department isresponsible for approving payment for capital assetacquisitions.

• If the invoice amount is greater than $5,000, theBuilding and Equipment purchasing managerapproves the payment and assigns an appropriatebalance sheet account code for the purpose of mak-ing the general ledger entry. If the invoice is less than$5,000 the payment is charged to a MiscellaneousSupplies expense account code in the general ledger.

• The Building and Equipment manager enters thepurchases greater than $5,000 into the Fixed Assetsdatabase under the appropriate capital asset cate-gory. Each category has its own balance sheet cap-tion, accounting amortization policy and CapitalCost Allowance class for tax purposes. Each assetpurchased is assigned a unique identifier thatincludes a description, the date of purchase, and itsserial number or any other identifying informationthat is available.

• When Building and Equipment technicians deter-mine that a capital asset is to be disposed of, theycomplete an “Asset Retirement Report,” which isapproved by the Building and Equipment manager.The manager then removes the item from its cate-gory in the database and manually prepares a journalentry voucher to remove the cost and accumulatedamortization related to the item from the generalledger, which is forwarded to the accounting man-ager. Any proceeds of disposal are also recorded atthis time.

• At each quarter-end, a report is generated from theFixed Asset database that presents a continuityschedule (opening balance, additions, disposals, end-ing balance) for all capital asset categories for thecost, accumulated amortization, and net book value.The continuity schedule of tax balances and maxi-mum CCA claim are also generated. This report isreviewed for accuracy by the Building andEquipment department manager, and is used by thecompany controller to prepare quarterly or annualfinancial statements and the annual corporate taxreturn.

Required:a. Plan a walkthrough of Sunbird’s capital asset

accounting system. Include in your plan the purposeof the walkthrough, the specific steps you will take,and your conclusions about the adequacy of the sys-tem as described above to control capital asset pur-chases, disposals and accounting.

b. Identify additional control tests or substantive pro-cedures that are possible in Sunbird’s system, includ-ing the control objective and/or assertion for whichthe test can provide evidence.

6.68 Internal Control, Cost Effectiveness. Can external au-ditors contribute to a company’s internal control? Underwhat circumstances? Could this be cost effective? If thework of external auditors serves an important internalcontrol objective, what impact does this have on the ex-ternal auditor’s control assessment?


8.60 Check Digit. Suppose that a credit sale was made toJohn Q. Smyth, customer account number 8149732. Thelast digit is a check calculated by the “Modulus 11Prime Number” method. The data entry operator madean error and keyed in the customer as 8419732.

Required (refer to Chapter 11):a. Calculate the check digit for the number that was

keyed in.b. How would the self-checking number control detect

this data input error?

8.61 File Retention and Backup. You have audited the fi-nancial statements of the Solt Manufacturing Companyfor several years and are making preliminary plans forthe audit for the year ended June 30. This year, however,the company has installed and used a computer systemfor processing a portion of its accounting data.

The following output computer files are produced inthe daily processing runs:1. Cash disbursements sequenced by cheque number.2. Outstanding payables balances (alphabetized).3. Purchase journals arranged by (a) account charged

and (b) vendor.Company records, as described above, are main-

tained on magnetic tapes. All tapes are stored in a re-stricted area within the computer room. A grandfather-father-son policy is followed in retaining andsafeguarding tape files.

Vouchers (with supporting invoices, receiving re-ports, and purchase order copies) are filed by vendorcode. Another purchase order copy and the cheques arefiled numerically.

Required:a. Explain the grandfather-father-son policy. Describe

how files could be reconstructed when this policy isused.

b. Discuss whether company policies for retaining andsafeguarding the tape files provide adequate protec-tion against losses of data.

8.62 Misstatements, Qualitative Evaluation. For each ofthe following misstatements in the current period, indi-cate what other account (or accounts) would be affected,in what periods, and whether it would be overstated orunderstated. State any assumptions you make.1. Understatement of accounts payable (for inventory

purchases),2. Overstatement of accrued lawyer’s fees,3. Understatement of vacation pay accrual,4. Overstatement of interest receivable,5. Understatement of repairs expense (repairs were cap-

italized as building cost),6. Overstatement of work-in-process inventory,7. Understatement of allowance for bad debts,

8. Overstatement of percentage of completion revenuerecognized.

8.63 Separation of Duties and General Control Proce-dures. You are engaged to examine the financial state-ments of Horizon Incorporated, which has its own com-puter installation. During the preliminary understandingwork, you found that Horizon lacked proper segregationof the programming and operating functions. As a re-sult, you intensified the evaluation of the internal con-trol structures surrounding the computer and concludedthat the existing compensating general control proce-dures provided reasonable assurance that the objectivesof internal control were being met.

Required:a. In a properly functioning computer environment,

how is the separation of the programming and oper-ating functions achieved?

b. What are the compensating general control proce-dures that you most likely found?

(AICPA adapted)

8.64 Advanced Computer Systems Control Procedures.The revenue ministry of one province is developing anew computer system for processing provincial incometax returns of individuals and corporations. The newsystem features direct data input and enquiry capabili-ties. Identification of taxpayers is provided by using thesocial insurance number for individuals and the federalidentification number for corporations. The new systemshould be fully implemented in time for the next taxseason. The new system will serve three primary pur-poses as described below:1. Data will be input into the system directly from tax

returns through terminals located at the central head-quarters of the Department of Taxation.

2. The returns will be processed using the main com-puter facilities at central headquarters. The process-ing includes:

a. Verification of mathematical accuracy.b. Auditing the reasonableness of deductions, tax

due, and so forth through the use of edit routines;these routines also include a comparison of thecurrent year’s data with the prior year’s data.

c. Identification of returns that should be consideredfor audit by revenue agents of the department.

d. Issuing refund cheques to taxpayers.3. Enquiry service will be provided to taxpayers on

request through the assistance of Tax Departmentpersonnel at five regional offices. A total of 50 ter-minals will be placed at the regional offices. A tax-payer will be allowed to determine the status of hisor her return or get information from the last threeyears’ returns by calling or visiting one of the depart-ment’s regional offices.


CHAPTER 8

The provincial revenue minister is concerned aboutdata security over and above protection against naturalhazards such as fire and flood. He is concerned with pro-tection against the loss or damage of data during data in-put or processing. Also, both he and the provincial at-torney general have discussed the general problem ofdata confidentiality. Both officials want to have all po-tential problems identified before the system is fully de-veloped and implemented so that the proper controlscan be incorporated into the new system.

Required:a. Describe the potential confidentiality problems that

could arise in each of the following three areas ofprocessing and recommend the corrective action(s)to solve the problem: (1) Data input. (2) Processingof returns. (3) Data enquiry.

b. The provincial revenue minister wants to incorporatecontrol procedures to provide data security againstthe loss, damage or improper input or use of dataduring data input and processing. Identify the poten-tial problems (other than of natural hazards such asfire and flood) for which the Department of Taxationshould develop controls, and recommend the possi-ble controls for each problem identified.

(CMA adapted)

8.65 Computer Frauds and Missing Control Procedures.The following are brief stories of actual employee theftsand embezzlements perpetrated using computers.

Required:What kind of control procedures were missing or inop-erative that might have prevented or detected the fraud?a. An accounts payable terminal operator at a subsidiary

company fabricated false invoices from a fictitiousvendor, and entered them in the parent company’scentral accounts payable/cash disbursement system.Five cheques totalling $155,000 were issued to the“vendor.”

b. A bank provided custodial and recordkeeping serv-ices for several mutual funds. A proof-and-controldepartment employee substituted his own name andaccount number for those of the actual purchasers ofsome shares. He used the computerized recordkeep-ing and correction system to conceal and shift bal-ances from his name and account to names andaccounts of the real investors when he needed toavoid detection because of missing amounts in theinvestors’ accounts.

c. The university computer system was entered. Vandalschanged many students’ first name to “Susan,” studenttelephone numbers were changed to the number of theuniversity president, grade point averages were modi-fied and some academic files were deleted completely.

d. A computer operator at a state-run horse race bettingagency set the computer clock back three minutes.After the race was won, he quickly telephoned betsto his girlfriend, an input clerk at the agency, gaveher the winning horse and the bet amount, and wonevery time!


DISCUSSION CASES

8.66 Control Weaknesses and Recommendations—Fron-tenac Sales Corporation.George Beemster, CPA, isexamining the financial statements of the FrontenacSales Corporation, which recently installed a computer.The following comments have been extracted from Mr.Beemster’s notes on computer operations and the pro-cessing and control of shipping notices and customer in-voices:

To minimize inconvenience, Frontenac convertedwithout changing its existing data processing system,which utilized tabulating equipment. The computercompany supervised the conversion and provided train-ing to all computer department employees in systemsdesign, operations and programming.

Each computer run is assigned to a specific employeewho is responsible for making program changes, run-ning the program and answering questions. This proce-dure has the advantage of eliminating the need forrecords of computer operations because each employeeis responsible for her or his own computer runs.

At least one computer department employee remainsin the computer room during office hours, and only

computer department employees have keys to the com-puter room.

Systems documentation consists of those materialsfurnished by the computer company—a set of recordformats and program listings. These and the tape libraryare kept in a corner of the computer department.

The company considered the desirability of pro-grammed controls but decided to retain the manual con-trols from its existing system.

Company products are shipped directly from publicwarehouses, which forward shipping notices to generalaccounting. There, a billing clerk enters the prices of theitems and accounts for the numerical sequence of ship-ping notices from each warehouse. The billing clerk alsoprepares daily adding machine tapes (“control tapes”) ofthe units shipped and the unit prices.

Shipping notices and control tapes are forwarded tothe computer department for input and processing. Ex-tensions are made on the computer. Output consists ofinvoices (in six copies) and a daily sales register. Thedaily sales register shows the aggregate totals of unitsshipped and unit prices, which the computer operatorcompares to the control tapes.

All copies of the invoice are returned to the billingclerk. The clerk mails three copies to the customer, for-wards one copy to the warehouse, maintains one copy ina numerical file, and retains one copy in an open invoicefile that serves as a detail accounts receivable record.

Required:Describe the weaknesses in the internal control struc-ture over information and data flows and the proceduresfor processing shipping notices and customer invoices.Recommend some improvements in these control poli-cies and procedures. Organize your answer sheet withtwo columns, one headed “Weaknesses” and the otherheaded “Recommended Improvements.”

(AICPA adapted)

8.67 Internal Control Considerations in a Microcom-puter Environment.

INTRODUCTIONThe second standard of field work requires that an auditinclude “a sufficient understanding of the internal con-trol to plan the audit and to determine the nature, timingand extent of tests to be performed.”

Given the increasing use of PCs by many businessestoday, auditors must know about the potential internalcontrol weaknesses inherent in a PC environment. Suchknowledge is crucial if the auditor is to make a properassessment of the related control risk and to plan an ef-fective and efficient audit approach.

Required:In the following case study, assume that you are partic-ipating in the audit of Calgary Appliance Company andthat the background information below has been ob-tained during the planning phase. You have been askedto (1) consider the potential effects on internal controlthat have been introduced by the PC application and (2)assess how those internal control effects may alter theaudit plan for the current year.

BACKGROUND INFORMATIONCalgary Appliance is a wholesale distributor of electricappliances. The company’s sales in each of the last twoyears have been approximately $40 million. All ac-counting applications are handled at the company’s cor-porate office.

The data processing operations have historically cen-tred around an onsite minicomputer. The computer ap-plications include accounts payable and cash disburse-ments, payroll, inventory and general ledger. Accountsreceivable and fixed asset records have been preparedmanually in the past. Internal controls in all areas havebeen considered strong in the last few years.

