Contemporary Auditing Issues Final Exam Questions 1. Identify at least four professional or regulatory organizations that affect the auditing profession. Explain how and why they assist and/or monitor the auditing profession. The Securities and Exchange Commission (SEC) is the government authority exersing oversight over accounting and auditing standards applicable to publicly traded companies. An auditor must comply with all rules and standards set forth in the regulations of SEC and corresponding federal securities laws. Financia Accounting and Standards Board (FASB) is a private, non-profit standard setting body. It is responsible for establishing and improving the Generally Accepted Accounting Principles (GAAP). The SEC has designated FASB as the body responsible for setting accounting standards for public companies. Public Company Accounting Oversight Board (PCAOB) is a private, nonprofit corporation established by the Sarbanes-Oxley Act, which oversees the auditing profession. It registers public accounting firms that prepare audit reports for issuers and broker-dealers and it sets audit, quality control and ethics standards. It essentially acts as an external oversight to the previously self-regulated audit firms. American Institute of Certified Public Accountants (AICPA) is a professional organization for Certified Public Accountants. While AICPA has transferred the responsibility for setting GAAP to FASB, it still sets standards in auditing, ethics, CPA firm quality control etc. It also provides technical support to FASB and issues guidelines in conjuction with FASB’s work. 2. Identify at least three types of users of financial statements. Describe their primary use of the financial statements and how the misstatement of those statements might injure the user. Investors: as the owners of the firms, they have a special interest in the financial performance in the firm. In large public companies, where magagement is separated from ownership, the investors are not aware on a daily basis of the performance of the firm since they do not have access to insider information. Therefore, investors rely on financial statements to evaluate whether the firm is reaching it’s financial goals and how it compares with its competitors. Misstatements can deprive investors from their due share of profits and decrease the value of their holdings without them being aware of it in a timely manner. Lenders: financial institutions that loan money want to ensure that they will receive ther loan back. By consulting financial statements (and perhaps other additionally disclosed information) the loan issuing institution can understand the health of the company, the risks involved with lending it money and be able to calculate an appropriate interest rate and/or loan maturity. Misstatements can lead to lenders miscalculating their loan portfolio and not being aware or the correct possibility of a default from the company. Government/regulators: The first and most immediate interest of government in financial statements is related to taxes. Different financial indicators, obviously including but not limited to profits are the basis on calculating the tax rate owed. However, governments are interested in financial statements also from their position of regulator, trying to ensure fair competition and equal treatment of all investors. Misstatements can lead decreased tax intake or unfair competition. Other users include customers, suppliers, rating agencies, financial analysts, employers, etc. 3. The auditor assesses the identified fraud risks after taking into account an evaluation of the client’s programs and controls. How might the auditor respond to the results of the assessment of higher fraud risk? After a proper assessment of fraud risks (which does not necessarily mean that there is fraud) should review the planned audit procedures and try to evaluate whether they are sufficient. Faced with higher fraud risk, the auditor should provide a higher degree of skepticism to the materials and records provided by the company and evaluate the accounting decision’s more carefully. In addition, higher level and more experienced personnel should be assigned to this particular audit. Finally, if the auditor does not believe that the audit plan can be modified in time or sufficiently to account for higher fraud risk, then the auditor should withdraw from the engagement. 4. Research consistently shows that there are three elements associated with most frauds. List these elements and at least three indicators that the element may exist for a particular company. The three elements most associated with fraud are Incentive/pressure, opportunity and attitude/rationalization. Pressure: (1) if the industry has a high degree of competition, then that would create pressure on management to commit fraud; (2) if the management has made unrealistic commitments to analysts in order to boost stock price then there is pressure on management to commit fraud; (3) unrealistic goals for operating personnel puts them under pressure to commit fraud. Opportunity: (1) an overly complex structure with confused lines of authorizing transactions increases opportunities to commit fraud; (2) inadequate physical safeguards over physical assets such as inventory creates opportunities for missapropriation of assets/fraud; (3) inadequate recordkeeping increases fraud risk. Attitude/rationalization: (1) low employee morale might make employees to want to “get back” at the company; (2) high employee turnover can make employees think that they have no stake in the company or that they can easily get away with fraud/misappropriation; (3) high share of variable compensation (such as bonuses) to total compensation which is linked to aggressive targets can make the employess feel that they are simply getting what they deserve through fraud or getting what they need to support their family. 5. The five components of the COSO internal control system are conceptually and logically integrated. List the five components of the model and describe how they are integrated with each other in the internal control process. The five components of COSO internal control system are: Control Environment, Risk assessment, Control activities, Information and Communication, Monitoring. The five components of the COSO internal control system should not be considered in isolation. Instead, they are integrated together to reduce fraud risk at an acceptable level. They should all be present and functioning within an organization. The control environment sets out the standards and structures for carrying out internal control within an organization. The risk assessment evaluates the possibility of a negative event occurring and serves as the basis of how risks should be managed. The individual responsible, as specified in the control environment, use the risk assessment to carry out control activities at different levels of the company and at different stages of the process. The results of the control activities are regularly communicated with management and other stakeholders, thus insuring that the correct information flow within the company. Finally monitoring activities ensure that the different components of internal control are both in place and actively carried out by those assigned as responsible in the control environment. 6. Identify and describe the five management assertions inherent in the financial statements. Provide examples. The five management assertions inherent in financial statements are : Existence/occurrence: the assets, the liabilities exist and the recorded transactions have actually happened and pertain to the company. Rights/obligations: the company has rights on the assets listed. The listed liabilities also belong to the company and form their obligations. Disclosed events pertain to the company. Completeness: all assets and liabilities are listed; there are no other assets or liabilities that exist but which are not recorded. No relevant disclosures are omitted. The cut-off date for reporting is correct. Valuation: the assets and liabilities are listed with an appropriate amount. The information disclosed contains the correct amounts. Presentation: Accounts re described and classified according to generally accepted accounting principles. All financial disclosures are completely and clearly expressed. 7. Explain the meaning of "directional testing" and identify the reasons why directional testing leads to audit efficiency. Give examples of directional testing for the existence and completeness assertions. Directional testing requires a “from” and a “to” and it has two elements: source documents and recorded easy. Tracing forward is one form of direction testing. It entails starting from the source document and then checking whether the recorded entry fully matches the source document. Tracing forward tests for completeness. For example, let us assume that we have some sales invoices as source documents. If the corresponding amounts are correctly recorded, then we have a correct assertion of completeness. The other direction is vouching. It entails starting from the recorded document and moving back to check that the source document fully matches the recorded entry. Vouching tests existence. Let us assume that we have a recorded entry for sales on a certain date. Then we try to identify the source document, the original sales receipt. If the receipt matches the recorded entry, then we have a correct assertion of existence. 8. Identify how an increase in each of the