During the past year, financial management decidedto automate the processing of sales, accounts receivableand fixed asset transactions and accounting. Manage-ment also concluded that purchasing a PC and relatedavailable software was more cost effective than increas-ing the minicomputer capacity and hiring a secondcomputer operator. The controller and accounting clerks

have been encouraged to find additional uses for the PCand to “experiment” with it when they are not too busy.

The accounts receivable clerk is enthusiastic about thePC, but the fixed asset clerk seems somewhat apprehen-sive about it because he has no prior experience withcomputers. The accounts receivable clerk explained thatthe controller had purchased a “very easy to use” ac-counts receivable software application program for thePC, which enables her to input the daily information re-garding billings and payments received quickly and eas-ily. The controller has added some programming of hisown to the software to give it better report-writing fea-tures.

During a recent demonstration, the accounts receiv-able clerk explained that the program required her onlyto input the customer’s name and invoice amount in thecase of billings, or the customer’s name and chequeamount in the case of payments. The PC then automat-ically updates the respective customer’s account bal-ance. At the end of every month, the accounts receivabletrial balance is printed and reconciled by the clerk to thegeneral ledger balance. The reconciliation is reviewedby the controller.

The fixed asset program also was purchased from anoutside vendor. The controller indicated that the soft-ware package had just recently been put on the marketand that it was programmed to compute tax depreciationbased on recent changes in the federal tax laws. He alsostated that, because of the fixed asset clerk’s reluctanceto use the PC, he had input all the information from thefixed asset manual records. He indicated, however, thatthe fixed asset clerk would be responsible for the futureprocessing related to the fixed assets files and for gen-erating the month-end and year-end reports used to pre-pare the related accounting entries.

The various accounts receivable and fixed assetdiskettes are all adequately labelled as to the type ofprogram or data file. They are arranged in an organizedmanner in a diskette holder located near the PC.

(Adapted from a case contributed by Price Waterhouse to The Auditor’s Report.)

8.68 Use of CAATs.Jane Ford has just joined the publicpractice firm in which you are employed as a junior staffmember. The two of you are meeting with Jay Birch,who will be the senior on your next (starting tomorrow)audit. Jane is very enthusiastic about her first audit as-signment, which will provide an opportunity to useCAATs. She says to Jay, “We should use CAATs forevery audit of a client who has an EDP system. That’sthe only way to go.”

Jay relies, “It’s not quite that simple—there are anumber of considerations we have to bear in mind whenwe’re deciding whether to use CAATs.”

RequiredElaborate on Jay’s comment to Jane.

(CGAAC adapted)


8.69 General Controls.Frank Wu has been assigned to as-sist you with the audit of Nercando Inc. Frank will bemaking an initial visit to the client’s office in a few daysto familiarize himself with the company’s operations.Nercando is an owner-managed business that has its ac-counting applications performed in a PC environment.One of Frank’s tasks will be to make a preliminary as-sessment of Nercando’s EDP internal control systemand inform you so that you may incorporate that infor-mation into your audit planning. Frank is somewhat un-sure of what he should be looking for with respect to theEDP internal control system, and asks you for some di-rection.

Required:Draft a memo to Frank giving him guidance as to howto evaluate the general EDP internal control environ-ment and the concerns that may exist in the case of asmall, owner-managed company such as Nercando.

(CGAAC adapted)



CHAPTER 9

9.66 Trinity Company—Defalcations. Assume that you areparticipating in the audit of the Trinity Company’s fi-nancial statements. The situations described belowcame to your attention when you performed certain sub-stantive audit procedures of account balance details.1. The July sales journal indicated that customers were

billed $140,000 during that month. This amount wasposted as a debit to accounts receivable and a creditto sales. However, you tested the footing of the Julysales journal and determined that the correct sum ofthe customer billings was $144,500.

2. You noted that an $8,500 debit posting had beenentered in the miscellaneous expense account, butyou could not vouch this posting to any “preceding”record (such as a purchases journal, payroll journalor general journal).

3. When you examined a voucher for the purchase ofoffice supplies, you noted that the cheque signer hadinitialed the vendor’s invoice to indicate her ap-proval, but the purchase order and receiving reporthad not been initialed or otherwise cancelled.

4. When you audited the reconciliation of the com-pany’s chequing account at year-end, you noted thata $6,000 cheque had been omitted from the list ofoutstanding cheques. The cheque had been issuedand recorded as a disbursement during the previousmonth, but it had not yet cleared the bank.

Required:1. Describe how each situation may indicate an

attempted concealment of a defalcation.2. Answer the following general questions:

a. Are certain types of concealment “temporary” inthe sense that further actions will be required toprevent detection?

b. How might the direction of audit testing (testingfor over- or understatement) be influenced by theauditor’s responsibility to search for materialdefalcations?

c. Can auditors rely exclusively on a good internalcontrol structure to fulfill the responsibility tosearch for and detect material misstatements?

d. Can auditors rely exclusively on analytical proce-dures to fulfill the responsibility to search for anddetect material misstatements?

(Adapted from the case contributed by Deloitte Haskins &Sells to The Auditor’s Report)

9.67 Interbank Transfers.EverReady Corporation is in thehome building and repair business. Construction busi-ness has been in a slump, and the company has experi-enced financial difficulty over the past two years. Part ofthe problem lies in the company’s desire to avoid layingoff its skilled crews of bricklayers and cabinetmakers.Meeting the payroll has been a problem.

The auditors are engaged to audit the 2002 financialstatements. Knowing of EverReady’s financial difficultyand its business policy, the auditors decided to prepare aschedule of interbank transfers covering the 10 days be-fore and after December 31, which is the company’s bal-ance sheet date.

First, the auditors used the cash receipts and dis-bursements journals to prepare part of the scheduleshown in Exhibit 9.67–1. They obtained the information

E X H I B I T 9 . 6 7 – 1 SCHEDULE OF INTERBANK TRANSFERS

C-5 EVERREADY CORPORATION PreparedSchedule of Interbank Transfers Date

December 31, 2002 ReviewedDate

Disbursing Account Receiving Account

Date per Date per Date per Date per Check # Bank Amount Books Bank Bank Books Bank

1417 North Country 10,463✓ 24-Dec 24-Dec′′ North Country payroll 24-Dec r 24-Decχ1601 North Country 11,593✓ 31-Dec✗ 31-Dec′′ North Country payroll 31-Dec r 31-Decχ1982 North Country 9.971✓ 08-Jan 08-Jan′′ North Country payroll 08-Jan r 08-Janχ

✓ Traced from cash disbursements journal.✗ Cheque properly listed as outstanding on bank reconciliation.′′ Vouched to cheque cleared in bank statement.r Traced from cash receipts journal.χ Vouched deposit cleared in bank statement.Note: We scanned the cash disbursements and cash receipts journals for cheques to and deposits from other bank accounts.


for everything except the dates of deposit and paymentin the bank statements (disbursing date per bank and re-ceiving date per bank). They learned that EverReady al-ways transferred money to the payroll account at NorthCountry Bank from the general account at North Coun-try Bank. This transfer enabled the bank to clear thepayroll cheques without delay. The only bank accountsin the EverReady financial statements are the two atNorth Country Bank.

Next, the auditors obtained the December 2002 andJanuary 2003 bank statements for the general and pay-roll accounts at North Country Bank. They recorded thebank disbursement and receipt dates in the schedule ofinterbank transfers. For each transfer these dates areidentical because the accounts are in the same bank. Analert auditor noticed that the North Country Bank gen-

eral account bank statement also contains deposits re-ceived from Commerce Bank and cancelled chequenumber 1799 dated January 5 payable to CommerceBank. This cheque cleared the Commerce Bank accounton January 8 and was marked “transfer of funds.” Thisled to new information.

NEW INFORMATIONAsked about the Commerce Bank transactions, Ever-Ready’s chief financial officer readily admitted the ex-istence of an off-books bank account. He explained thatit was used for financing transactions in keeping withnormal practice in the construction industry. He gavethe auditors the December and January bank statementsfor the account at Commerce Bank. In it, the auditorsfound the following:

When asked about the Chase Bank transactions, Ever-Ready’s chief financial officer admitted the existence ofanother off-books bank account, which he said was thepersonal account of the principal shareholder. He ex-

plained that the shareholder often used it to finance Ever-Ready’s operations. He gave the auditors the Decemberand January bank statements for this account at ChaseBank; in it, the auditors found the following:

An abbreviated calendar for the period is in Exhibit9.67–2.

Required:a. Complete the schedule of interbank transfers (work-

ing paper C-5, Exhibit 9.67–1) by entering the newinformation.

b. What is the actual cash balance for the four bankaccounts combined, considering only the amountsgiven in this case information, as of December 31,

2002 (before any of the December 31 payrollcheques are cashed by employees)? As of January 8,2003 (before any of the January 8 payroll chequesare cashed by employees)? (Hint: Prepare a scheduleof “apparent balances” and “actual balances” illus-trated in Chapter 17 to explain cheque kiting.)

9.68 Manipulated Bank Reconciliation.Caulco, Inc., is theaudit client. You have obtained the client-prepared bankreconciliation as of February 28, 1998. (The bank state-

Commerce BankCheque # Payable to Amount Dated Cleared Bank

4050 North Country 10,000 23-Dec 29-Dec4051 Chase Bank 12,000 28-Dec 31-Dec4052 North Country 12,000 30-Dec 05-Jan4053 Chase Bank 14,000 04-Jan 07-Jan4054 North Country 20,000 08-Jan 13-Jan

Deposits

Received from Amount Dated

Chase Bank 11,000 22-DecChase Bank 15,000 30-DecNorth Country 10,000 05-JanChase Bank 12,000 07-Jan

Chase BankCheque # Payable to Amount Dated Cleared Bank

2220 Commerce Bank 11,000 22-Dec 28-–Dec2221 Commerce Bank 15,000 30-Dec 05-–Jan2222 Commerce Bank 12,000 07-Jan 12-–Jan

Deposits

Received from Amount Dated

Commerce Bank 12,000 28-DecCommerce Bank 14,000 04-Jan


ment and, thus, the dates are actual documents, althoughthe situation is contrived for the purposes of this prob-lem.)

Required:Cheque #2231 was the first cheque written in February.All earlier cheques cleared the bank, some in the Janu-ary bank statement and some in the February bank state-ment.

Assume that the only February-dated cancelledcheques returned in the March bank statement are#2231; #2239 and #2231; #2240, showing the amountslisted in the February bank reconciliation. They clearedthe bank on March 3 and March 2, respectively. The firstdeposit on the March bank statement was $1,097.69,credited on March 3. Assume further that all chequesentered in Caulco’s cash disbursements journal throughFebruary 28 have either cleared the bank or are listed asoutstanding cheques in the February bank reconcilia-tion.

Examine the February bank statement in Exhibit18–3 (Chapter 18). Determine whether anything iswrong with the bank statement and the bank reconcilia-tion. If anything is wrong, prepare a corrected reconcil-iation and explain the problem.

9.69 Employee Embezzlement via Cash Receipts andPayment of Personal Expenses (duplicated in Chap-ter 18, Case 18.52).Instructions for Discussion Cases9.64 and 9.65.

These cases are designed like the ones in the chapter.They give the problem, the method, the paper trail andthe amount. Your assignment is to write the audit ap-proach portion of the case, organized around these sec-tions:

Objective:Express the objective in terms of the factssupposedly asserted in financial records, accounts andstatements. (Refer to discussion of assertions in Chapter4).

Control: Write a brief explanation of desirable con-trols, missing controls and especially the kinds of “de-viations” that might arise from the situation described inthe case.

Test of controls:Write some procedures for gettingevidence about existing controls, especially proceduresthat could discover deviations from controls. If there areno controls to test, then there are no procedures to per-form; go then to the next section. A “procedure” shouldinstruct someone about the source(s) of evidence to tapand the work to do.

Audit of balance:Write some procedures for gettingevidence about the existence, completeness, valuation,ownership or disclosure assertions identified in your ob-jective section above.

Discovery summary:Write a short statement aboutthe discovery you expect to accomplish with your pro-cedures.

THE EXTRA BANK ACCOUNTProblem:Cash receipts pocketed and personal expensespaid from business account.

Method:The Ourtown Independent School District,like all others, had red tape about school board approvalof cash disbursements. To get around the rules and tomake timely payment of some bills possible, the super-intendent of schools had a school bank account that wasused in the manner of a petty cash fund. The board knewabout it and had given blanket approval in advance forits use to make timely payment of minor school ex-

E X H I B I T 9 . 6 7 – 2 CALENDAR

S M T W T F S

December 20 21 22 23 24 25 262002 27 28 29 30 31 1 2January 3 4 5 6 7 8 92003 10 11 12 13 14 15 16

CAULCO, INC.Bank ReconciliationFebruary 28, 1998

Balance per bank $7,374.93Deposit in transit 1,097.69Outstanding cheques

# Date Payee Amount

2239 Feb. 26 Alpha Supply 500.002240 Feb. 28 L.C. Stateman 254.37

Total outstanding (754.37)General ledger balance Feb. 28, 1998 $7,718.25

penses. The board, however, never reviewed the activityin this account. The business manager had sole respon-sibility for the account, subject to the annual audit. Theaccount got money from transfers from other school ac-counts and from deposit of cafeteria cash receipts. Thesuperintendent did not like to be bothered with details,and he often signed blank cheques so that the businessmanager would not need to run in for a signature all thetime. The business manager sometimes paid her per-sonal American Express credit card bills, charged per-sonal items to the school’s VISA account and pocketedsome cafeteria cash receipts before deposit.

Paper trail: An informant called the state educationaudit agency and told the story that this business man-ager had used school funds to buy hosiery. When told ofthis story, the superintendent told the auditor to place nocredibility in the informant, who is “out to get us.” (Theinformant had been fired after an accusation of improperbehaviour and later faced a similar charge at the nextplace of employment.) The business manager had in factused the account to write cheques to “cash” (herself),put her own American Express bills in the school files(the school district had a VISA card, not American Ex-press), and signed on the school card for gasoline andauto repairs during periods when school was not in ses-sion. (As for the hosiery, she purchased $700 worth withschool funds one year.) The superintendent was gen-uinely unaware of the misuse of funds.

Amount:The business manager had been employedfor six years, was trusted, and stole an estimated$15,000.

Required:Write the audit approach section according to the in-structions at the beginning of 9.69. You can assume thatyou received the informant’s message.

9.70 Overstated Sales and Accounts Receivable.Followthe instructions given with Case 17.64. Write the auditapproach section.

RING AROUND THE REVENUEProblem:Sales were recorded early, sometimes at ficti-tiously high prices, overstating sales revenue, accountsreceivable and income.

Method: Mattox Toy Manufacturing Company hadexperienced several years of good business. Income hadincreased steadily and the common shares were afavourite among investors. Management had confidentlypredicted continued growth and prosperity. But businessturned worse instead of better. Competition becamefierce.

In earlier years Mattox had accommodated a fewlarge retail customers with the practice of field ware-housing coupled with a “bill and hold” accounting pro-cedure. These large retail customers executed noncan-cellable written agreements, asserting their purchase oftoys and their obligation to pay. The toys were not actu-ally shipped because the customers did not have avail-able warehouse space. They were set aside in segregated

areas on the Mattox premises and identified as the cus-tomers’ property. Mattox would later drop-ship the toysto various retail locations upon instructions from thecustomers. The “field warehousing” was explained asMattox serving as a temporary warehouse and storagelocation for the customers’ toys. In the related bill-and-hold accounting procedure, Mattox prepared invoicesbilling the customers, delivered them to the customers,and recorded the sales and accounts receivable.

When business took the recent downturn, Mattox ex-panded its field warehousing and its bill-and-hold ac-counting practices. Invoices were recorded for cus-tomers who did not execute the written agreements usedin previous arrangements. Some customers signed thenoncancellable written agreements with clauses permit-ting subsequent inspection, acceptance and determina-tion of discounted prices. The toys were not always setaside in separate areas, either, and this failure later gaveshipping employees problems when it came to identify-ing shipments of toys that had been “sold” earlier andthose that had not.

Mattox also engaged in overbilling. Customers whoordered close-out toys at discounted prices were billedat regular prices, even though the customers’ ordersshowed the discounted prices agreed by Mattox salesrepresentatives.

In a few cases, the bill-and-hold invoices and theclose-out sales were billed and recorded in duplicate. Inmost cases the customers’ invoices were addressed andmailed to specific individuals in the customers’ man-agement instead of the routine mailing to the customers’accounts payable departments.

Paper trail: The field warehousing arrangementswere well known and acknowledged in the Mattox ac-counting manual. Related invoices were stamped “billand hold.” Customer orders and agreements were at-tached in a document file. Sales of close-out toys werestamped “close-out,” indicating the regular prices (basesfor salespersons’ commissions) and the invoice prices.Otherwise, the accounting for sales and accounts re-ceivable was unexceptionable. Efforts to record thesesales in January (last month of the fiscal year) causedthe month’s sales revenue to be 35 percent higher thanthe January of the previous year.

In the early years of the practice, inventory sold un-der the field warehousing arrangements (both regularand closeout toys) was segregated and identified. Theshipping orders for these toys left the “carrier name”and “shipping date” blank, even though they weresigned and dated by a company employee in the spacesfor the company representative and the carrier repre-sentative signature.

The lack of inventory segregation caused problemsfor the company. After the fiscal year-end, Mattoxsolved the problem by reversing $6.9 million of the $14million bill and hold sales. This caused another problembecause the reversal was larger than the month’s sales,causing the sales revenue for that month to be a negativenumber!


Amount:Company officials’ reasons for the validityof recognizing sales revenue and receivables on the bill-and-hold procedure and field warehousing were persua-sive. After due consideration of the facts and circum-stances, the company’s own accountants agreed that theaccounting practices appropriately accounted for rev-enue and receivables.

It was Mattox’s abuse of the practices that caused fi-nancial statements to be materially misstated. In Januaryof the year in question, the company overstated sales byabout $14 million, or 5 percent of the sales that shouldhave been recorded. The gross profit of $7 million onthese sales caused the income to be overstated by about 40percent.

9.71 Cutoff Tests for Sales.In connection with an audit ofthe financial statements of a wholesale food distributor,a PA will perform cutoff tests in several areas, includingmerchandise receipts, sales transactions and cash.

Required:a. Explain the general purpose of a cutoff test. To

which management assertion(s) are such testsrelated?

b. Assume the financial statements of the wholesaledistributor have never been audited. Must cutoff testsbe performed for both the beginning and end, or onlyat the end of the fiscal year? Explain.

c. List four procedures the PA could perform in testingthe cutoff of sales revenue at the end of the fiscal year.All of the company’s sales are made on account.

d. Explain how the PA should test the cutoff of cashreceipts at the end of the fiscal year.

(CGAAC adapted)

9.72 Audit of Receivables.You are the auditor of NorthShore Linen Supply Company, which performs laundryservices for restaurants and similar businesses. Thecompany’s drivers deliver clean linens (tablecloths, tow-els, uniforms, etc.) to each customer on a weekly basis,while picking up soiled goods for laundering and deliv-ery the following week. All linens are the property ofthe customer, and the drivers carry a stock of standarditems that are sold to customers who need to replacedamaged goods, etc. You are planning your examinationof the company’s accounts receivable balances and de-termine the following:1. There are 50 separate routes; each route consists of

25 to 40 customers, the number that can be servicedby a driver in one day.

2. Each driver maintains a route book. This consists ofa loosely bound volume that, among other things,shows the detailed charges and credits to each cus-tomer’s account.

3. Charges for laundry services are recorded on apreprinted, prenumbered invoice form at the plantand also recorded in the route book. The driver deliv-ers the invoice to the customer with the clean goods.Charges for any linens sold are entered in the routebooks directly by the drivers.

4. Drivers are authorized to collect cash. Amounts col-lected are recorded in the route book, and the cash isremitted to a cashier at the plant at the end of eachroute. When collecting the cash, the cashier verifiesthat the amount remitted agrees with the total creditsrecorded to the customers’ accounts by the driverthat day.

5. Some customers pay their accounts by cheque sentdirectly to the plant. The route books are updatedwhen these cheques are received.

6. Last year’s audit program for the selection ofaccounts receivable for confirmation states: “Selecttwo accounts from each route by opening the routebook twice, at random.”

Requireda. List six weaknesses in internal controls in the system

as described in the case. Do not include suggestionsfor improvements.

b. Would the procedure used last year to select a sam-ple of accounts for confirmation produce a statisti-cally valid random sample? Explain.

c. What form of customer confirmation request wouldbe most appropriate in this situation? Discuss.

d. Would dollar-unit sampling be an appropriatemethod of determining sample size and selecting asample of customer accounts for confirmation in thissituation? Discuss.

(CGAAC adapted)


INSTRUCTIONS FOR DISCUSSION CASES 10.73–10.77.

These cases are designed like the ones in the chapter. They givethe problem, the method, the paper trail and the amount. Yourassignment is to write the audit approach portion of the case,organized around these sections:

Objective:Express the objective in terms of the facts sup-posedly asserted in financial records, accounts and statements.(Refer to discussion of assertions in Chapter 9.)

Control: Write a brief explanation of desirable controls,missing controls and especially the kinds of “deviations” thatmight arise from the situation described in the case.

Test of controls:Write some procedures for getting evi-dence about existing controls, especially procedures that coulddiscover deviations from controls. If there are no controls totest, then there are no procedures to perform; go then to thenext section. A “procedure” should instruct someone about thesource(s) of evidence to tap and the work to do.

Audit of balance:Write some procedures for getting evi-dence about the existence, completeness, valuation, ownershipor disclosure assertions identified in your objective sectionabove. (Refer to Appendix 10B for suggestions.)

Discovery summary:Write a short statement about the dis-covery you expect to accomplish with your procedures.

10.73 Financial Reporting: Overstated Inventory andProfits. Follow the instructions above. For this case, re-calculate the income (loss) before taxes using the cor-rect inventory figures. (Assume the correct beginningamount two years ago was $5.5 million.)

THE PHANTOM OF THE INVENTORYProblem:Overstated physical inventory caused under-stated cost of goods sold and overstated net income, cur-rent assets, total assets and retained earnings.

Method:All Bright Company manufactured lamps.Paul M., manager of the Katherine Street plant, was un-der pressure to produce profits so that the companycould maintain its loans at the bank. The loans were se-cured by the inventory of 1,500 types of finished goods,

work in process and parts used for making lamps (bases,shades, wire, nuts, bolts and so on). Paul arranged thephysical inventory counting procedures and accompa-nied the external audit team while the external auditorsobserved the count and made test counts after the com-pany personnel had recorded their counts on tags at-tached to the inventory locations. At the auditors’ re-quest, Paul directed them to the “most valuable”inventory for their test count, although he did not showthem all of the most valuable types. When the auditorswere looking the other way, Paul raised the physicalcount on inventory tags the auditors would not includein their test counts. When everyone had finished eachfloor of the multistory warehouse, all the tags weregathered and sent to data processing for computer com-pilation and pricing at FIFO cost.

Paper trail: All Bright had no perpetual inventoryrecords. All the record of the inventory quantity andpricing was in the count tags and the priced compila-tion, which was produced by the data processing de-partment six weeks later. The auditors traced their testcounts to the compilation and did not notice the raisedphysical quantities on the inventory types they did nottest count. They also did not notice some extra (ficti-tious) tags Paul had handed over to data processing.

Amount:Paul falsified the inventory for three yearsbefore the company declared bankruptcy. Over that pe-riod, the inventory was overstated by $1 million (20 per-cent, two years ago), $2.5 million (45 percent, one yearago), and $3 million (42 percent, current year). The fi-nancial statements showed the following (dollars in000s):

10.74 Purchase Kickbacks. Follow the instructions precedingCase 10.73. This time, let your initial objective be to se-lect one vendor for investigation. Instead of a “test ofcontrols” section, name the one vendor you would selectfrom those in Exhibit 10.74–1 and tell your reasons. Inthe “test of balances” section, tell how you would inves-tigate the situation. In the “discovery summary” section,


CHAPTER 10

Two Years Ago One Year Ago Current Year

Sales $25,000 $29,000 $40,000Cost of goods sold (20,000) (22,000) (29,000)Expenses ( 5,000) ( 8,000) ( 9,000)Income (loss) before taxes 0 $ (1,000) $ 2,500Ending inventory $ 6,00 $ 8,000 $10,200Other current assets 9,000 8,500 17,500Total assets 21,000 21,600 34,300Current liabilities 5,000 5,500 13,000Long-term debt* 5,500 6,600 9,300Shareholder equity 10,500 9,500 12,000

*Secured by inventory pledged to the bank.

speculate about how your investigation might reveal theculprit.

PURCHASING STARSProblem:Kickbacks taken on books or supplies inven-tory purchases caused inflated inventory, cost of goodssold and expenses.

Method:Bailey Books, Inc., is a retail distributor ofupscale books, periodicals and magazines. Bailey has431 retail stores throughout the southeastern states.Three full-time purchasing agents work at corporateheadquarters. They are responsible for purchasing all theinventory at the best prices available from wholesale job-bers. They can purchase with or without obtaining com-petitive bids. The three purchasing agents are R.McGuire in charge of purchasing books, M. Garza incharge ofpurchasing magazines and periodicals, and L.Collins (manager of purchasing) in charge of orderingmiscellaneous items, such as paper products and storesupplies.

One of the purchasing agents is suspected of takingkickbacks from vendors. In return, Bailey is thought tobe paying inflated prices, which first go to inventory andthen to cost of goods sold and other expense accounts asthe assets are sold or used.

L. Collins is the manager in charge. Her duties do notinclude audit or inspection of the performance of theother two purchasing agents. No one audits or reviewsCollins’s performance.

Paper trail:The purchasing system is computerized,and detail records are retained. An extract from theserecords is in Exhibit 10.74–1.

Amount:This kickback scheme has been going onfor two or three years. Several hundred thousand dollarsmay have been overpaid by Bailey Books.

(NACFE adapted)

10.75 Fictitious Vendors, Theft and Embezzlement. Followthe instructions preceding Case 10.68. Write the AuditApproach section.

LIKE A SONProblem:Fictitious purchases, overstated inventory andinflated costs and expenses, causing misstated financialstatements and operating losses.

Method:Simon Construction Company had two di-visions. Simon, the president, managed the roofing divi-sion. Simon delegated authority and responsibility formanagement of the modular manufacturing division toJohn G. A widower, Simon had virtually adopted John


E X H I B I T 1 0 . 7 4 – 1 SUMMARY OF PURCHASING ACTIVITY

Bailey Books, IncorporatedSelected Purchases 2000-2002

Percent of Items Date of Purchases Bid

Vendor Purchased 2000 2001 2002 Last Bid (3-yr. Period)

Armour Books 683,409 702,929 810,100 12/01/02 87%Burdick Sundries 62,443 70,949 76,722 — —Canon Magazines 1,404,360 1,947,601 2,361,149 11/03/02 94DeBois, Inc. Paper 321,644 218,404 121,986 06/08/02 57Elton books Books 874,893 781,602 649,188 07/21/02 91Fergeson Books 921,666 1,021,440 1,567,811 09/08/02 81Guyford Magazines 2,377,821 2,868,988 3,262,49 10/08/02 81Hyman, Inc. Supplies 31,640 40,022 46,911 10/22/02 —Intertec Books 821,904 898,683 949,604 11/18/02 86Jerrico Paper 186,401 111,923 93,499 10/04/02 72Julian-Borg Magazine 431,470 589,182 371,920 02/07/02 44King Features Magazines 436,820 492,687 504,360 11/18/02 89Lycorp Sundries 16,280 17,404 21,410 — —Medallian Books — 61,227 410,163 12/15/02 99Northwood Books 861,382 992,121 — 12/07/01 —Orion Corp. Paper 86,904 416,777 803,493 11/02/01 15Peterson Supplies 114,623 — — N/A N/AQuick Supplies — 96,732 110,441 11/03/02 86Robertson Books 2,361,912 3,040,319 3,516,811 12/01/02 96Steele Magazines 621,490 823,707 482,082 11/03/02 90Telecom Sundries 81,406 101,193 146,316 — —Union Bay Books 4,322,639 4,971,682 5,368,114 12/03/02 97Victory Magazines 123,844 141,909 143,286 06/09/02 89Williams Sundries 31,629 35,111 42,686 — —


E X H I B I T 1 0 . 7 6 – 1 EXCERPT FROM ACCOUNTS PAYABLE TRIAL BALANCE: DECEMBER 31, 2002

Voucher # Vendor Name Invoice # Date Invoice Date Due Amount

26695 Industrial Uniforms 66681 01-Oct-02 01-Nov-02 112.1126694 Industrial Uniforms 67127 08-Oct-02 08-Nov-02 112.1127209 Industrial Uniforms 67582 15-Oct-02 15-Nov-02 112.1127208 Industrial Uniforms 67981 22-Oct-02 22-Nov-02 112.1127210 Industrial Uniforms 68462 29-Oct-02 29-Nov-02 112.1127552 Industrial Uniforms 68972 05-Nov-02 05-Dec-02 112.1127553 Industrial Uniforms 69463 12-Nov-02 12-Dec-02 112.1127854 Industrial Uniforms 69851 19-Nov-02 19-Dec-02 112.1129123 industrial Uniforms 70851 03-Dec-02 03-Jan-03 112.1128095 Industrial Uniforms 71353 10-Dec-02 10-Jan-03 112.1129437 Industrial Uniforms 71831 17-Dec-02 17-Jan-03 112.11Vendor total 1,233.2127484 B&B Experimental Co 17490 04-Nov-02 04-Dec-02 2,354.5027550 B&B Experimental Co 17492 04-Nov-02 04-Dec-02 371.2527559 B&B Experimental Co 17495 08-Nov-02 08-Dec-02 148.5027560 B&B Experimental Co 17493 08-Nov-02 08-Dec-02 396.0027741 B&B Experimental Co 17502 09-Nov-02 09-Dec-02 560.2527475 B&B Experimental Co 17508 12-Nov-02 12-Dec-02 145.1129494 B&B Experimental Co 17512 16-Nov-02 16-Dec-02 1,284.2527556 B&B Experimental Co 17474 18-Nov-01 18-Nov-02 265.5027662 B&B Experimental Co 17514 22-Nov-02 22-Dec-02 519.7528084 B&B Experimental Co 17523 26-Nov-02 26-Dec-02 938.3428085 B&B Experimental Co 17546 30-Nov-02 20-Dec-02 893.6228086 B&B Experimental Co 17549 06-Dec-02 06-Jan-03 1,607.72Vendor total 9,484.7929377 Cameo Corp 44298 06-Dec-02 28-Feb-03 1,429.0229379 Cameo Corp 44300 06-Dec-02 28-Feb-03 1,747.9329378 Cameo Corp 44413 07-Dec-02 28-Feb-03 259.3329374 Cameo Corp 44412 07-Dec-02 28-Feb-03 808.3329380 Cameo Corp 44415 07-Dec-02 28-Feb-03 844.7129382 Cameo Corp 44414 07-Dec-02 07-Feb-03 1,553.1929372 Cameo Corp 44596 09-Dec-02 28-Feb-03 3,781.0129371 Cameo Corp 44682 10-Dec-02 28-Feb-03 1,262.5929383 Cameo Corp 44684 10-Dec-02 10-Feb-03 4,094.8229381 Cameo Corp 44681 10-Dec-02 28-Feb-03 926.5129385 Cameo Corp 44685 10-Dec-02 28-Feb-03 3,750.4429373 Cameo Corp 44680 10-Dec-02 28-Feb-03 1,124.7829370 Cameo Corp 44983 10-Dec-02 28-Feb-03 3,973.39Vendor total 25,556.0527120 Central Pension 15-Apr-02 15-Apr-02 10,558.2327121 Central Pension 15-May-02 15-May-02 10,558.2327122 Central Pension 15-Jun-02 15-Jun-02 10,558.2327123 Central Pension 15-Jul-02 15-Jul-02 10,558.2327124 Central Pension 15-Aug-02 15-Aug-02 10,558.2327125 Central Pension 15-Sep-02 15-Sep-02 10,558.2327126 Central Pension 15-Oct-02 15-Oct-02 10,588.23Vendor total 73,907.61


when he ran away from an orphanage 20 years earlier,treating him like the son he never had, even buildinghim a fine house on the outskirts of the city.

John and his secretary handled all the bids for manu-facturing jobs, purchased all the material, controlled thephysical inventory of materials, contracted for shippingby truck, supervised the construction activity, billed thecustomers when jobs were in progress and finished, ap-proved all bid changes and collected payments from thecustomers. With Simon’s approval, John asked the com-pany internal auditor not to interfere with his busy sched-ule. The secretary entered all the division’s transactionsinto the computerized accounting system from a dedi-cated terminal in the manufacturing division office.

John did everything crooked, and the secretary wasan accomplice. He rigged low bids and gave kickbacksto customers’ purchasing agents, paid high prices tosuppliers and took kickbacks, set up dummy companiesto sell materials to Simon Construction at inflatedprices, removed excess materials inventory and sold itand took the money, manipulated the inventory ac-counts to overstate the inventory and hide the thefts, andcaused Simon Construction to pay trucking bills for aside business he owned. Simon exercised no controlover John’s operations.

Paper trail: Paper evidence was plentiful, if some-body looked for it. Bid records showed original lowbids, later raised for basic construction (e.g., addingsecond floor, when the original request for bid includeda second floor). Cheques payable to “cash” were en-dorsed by people known to be customers’ purchasingagents. Prices paid for materials and supplies werehigher than the list prices shown in the competing sup-pliers’ price books kept in the manufacturing division li-brary. John’s kickbacks were deposited in his own bankaccount. Dummy companies were incorporated in thesame province, with John and the secretary listed asoriginal incorporators. The physical inventory shown inthe accounts simply did not exist. Trucking bills showeddeliveries to locations where the manufacturing divisionhad no jobs in progress.

Amount:John drained $1.2 million from Simon Con-struction over a nine-year period before he was caught.Auditors were engaged to analyze the situation when Si-mon finally noticed the reported losses in the manufac-turing division and had a violent argument with John.

10.76 Liability Understatement.Follow the instructions pre-ceding Case 10.73. This time, along with your proce-dural solution, specify the discrepancies you notice bystudying the excerpt from the accounts payable trial bal-ance in Exhibit 10.76–1. Also, recalculate the incomebefore taxes and write the adjusting journal entry youwould propose.

THE BULGING DESK DRAWERSProblem:Failure to record purchases of raw materialsand expense items caused understated accounts payable,understated cost of goods sold, understated expensesand overstated income.

Method:All Bright Company manufactured lamps. L.Mendoza, the company financial vice president, knew thecompany was under pressure to produce profits in orderto maintain its loans at the bank. One of the surest waysaccountants know to produce profits with a pencil isto fail to record purchases. This keeps expenses off thebooks and understates cost of goods sold figured on a pe-riodic inventory basis. (Cost of goods sold = Beginninginventory + Purchases – Ending inventory.)

Mendoza opened the mail each day and removed theinvoices from suppliers, putting them in the office deskdrawer. Later, when the company could “afford it,”some invoices were sent to the accounts payable de-partment for recording. Mendoza did not always getthem in sequence of arrival, but that didn’t matter muchto her. Anyway, the desk drawers were getting full.

The clerks in the accounts payable department knewabout this manipulation. They would go through periodswith very little to record, then a large stack of invoiceswould be delivered for recording. (Must have made a bigsale, they gossiped.)

The clerks followed control procedures about match-ing invoices with receiving reports, and they always hada full file of “unmatched receiving reports” awaiting thearrival of invoices. Mendoza had the power to overridecontrols that called for the timely recording of pur-chases, and the clerks could not record invoices they hadnot yet received.

Paper trail: The accounts payable clerks gave eachinvoice-receiving report-purchase order set a vouchernumber in numerical sequence. They dated the accountspayable and related debit recordings on the day theyprocessed the vouchers. Their vouchers were alwayscomplete because they were under strict orders not torecord any payables that were not supported by sourcedocuments.

The problem with the paper trail is that the recordingdid not get started until Mendoza delivered the invoices.However, there was a file of the unmatched receiving re-ports in the accounts payable department, forwarded fromthe receiving employees, and there was a trial balance ofaccounts payable produced for the auditors.

An excerpt from this trial balance is in Exhibit10.76–1. The total accounts payable on the trial balance,not shown in Exhibit 10.76–1, was $1.8 million for theyear ended December 31, 2002. (The signs of delayedrecording of accounts payable are in the exhibit. Can youfind them?)

Amount: Mendoza held back the recording of ac-counts payable for two years (the current year 2002, andone year ago 2001). One year ago, the accounts payablewere understated by $500,000, of which $200,000 wasunrecorded purchases for inventory and $300,000 wasunrecorded operating expenses. In the current year(2002), the accounts payable were understated at De-cember 31 by $750,000, of which $450,000 was for in-ventory purchases, and $300,000 was unrecorded operat-ing expenses. The financial statements showed thefollowing (dollars in 000s):

10.77 Audit of Capital Assets.At the beginning of her exam-ination of the financial statements of Nuclear Data Ltd.,a small manufacturer of nuclear particle analysers usedin university research laboratories and the like, a PA andher audit team studied the company’s business and in-dustry. The company’s shares were recently listed on theVancouver Stock Exchange.

While performing analytical procedures, the PAnoted that Nuclear Data’s debt-to-equity ratio had in-creased substantially from 1:2 to 2:1 during the year.However, the rate of return on common equity also in-creased.

Profitability was improved relative to the previousyear primarily because of excellent results in the fourthquarter. Not only were quarterly sales about 25 percentgreater than in the previous fiscal year, but the gross mar-gin also increased. The controller pointed out that onereason for the profitability improvement was the use ofpercentage-of-completion method to account for certainlarge pieces of equipment being built on special order fora major university. The equipment was about 75 percentcomplete at year-end, and 75 percent of the expectedgross profit was therefore recorded in the current ficalyear.

A preliminary review of internal control showed thatthe documents and records were adequate, and thatthere was a system of authorization and approval formajor purchases, sales, cash receipts and cash disburse-ments. However, because of the small size of the com-pany, the number of personnel involved in processingtransactions was very limited. Moreover, top manage-ment was by and large neither involved nor interested inthe internal control system, concentrating instead onmarketing, production and other operation matters.

Required:a. Identify the various elements of the audit risk model

and explain how (if at all) each element is affected inthis case (that is, would increase or decrease relativeto a normal or typical audit).

b. List six substantive audit procedures the PA shouldperform with respect to the items being accountedfor on a percentage-of-completion basis in the finan-cial statements.

c. The PA is thinking of using physical units attributesampling in performing certain audit tests. Do youthink the use of attribute sampling is appropriate inthis case? Explain.

(CGAAC adapted)


Two Years Ago One Year Ago Current Year

Sales $(25,000) $(29,000) $(40,500)Cost of goods sold (20,000) (22,000) (29,000)Expenses (5,000) (8,000) (9,000)Income (loss)before taxes 0 $ (1,000) $ (2,500)Ending inventory $ (6,000) $ (8,000) $(10,200)Current assets (9,000) (8,500) (17,500)Total assets (21,000) 21,600) (34,300)Current liabilities (5,000) (5,500) (13,000)Long-term debt* (5,500) (6,600) (9,300)Shareholder equity (10,500) (9,500) (12,000)

*Secured by inventory pledged to the bank.

11.70 Inventory and Deferred Cost Overstatement.

INSTRUCTIONS FOR DISCUSSION CASES 11.70–11.72:These cases are designed like the ones in the chapter.They give the problem, the method, the paper trail andthe amount. Your assignment is to write the audit ap-proach portion of the case organized around these sec-tions:

Objective:Express the objective in terms of the factssupposedly asserted in financial records, accounts andstatements. (Refer to discussion of assertions in Chap-ter 4.)

Control: Write a brief explanation of desirable con-trols, missing controls and especially the kinds of “de-viations” that may arise from the situation described inthe case.

Test of controls:Write some procedures for gettingevidence about existing controls, especially proceduresthat could discover deviations from controls. If there areno controls to test, then there are no procedures to per-form; go then to the next section. A “procedure” shouldinstruct someone about the source(s) of evidence to tapand the work to do.

Audit of balance:Write some procedures for gettingevidence about the existence, completeness, valuation,ownership or disclosure assertions identified in your ob-jective section above.

Discovery summary:Write a short statement aboutthe discovery you expect to accomplish with your pro-cedures.

TOYING AROUND WITH THE NUMBERSProblem:Mattel, Inc., a manufacturer of toys, failed towrite off obsolete inventory, thereby overstating inven-tory, and improperly deferred tooling costs, both ofwhich understated cost of goods sold and overstated in-come.

Method:“Excess” inventory was identified by com-paring types of toys (wheels, general toys, dolls,games), parts and raw materials with the forecastedsales or use. Lower-of-cost-or-market (LCM) determi-nations then were made to calculate the obsolescencewrite-off. Obsolescence was expected, and the target forthe year was $700,000. The first comparison computerrun showed $21 million “excess” inventory! The com-pany “adjusted” the forecast by increasing the quantitiesof expected sales for many toy lines. (Forty percent ofitems had forecasted sales greater than the recent actualsales experience.) Another “adjustment” was to forecasttoy closeout sales not at reduced prices but at regularprices. Also, certain parts were labelled “interchange-able” without the normal reference to a new toy product.These “adjustments” to the forecast reduced the “ex-cess” inventory exposed to LCM valuation and write-off.

The cost of setting up machines, preparing dies andother preparations for manufacture are “tooling costs.”They benefit the lifetime run of the toy manufactured.The company capitalized them as prepaid expenses andamortized them in the ratio of current-year sales to ex-pected product lifetime sales (much like a natural re-source depletion calculation). To get the amortizationcost lower, the company transferred unamortized tool-ing costs from toys with low forecasted sales to oneswith high forecasted sales. This caused the year’s amor-tization ratio to be smaller, the calculated cost write-offlower and the cost of goods sold lower than it shouldhave been.

Paper trail: The computer-forecast runs of expecteduse of interchangeable parts provided a space for a ref-erence to the code number of the new toy where the partwould be used. Some of these references contained thecode number of the part itself, not a new toy. In othercases the forecast of toy sales and parts use containedthe quantity on hand, not a forecast number.

In the tooling cost detail records, unamortized costwas classified by lines of toys (similar to classifying as-set cost by asset name or description). Unamortized bal-ances were carried forward to the next year. The com-pany changed the classifications shown at the prioryear-end to other toy lines that had no balances or dif-ferent balances. In other words, the balances of unamor-tized cost at the end of the prior year did not match thebeginning balances of the current year, except that the to-tal prepaid expense amount was the same.

Amount:For lack of obsolescence write-offs, inven-tory was overstated $4 million. The company recordeda $700,000 obsolescence write-off. It should have beenabout $4.7 million, as later determined.

The tooling cost manipulations overstated the prepaidexpense by $3.6 million.

The company reported net income (after taxes) of$12.1 million in the year before the manipulations tookplace. If pretax income was in the $20–$28 millionrange in the year of the misstatements, the obsolescenceand tooling misstatements alone amounted to about 32percent income overstatement.

11.71 Inadequate Payroll Time Records. Follow the in-structions accompanying Discussion Case 11.70.

PAYROLL IN THE BLUE SKYProblem:SueCan Corporation deferred costs under theheading of defence contract claims for reimbursementand deferred tooling labour costs, thus overstating as-sets, understating cost of goods sold and overstating in-come.

Method:SueCan manufactured electronic and otherequipment for private customers and government de-fence contracts. Near the end of the year, the companyused a journal entry to remove $110,000 from cost of


CHAPTER 11

goods sold and defer it as deferred tooling cost. This$110,000 purported to be the labour cost associatedwith preparing tools and dies for long production runs.

The company opened a receivables account for “costoverrun reimbursement receivable” as a claim for reim-bursement on defence contracts ($378,000).

Paper trail: The company altered the labour timerecords for the tooling costs in an effort to provide sub-stantiating documentation. Company employees pre-pared new work orders numbered in the series used latein the fiscal year and attached labour time records datedmuch earlier in the year. The production orders origi-nally charged with the labour cost were left completedbut with no labour charges!

The claim for reimbursement on defence contractsdid not have documentation specifically identifying thelabour costs as being related to the contract. There wereno work orders. (Auditors know that Defence Ministryauditors insist on documentation and justification beforeapproving such a claim.)

Amount: SueCan reported net income of about$442,000 for the year, an overstatement of approxi-mately 60 percent.

11.72 Employee Embezzlement via Padded Payroll. Followthe instructions accompanying Discussion Case 11.70.In this case (11.72, aka 19.53) your assignment is to an-alyze the payroll register and see if you can identify anyof the ghosts. (This register is short, and you can try todo the analysis visually.

This case is a duplication of Discussion Case 19.53in Chapter 19 (Ghost Riders on the Payroll). It involvesan examination of some payroll information for ficti-tious employees using fraud auditing knowledge fromChapter 19. Case 19.53 is at the end of Chapter 19.

Required:Analyze the payroll register in Exhibit 19.53–1 andidentify the questionable employees who might beghosts on the payroll.


12.60 Loss Deferral on Hedged Investments.This case con-tains complexities that preclude writing the entire AuditApproach according to the instructions accompanyingCase 12.53. Instead, respond to these requirements:a. What is the objective of the audit work on the invest-

ment account described in the Sharp Hedge Clipperscase?

b. What is your conclusion about the propriety of defer-ring the losses on the hedged investments sales andthe futures contracts? about the proper carryingamount of the investment in the balance sheet?

c. Do you believe the successor auditors were inde-pendent? competent? Discuss the practice of “shop-ping around” for an unqualified audit report.

SHARP HEDGE CLIPPERSProblem: Southeastern Savings & Loan Company(Southeastern) overstated its assets and income by im-properly deferring losses on hedged investment transac-tions.

Method: In the course of its normal operations,Southeastern held investments in 15 percent and 16 per-cent GNMA certificates. Fearing an increase in interestrates and a consequent loss in the market value of theseinvestments, Southeastern sought to hedge by selling fu-tures contracts for U.S. Treasury bonds. If market inter-est rates increased, the losses in the GNMA investmentswould be offset by gains in the futures contracts.

However, interest rates declined, and Southeasternwas caught in an odd market quirk. The value of theGNMAs increased with the lower interest rates, but notvery much. (GNMAs are certificates in pools of gov-ernment-backed mortgages, which pass through the in-terest and principle collections to the certificate hold-ers.) As interest rates declined, the market perceivedthat the underlying mortgages would be paid off morequickly, that investors would receive all their proceedsearlier than previously expected, and that they wouldneed to reinvest their money at the now-lower interestrates. Consequently, the 15 percent and 16 percent GN-MAs held by Southeastern began trading as if the ex-pected maturity were 4–5 years instead of the previ-ously expected 8–12 years, which means that theirprices did not rise as much as other interest-sensitive se-curities. On the other hand, the U.S. Treasury bondswith fixed maturity dates fell in price, and the futureshedge generated large losses.

Southeastern sold its 15 percent and 16 percent GN-MAs and realized a $750,000 gain. Before and afterthese sales, the company purchased 8.0–12.5 percentGNMAs. The goal was to be invested in substantiallydifferent securities, ones that had a market return andthe normal 8–12-year expected life payout. Later,Southeastern closed out its Treasury bond futures andrealized a loss of $3.7 million. Still later, Southeasternsold GNMA futures contracts to hedge the investment in

the 8.0–12.5 percent GNMA investments. The net lossof about $3 million was deferred in the balance sheet,instead of being recognized as a loss in the incomestatement.

Paper trail/accounting principles:The accountingfor these transactions is complex and requires some sig-nificant judgements. In general, no gain or loss isrecognized when the security sold is simultaneously re-placed by the same or substantially the same security (a“wash” transaction), provided that any loss deferraldoes not result in carrying the investment at an amountgreater than its market value. When a futures hedge isrelated to the securities sold, gains and losses on the fu-tures contracts must be recognized when the hedged se-curities are sold, unless the sale of the hedged securitiesis part of a wash sale.

The significant accounting judgement is the identifi-cation of the disposition and new investment as a washtransaction. In turn, this requires a determination ofwhether the sale and reinvestment is “simultaneous”and involves “substantially the same security.”

The “paper trail” is littered with information relevantto these judgements:

Southeastern Criterion Transaction

Timing:Simultaneous sale/ Some of the 15 percent and 16 percent

purchase or GNMAs were sold six weeks afterpurchase/sale. the 8.0–12.5 percent GNMAs were

purchased.Substantial similarity:Same issuer. Both the securities sold and the securities

purchased were GNMAs.Similar market yield. The yields on the two different GNMA

series differed by about 3 percentagepoints.

Similar contractual The contractual maturity maturity date. dates were the same.

Similar prospects for The market priced and sold redemption.the 15 percent and 16 percent GNMAsas though payback would occur in 4–5years and the 8.0–12.5 percent GNMAsas though payback would occur in 8–12 years.

Carrying value:Asset carrying amount, Asset value in financial statements exceeded

including any deferred the market value.loss, shall not exceed securities’ market value.

Paper trail/auditor involvement:Southeastern’s inde-pendent auditors concluded that the losses should not bedeferred. Southeastern fired the auditors and reportedthe disagreement in the 8-K report filed with the SEC.After consulting other auditors, who agreed with theformer auditors, Southeastern found a PA firm whose


CHAPTER 12

local partners would give an unqualified audit report onfinancial statements containing the deferral.

In February the auditors who disagreed with the de-ferral were fired. The new auditors were hired on Feb-ruary 18 to audit the financial statements for the yearended the previous December 31. The unqualified auditreport was dated March 28, 39 days after the new audi-tors were engaged by Southeastern’s audit committee.

The new auditors were well aware of the accountingjudgements required. They knew the former auditorsand another PA firm had concluded that the lossesshould not be deferred. They saw memoranda of the dis-agreement and the conclusion in the predecessor’sworking papers. They spoke with the predecessor part-ner on the engagement.


14.56 Omitted Audit Procedures.The following are inde-pendent situations that have occurred in your audit firm,Arthur Hurdman (AH):*1. During the internal inspection review by the regional

office of AH, one of your clients, Wildcat OilSuppliers, was selected for review. The reviewersquestioned the thoroughness of inventory obsoles-cence procedures, especially in light of the depressedstate of the oil exploration industry at the time. Theyfelt that specific procedures, which they consideredappropriate, were not performed by your audit team.

2. Top Stove, one of your clients, installed a micro-computer in July 2002 to process part of the account-ing transactions. You completed the audit of TopStove’s December 31, 2002 statements on February15, 2003. During the April 2003 review work on TopStove’s first-quarter financial information, you dis-covered that during the audit of the 2002 statementsonly the manual records were investigated in thesearch for unrecorded liabilities.

3. AH belongs to the private companies practice section(PCPS) of the AICPA division of firms. In keepingwith membership requirements of the PCPS, AHcontracted with Haskin and Anderson (HA) to con-duct a peer review of AH’s audit quality control pro-cedures. In HA’s report to AH, the audit of Al’s StoreOrganization (ASO) was criticized due to the letter-head on ASO’s representation letter. Although therepresentation letter complied with the requirementsof SAS 19, it was prepared on the letterhead of thePalo Alto Garden Club. (Al’s wife, Alice, had beenpresident of the club during the period of the audit.)

Required:a. Without regard to the specific situation given, answer

the following questions:(1) What are the proper steps auditors should take if

it is discovered, after the report date, that anauditing procedure was omitted?

(2) How are auditors’ decisions affected if, afterreview of the workpapers, it is determined thatother audit procedures produced the necessarysufficient, appropriate evidence?

(3) If in subsequently applying the omitted proce-dure, the auditors become aware of material newinformation that should have been disclosed inthe financial statements, how should they pro-ceed?

b. Describe the proper action to take in each situationabove, given the additional information providedbelow:Case 1:You made a thorough consideration on thescope of the audit of Wildcat Oil Suppliers, and youmade a detailed review of the working papers. Youhave concluded that compensating procedures wereconducted sufficient to support the valuation ofinventory.Case 2:Your subsequent investigation of the micro-computer records of Top Stove revealed that materialliabilities were not recorded as of December 31.Case 3:You were requested to investigate the ASOalleged audit procedure deficiency. Your investiga-tions revealed that ASO had a significant loan fromthe local bank that had received the AH report onASO’s financial statements. The loan is still out-standing, and indeed the representation letter waswritten on the garden club letterhead.

14.57 Second Partner Review and Dual Dating.You havebeen assigned to perform a review of a correspondentPA firm’s audit of Oxford Millwork Company for thecalendar year ending December 31. In the audited fi-nancial statements of Oxford Millwork Company, youfind the following representations:

Common shares, $10 par value,100,000 shares outstanding,400,000 shares authorized(Note 1) $1,000,000Note 1: Subsequent event (dated January 20). Theboard of directors approved a three-for-one stockdividend effective January 20. At the effective date,the par value of outstanding common shares is $3million.You have reviewed the correspondent PA firm’s au-

dit report and found the opinion dated “January 15,2003, except as to Note 1 which is dated January 20,2003.”

Required:a. What is the purpose of a second partner review?b. What is the purpose of dual dating?c. What recommendations would you make to the PA

firm concerning presentation of the subsequentevent?


CHAPTER 14

* Situation derived from examples given in Thomas R. Weirich and Elizabeth J. Ringelberg, “Omitted Audit Procedures,” CPA Journal, March 1984, p. 36.

14.58 Recognizing Income of a Purchased Subsidiary.Thefollowing brief dialogue occurred in a controversywherein a plaintiff claimed that management backdatedthe effective date of an acquisition in order to pump upearnings improperly. The independent auditors, East-ford and Redwood (E&R), are involved because theysigned an unqualified report on the consolidated finan-cial statements in question.Plaintiff’s lawyer: Plaintiff alleges that COSIF Com-pany’s purchase of 100 percent of the stock of Prosper,Inc., was effective on April 28, almost four months af-ter the beginning of COSIF’s fiscal year on January 1.However, COSIF included in consolidated income theresults of Prosper’s operations for the full 12 monthsended December 31. This was improper accountingwhich failed to reflect the substance of the transaction.

Eastford and Redwood knew, or should have known,that the effective date was April 28. The evidence showntoday proves that the first written agreement concerningthe acquisition was a memorandum dated March 5,which set forth the general terms of the transaction. Thefinal written agreement was signed and dated on April28. Their unqualified opinion was improperly rendered.Eastford and Redwood’s Lawyer:The issue is whetherJanuary 1 or some later date should have been used asthe acquisition date for accounting purposes. E&R stip-ulate that the first written memorandum was datedMarch 5 and the final agreement April 28. However, wehave also introduced into evidence written representa-tions from the president of COSIF and COSIF’s outsidecounsel that an oral agreement substantially equivalentto the March 5 memorandum agreement was reached onor about January 1. COSIF’s outside counsel is one ofthe most highly regarded law firms in the Maritimes.

These representations were meaningful to E&R be-cause we were not engaged as COSIF’s auditors untilNovember 14 and were not present when the actual ne-gotiations took place.

Plaintiff alleges that applicable accounting principleswere misapplied because no written agreement existedon January 1.

We insist that elements of the April 28 agreement,which made the acquisition effective as of January 1,show that the substance of the transaction supports ourconclusion that January 1 was the proper accountingdate. We cite the following:1. COSIF and Prosper clearly intended an effective date

of January 1.2. The fixed portion of the purchase price depended on

a minimum amount of Prosper’s income throughDecember 31 of the year preceding. (At March 5 theaudit of Prosper’s financial year had not yet beencompleted.)

3. The contingent portion of the purchase pricedepended on a minimum amount of Prosper’sincome for the year beginning January 1 and twoyears thereafter.

4. Warranties made by Prosper as to assets and liabili-ties were as of December 31 (just prior to the January1 effective date).

5. Interest on COSIF’s notes issued in the paymentpackage ran from January 1.

6. The full amount of Prosper’s earnings from January1 inured to the benefit of COSIF.

Required:What is the proper accounting date for COSIF’s invest-ment in Prosper?

14.59 Contingencies. Northern Lights Pulp and Paper Com-pany (NL) has been an audit client of Web & Web, Char-tered Accountants, for several years. NL was provinciallyincorporated in 1975 and has operated two small pulp-and-paper mills in Northern Ontario since that time.

Hard hit by the recession, the company has experi-enced losses in its last three years, but current-year in-come projections are optimistic. Like its competitors inthe forest industry, NL has managed to cut costs and in-crease productivity and predicts a significant profit forthe year ended December 31, 2004.

It is August 2004. You have just been assigned as thesenior-in-charge of NL since the previous senior ac-cepted a position as controller in the private sector. Theinterim audit was completed by the previous senior. Thepartner has asked you to become familiar with the clientby reviewing the permanent file, the interim file and themany notes prepared by the previous senior. He wouldalso like you to prepare a memo addressing audit issuesyou identify based on your review. You noted the fol-lowing in performing your review of the files:1. Current year (2004) projected net income is

$5,000,000. Prior year (2003) losses were $1,200,000(2002–$2,000,000, and 2001–$3,500,000). Industrystatistics reported total annual losses of $1.4 billion in2002 to under $200 million in 2003.

2. The controller who had been with the company for12 years was fired in April 2004. A recently qualifiedchartered accountant was hired as the new controller.

3. The computerized system was converted during thefirst six months of the year. No parallel runs wereperformed since the software package purchased wascommon to the forest industry. At the interim audit,several accounts were not reconciled. The vice pres-ident, finance, believes that the balances were nottransferred correctly and has promised to look intothis before year-end.

4. A letter was received in May 2004 from the provin-cial government requiring the company to meet anindividual contamination reduction target by 2005.To meet these targets, NL must build a new, second-ary biological treatment plant. No action to meetthese targets had been taken at the time of the interimaudit. The company plans to begin construction ofthe new treatment plant in September 2004. The let-


DISCUSSION CASES

ter indicates that heavy fines will be imposed if thecompany does not comply by the due date.

5. In March 2004, a chemical engineer was hired tohelp the general manager of each mill establish duediligence standards. This action was taken inresponse to fears raised by the president, whobecame aware that Bata Industries and two of itsdirectors were convicted of an environmental offencein 2002. The due diligence standards had not beendeveloped at the time of the interim audit as thechemical engineer had been involved in establishinga way to reduce costs. In 2003, NL was fined$30,000 for failing to meet pollution emission stan-dards.

6. Legal fees increased 150 percent during the first sixmonths of 2004, in comparison to the first six monthsof 2003.

7. Over the period April to June 2004, NL issuedcheques totalling $90,000 to the president and thechemical engineer. According to the new controller,the president and the chemical engineer each earneda $45,000 bonus for the first six months of the yeardue to the improved financial performance of thecompany. The president asked the controller to paythe bonus over a three-month period. Therefore, sixcheques of $15,000 each were issued.

8. The minute book (shareholders’ and directors’ meet-ings) was not updated for the interim audit but isexpected to be up to date for the year-end audit.

9. After much hesitation, the president finally agreed tosign the 2003 management representation letter.

Required plan:Prepare the memo requested by the partner addressingaudit issues and their impact on the 2004 audit. Thememo should also address risk factors, materiality andthe overall audit approach for the 2004 audit.

(ICAO adapted)

14.60 Contingencies. You are the senior auditor in charge ofthe field work for the examination of the financial state-ments of ABC Chemical Corporation for the year endedDecember 31, 2005. The company produces chlorineand related products, which are used as bleachingagents, primarily by pulp-and-paper companies.

An analytical review of the company’s operation forthe current year reveals that recorded sales have in-creased about 10 percent, and net income about 20 per-cent relative to the previous year. This is surprising,since demand for the company’s products has beenweak because of a long and continuing recession in theNorth American pulp-and-paper industry.

The controller attributes the improvement to an ag-gressive marketing program directed at foreign compa-nies. In addition, he claims that ABC Chemical has sig-nificantly reduced its production costs this year whilestill remaining, he thinks, within applicable pollutionand commercial laws and regulations. He also requeststhat you not include any of the foreign accounts receiv-able at year-end in your confirmation sample, since “the

practice is not normal in these countries, and is likely toharm our business relationship with these new cus-tomers.” Finally, he mentions that because of the un-usually good operating results and improving marketconditions, the company sold $10,000,000 of commonshares in November 2005.

Required:a. As auditor, do you have any responsibility for deter-

mining whether the company actually complies withpollution control laws and regulations in its opera-tions? Briefly explain.

b. Assume the foreign receivables are material inamount at December 31, 2005. Explain how youwould deal with the restriction imposed by the con-troller and how the restriction could affect your audi-tor’s report.

c. Explain how you would design a dollar unit sam-pling plan to determine the sample size for testingthe foreign receivables at year-end. Be specific inidentifying relative factors affecting sample size andtheir likely values (high, medium, or low). (Do notdiscuss selection or evaluation of the sample.)

d. List four audit procedures you would perform withrespect to the sale of common shares during the year.

(CGAAC adapted)

14.61 Contingencies. A PA is performing an audit of financialstatements of a publicly held company in accordancewith generally accepted auditing standards and hascompleted all the appropriate audit steps up to andthrough the performance of substantive tests of detailsof transaction cycles and account balances. She is there-fore in the final stages of completing the audit.

Required:a. With what third parties (if any) is the PA likely to

communicate at this stage of the audit process andwhat would be the purpose of such communication?Explain.

b. Discuss the PA’s responsibilities (if any) with respectto subsequent events occurring after the balancesheet date.

c. Discuss the PA’s responsibilities (if any) with respectto the MD&A portion of the company’s annualreport to shareholders.

d. Would it be appropriate to perform analytical proce-dures at this point in the audit? Explain.

(CGAAC adapted)

14.62 Evaluating Evidence. The purpose of substantive testingis to verify the assertions made by management in the fi-nancial statements. An auditor does this by using variousevidence gathering methods including inspection, obser-vation, enquiry, confirmation, computation and analysis.

Consider the following six unrelated audit tests thata PA performed in conjunction with the examination ofthe financial statements of a client whose fiscal yearended December 31, 2004.


1. Sent negative confirmation requests to a sample ofthe client’s customers with unpaid balances atNovember 30, 2004.

2. Requested statements as of December 31, 2004,from a large sample of vendors with whom the clientdid business during 2004.

3. Examined invoice copies and shipping documentssupporting the first 20 sales transactions recorded inJanuary 2005.

4. Inspected share certificates associated with tempo-rary investments in marketable securities, held in theclient’s safety deposit box on December 31, 2004.

5. Verified the mechanical accuracy of the “aged” list-ings, prepared by the chief accountant, of the client’saccounts receivable at December 31, 2004.

6. Counted cash on hand at December 31, 2004.

Required:For each of the six audit tests, list the management as-sertion(s) which is (are) primarily being verified andcomment on the quality (appropriateness) of the evi-dence obtained. Organize your answer as follows.

Management | Quality of|Assertion(s) | Evidence|

(CGAAC adapted)

14.63 Related Party Transactions. Susan Sharp,PA, auditedthe financial statements of her continuing client, Octo-pos Industries, for the year ended December 31, 2003.Octopos is a publicly held company whose shares aretraded on the Vancouver Stock Exchange. In discussingthe property, plant and equipment accounts with thecontroller, Sharp learned that a new machine costing$55,000,000 (a material amount) was constructed forthe company during the year by an affiliated firm, ofwhich the president of Octopos Industries is the soleshareholder.

In support of this transaction, Sharp examined an in-voice from the vendor for $55,000,000 that was stamped“paid.” She also examined a memo from the president tothe controller of Octopos, authorizing the payment ofthe invoice. Given the sensitivity of the matter, the pres-ident of Octopos instructed the controller not to disclosethe transaction in the company’s financial statements.

No other problems or unusual situations were encoun-tered during the audit, which was completed on February25, 2004.

Required:a. Describe the additional audit procedures (if any) that

Sharp should have performed with respect to themachine acquired from the affiliated company.

b. Without prejudice to your answer to part (a), assumethat Sharp had obtained sufficient, appropriate evi-dence with respect to the transaction. Prepare anauditor’s report for the case, in good form. Sharp isthe managing partner of a firm of PAs whose execu-tive offices are in Vancouver.

(CGAAC adapted)


15.49 Current Value Supplement.Ms. Carboy (Kingston’scontroller) has prepared current cost information fol-lowing the SFAS 89 guidelines. The information hasbeen placed in a section at the front of the corporate an-nual report, apart from the audited financial statements.The section declares that Anderson, Olds & Watershedhave not performed any review procedures on the infor-mation and does not express any opinion on it.

Kingston performs some welding work for customersand uses a ZB40-X-ray machine to inspect the strengthof the welds. Kingston bought its ZB40 three years agofor $60,000. Most such X-ray machines last 10 years, soKingston has recorded $6,000 amortization expense forthe current year—the third year the machine has beenused. A new ZB40 now costs $75,000. Kingston is plan-ning to purchase a second one because it is the best onthe market.

When Ms. Carboy prepared the supplementary cur-rent cost information, the BZ40 was reflected as fol-lows:

Current-year amortization expense $75,000Machinery and equipment $75,000Accumulated amortization $22,500Current-year amortization expense $7,500

Required:a. Should the audit report contain a disclaimer on the

current value supplementary information? Explain.b. Does AOW have any responsibility regarding the

current value information?c. What audit procedures can be performed with regard

to supplementary current value information? Withreference to the ZB40 machine, explain the proce-dures.


CHAPTER 15

15.50 Prepare a Compilation Report.You have been en-gaged by the Coffin Brothers to compile their financialschedules from books and records maintained by JamesCoffin. The brothers own and operate three auto partsstores in Central City. Even though their business isgrowing, they have not wanted to employ a full-timebookkeeper. James specifies that all he wants is a bal-ance sheet, a statement of operations and a statement ofcash flows. He does not have time to write up footnotesto accompany the statement.

James directed the physical count of inventory onJune 30 and adjusted and closed the books on that date.You find that he actually is a good accountant, havingtaken some night courses at the community college. Theaccounts appear to have been maintained in conformitywith generally accepted accounting principles. At leastyou have noticed no obvious errors.

Required:You are independent with respect to the Coffin brothersand their Coffin Auto Speed Shop business. Prepare areport on your compilation services engagement.

15.51 Reporting on Comparative Unaudited FinancialStatements.Anson Jones, PA, performed a review serv-ice for the Independence Company in 2003. He wants topresent comparative financial statements. However, the2002 statements were compiled by Able and Associates,PAs, and Able does not want to co-operate with Jones byreissuing the prior-year compilation report. Jones has noindication that any adjustments should be made to eitherthe 2003 or 2002 statements, which are to be presentedwith all necessary disclosures. However, he does nothave time to perform a review of the 2002 statements.

He completed his work on January 15, 2004, for thestatement dated December 31, 2003.

Required:Write Jones’ review report and include the paragraphdescribing the report on the 2002 statements.

15.52 Erroneous Reporting on Interim Financial Informa-tion. The report in the box on the following page wasprepared by Baker & Baker, public accountants, on theinterim financial information of Micro Mini Company.The interim financial information was presented in thefirst quarterly report for the three-month period endedMarch 31, 2003. No comparative quarterly informationof the first quarter of the prior year was presented. Baker& Baker completed a review in accordance with stan-dards established by the CICA and found that, to the bestof their knowledge, the information was presented inconformity with CICA requirements. In an audit reportdated January 21, 2003, Baker & Baker had given a stan-dard unqualified audit report on Micro Mini’s 2002 and2001 annual financial statements.

Required:a. Review the report and list, with explanation, the

erroneous portions in it.b. Rewrite the report.

15.53 Report on Comprehensive Basis Other Than GAAP.The Brockville Life Insurance Company prepares its fi-nancial statements on a statutory basis in conformitywith the accounting practices prescribed and permittedby the Commissioner of Insurance of the Province ofOntario. This statutory basis produces financial state-

DISCUSSION CASES

ments that differ materially from statements prepared inconformity with generally accepted accounting princi-ples. On the statutory basis, for example, agents’ first-year commissions are expensed instead of being par-tially deferred, and equity securities are reported atmarket value lower than cost, even if a “permanent im-pairment” of value is not evident.

The company engaged its auditors, Major and MajorAssociates, to audit the statutory basis financial state-ments and report on them. Footnote 10 in the statementscontains a narrative description and a numerical tableexplaining the differences between the statutory basisand GAAP accounting. Footnote 10 also reconciles thestatutory basis assets, liabilities, income, expense andnet income (statutory basis) to the measurements thatwould be obtained using GAAP.

Required:Write the audit report appropriate in the circumstances.The year-end date is December 31, 2002, and the auditfield work was completed on February 20, 2003. (Thecompany plans to distribute this report to persons otherthan the department of insurance regulators.

15.54 Service Bureau Controls.Your firm has been engagedto render an opinion on control procedures at ABC Ser-vices Ltd., which is a payroll service bureau.

Required:a. What type of circumstances might arise that would

prevent the auditor of a service organization fromissuing an opinion without reservation on controlprocedures?

b. Identify the two types of engagements for a servicebureau and compare and contrast the two types withrespect to audit standards and procedures.

(CGAAC adapted)

15.55 Audits vs. Non-audits.Woo, PA, has been engaged toperform an audit of financial statements of FST Inc.,which Smith, the owner-manager of FST, intends tosubmit to the bank in support of a loan application. Woohas applied the audit procedures he considered neces-sary in the circumstances and is “about halfway”through his collection of audit evidence when Smith in-forms him that since the bank has just indicated that areview engagement report is sufficient for its purposes,FST does not require a full audit.

Required:a. Contrast the auditor’s overall objective in the per-

formance of an audit with the accountant’s overallobjective in the performance of a review engage-ment.

b. Considering that Woo has already applied some auditprocedures to and obtained evidence regarding thefinancial statements of FST, what modificationsshould Woo make to the standard review engagementreport?

c. What are the appropriate criteria against which thefinancial statements and related disclosures aremeasured in the case of:(1) an audit?(2) a review engagement?(3) a compilation engagement?

15.56 Special Reports.As well as engagements to examine fi-nancial statements in their entirety, a PA may be en-gaged to prepare other types of special reports for aclient.

Required:a. Section 5800 of the CICA Handbookprovides for

two types of special reports.(1) Identify each type of special report.


Report of Independent AuditorsThe Board of Directors and Stockholders,Micro Mini Company:

We have made a review of the balance sheet of Micro Mini Company at March 31,2003, the related statementof income for the three-month period ended March 31, 2003,and the statement of cash flows for the three-monthperiod ended March 31, 2003, in accordance with standards established by the Canadian Institute of CharteredAccountants.

A review of interim financial information consists principally of obtaining an understanding of the systemfor the preparation of the interim financial information, applying analytical review procedures to financial dataand making enquiries to persons responsible for financial and accounting matters.

In our opinion, the accompanying interim financial information presents fairly, in all material respects, thefinancial position of Micro Mini Company at March 31, 2003, and the results of its operations and its cashflows for the three-month period then ended in conformity with generally accepted accounting principles.

Baker & Baker, PAsMarch 31, 2004

(2) Identify the standards governing each type ofexamination.

(3) Briefly explain how each of the resulting reportsdiffers from an opinion on financial statements.

b. When the auditor is engaged to report on the design,effective operation and continuity of control proce-dures at a service organization, what are the addi-tional examination responsibilities of the auditor?

(CGAAC adapted)

15.57 Objectives of Different Engagements.Pierre Landrethas recently started a landscaping and landscaping sup-ply business. The business is incorporated, with theshareholders being Pierre and his wife. His educationalbackground is a bachelor’s degree in agricultural sci-ence, and he is unfamiliar with the accounting aspects ofhis new venture. He has come to you, a CGA, for ad-vice. He says, “I want you to look at the records of mybusiness for the past year. I understand that there arethree different types of engagements that you can per-form. What are the differences between them as they af-fect my business, and what purpose might each oneserve for my business?

Required:a. Draft a reply to Mr. Landret.b. State the two matters that the public accountant must

be satisfied about before accepting a review engage-ment.

c. State the three matters that the public accountant mustbe satisfied about before accepting a compilationengagement.

(CGAAC adapted)


16.49 Failure to Follow GAAS.It’s going to be a long night!First thing this morning, the senior partner of yourthree-partner firm, Peters, Peters and Paul (“PPP”),called you into her office to tell you that she had a con-fidential but exciting assignment for you. The firm hasbeen retained to review the audit working papers of an-other firm in connection with its audit of TVB Software(TVB), a public company. That firm, Yeller, Louder andSoft (YLS), had performed the audit of TVB for the lasttwo years, since the date it went public. It appears thatthe bank did not renew TVB’s loan when it maturedsome six months ago and TVB was unable to obtainother financing. As a result, your firm’s client lost agood portion of the $2 million he had invested in theshares of TVB. Your client is suing the auditors of TVB,alleging that they failed to perform the audit in accor-dance with generally accepted auditing standards(GAAS), and that as a result, your client relied on fi-nancial statements that were not correct when he made

his decision to hold on to his TVB shares. The last au-dited statements are included in Exhibit 16.49–1.

Victoria Smyth, the partner, has reviewed the contentsof YLS’s working papers. Her notes are in Exhibit16.49–2. You have been asked to review these notes andprepare a report identifying any departures from GAASto support your client’s view that the audit was not con-ducted in accordance with GAAS. In this regard, youshould note whether each instance is a clear departurefrom GAAS or whether the matter is grey and, therefore,subject to potential challenge in court. Victoria is alsoconcerned that your firm may have some professional re-sponsibilities under the Rules of Professional Conduct inconnection with this agreement. She would like you toidentify these for her.

RequiredPrepare the report requested by Victoria Smyth.

(ICAO adapted)


CHAPTER 16


E X H I B I T 16.49–1 EXTRACTS FROM AUDITED FINANCIAL STATEMENTS

TVB SoftwareBalance Sheet

As at December 31(in thousands of dollars)

20–3 20–2

AssetsCurrent Assets

Prepaids $ 237 $ 410Accounts receivable 6,146 5,410Inventory 13,904 9,382

20,287 15,202Other Assets

Fixed assets 13,640 14,975Goodwill 4,084 4,310Other assets 6,950 7,010

24,674 26,295$44,961 $41,497

Liabilities and Shareholder EquityCurrent Liabilities

Bank indebtedness $ 4,940 $ 1,749Accounts payable 10,641 5,940Deferred revenue 140 3,643Current portion of long-term debt 1,400 1,400

17,121 12,732Long-term Debt 18,210 19,990Share capital 8,500 8,500Retained Earnings 1,130 275

Total Liabilities and Capital $44,961 $41,497

TVB SoftwareIncome Statement

For the years ended December 31(in thousands of dollars)

20–3 20–2

Sales $21,724 $31,490Cost of Sales 15,908 20,130Gross Margin 5,816 11,360Sales and Administrative Expenses

Salaries 1,760 3,170Research costs 304 3,775Marketing and sales 501 2,607Interest 1,739 1,889Other 657 16

4,961 11,457Net Income Before Taxes 855 (97)Income Taxes — 203Net Income $ 855 ($ 300)


E X H I B I T 16.49–1 (continued)

TVB SoftwareFor the year ended December 31, 2003

From Note 1—Accounting PoliciesGoodwill

Goodwill is amortized to income over its 40-year life.From Note 7—Fixed Assets

Fixed assets comprises.

December 31, 2003Accumulated Book

Cost Debt Value

Computer Equipment $29,790 $26,100 $ 3,690Furniture and Fixtures 10,650 7,700 2,950Building 11,000 4,000 7,000

Total $51,440 $37,800 $13,640

E X H I B I T 16.49–2 TVB SOFTWARE

“PRIVILEGED”

Victoria Smyth’s notes on review of audit working papers of TVB Software prepared by Yeller, Louder &Soft

1. I reviewed YLS’s working papers at their office. The audit report for the year ended December 31, 2003 wassigned by YLS on February 20, 2004.The working papers were neat and appeared to be well organized. All of the files have been prepared by auditstaff and have been reviewed by a YLS junior audit partner, though not the one who signed the financialstatements. This is the only public company audited by YLS.I asked to review the files of the previous year but was told that YLS only retains one year of files. The 2002 fileshad been destroyed. I reminded YLS that the 2002 files had now been subpoenaed by the Court.

2. The audit was staffed by two YLS CAs. Neither had performed audits of a software company before, but one ofthem had several years of auditing experience. The other CA had recently qualified and had spent the previoustwo years working for a government internal auditor’s department. The audit partner told me that he wasn’tconcerned about this other CA because he was related to TVB’s CFO and, hence, had a good knowledge ofsome of the workings of the company.

3. The audit was fully substantive in nature. All three of YLS’s files contain working papers documenting the results ofits substantive testing. Each section of the work contains a checklist of substantive tests. The tests appear to havebeen developed specifically for this assignment. The steps on the checklists appear to be signed off and cross-referenced to the appropriate working papers.

4. The first file is called the “TOP FILE” and contains several memos to file. The most significant of these are as follows:a) Materiality. A short memo sets materiality at $400,000. The memo notes that the company is not currently

profitable although it is expected to be in the near future. As a result, it is more appropriate to use balancesheet numbers to determine materiality. Once the company becomes profitable, YLS would expect to usenormalized income as a basis for materiality. Thus, one per cent of total assets is approximately $400,000.

b) Plan. A short memo sets out that the audit will be fully substantive against a materiality of $400,000 andfollow the approach used in the previous year, including the tailored audit programs developed that year.

c) Engagement letter, signed by the client.d) Legal letters to each of TVB’s lawyers, each with a standard reply.e) A standard management representation letter, containing no unusual or tailored paragraphs.

5. Prepaids. As these amounts were not material, YLS only compared this year’s schedule to that of the previousyear. There were no unusual items on either of the schedules.

6. Accounts receivable. The audit work in this section included a confirmation of the 15 largest accounts and 10other accounts selected at random, covering 79% of the population. All but two of the confirmations (totalling$326,000) were received back with no problems noted. In view of the satisfactory result on the otherconfirmations, no additional procedures were carried out in relation to these two items.A review was done to identify subsequent payments, and as at the date of the audit opinion, 85 percent of thereceivables had been collected. Of the remaining accounts, none were above $100,000, so no further workwas carried out.Procedures were carried out to ensure that balances outstanding at year end related to shipments before year-end. These procedures included agreeing amounts to invoices and shipping documents.


E X H I B I T 16.49–2 TVB SOFTWARE (continued)

7. Inventory. The inventory consisted of software packages, most of which were manufactured by TVB, and somepurchased for modification and resale.YLS attended the inventory count at year-end and reviewed the procedures necessary to achieve a proper cut-off.As a result of these procedures, YLS found cut-off errors that resulted in an overstatement of sales of $182,500.They concluded that, as this amount was not material, no adjustment was necessary. They also reviewed theinventory valuation by reviewing the process for allocating costs to specific products. This is a very complex processand the audit work seems to be detailed and thorough with much recomputation and testing in the files. Theyconcluded that the allocation methodology was appropriate in the circumstances. They did not identify any errors.

8. Fixed assets. YLS’s work was limited to reviewing the schedule of purchases (there were none above $100,000)and recomputing the depreciation for the year.

9. Goodwill. YLS recomputed the amortization for the year.

10. Bank indebtedness. YLS confirmed the amount of the bank indebtedness and the long-term debt, which is alsoowing to the bank. The confirmation noted that the debt was up for renewal in June of the following year. Thereis a note in the file that company management was confident that the debt would be renewed for a five-yearterm. As well, the file contained copies of some internal TVB memoranda, written over a four-month period in2003, summarizing management’s meetings with the bank and supporting the view that the debt would likely berenewed. On this basis, YLS concurred with management’s view that the debt should continue to be classified aslong-term debt.

11. Accounts payable. The files contained a confirmation of 100% of the accounts payable. All of the replies were inthe file and all discrepancies had been followed up. As a result of these procedures, YLS concluded that accountspayable were understated by $232,000 but that, as this amount was immaterial, no adjustment was required.

12. Income taxes. Very detailed work was carried out in this section by a tax manager from YLS. The review appearsvery thorough and amounts are reconciled down to the penny.

13. Profit and loss. YLS carried out analytical procedures, comparing the current year’s results to those of the previousyear on an account-by-account basis. Explanations were obtained from management for all variances over$50,000 or 5 percent of the previous year’s balance.The file includes a detailed review of all invoices paid to outside consultants, including several other accountingfirms, and copies of their reports. One of the assignments relates to a “business review” of TVB carried out at therequest of the bank. The report for that assignment is not in the file.

Documents

Robertson OLC EOC ND - highered.mheducation.comhighered.mheducation.com/sites/dl/free/0070914176/120500/Robertson... · 2.53 Auditing Standards Case Study. Ray, the owner of a small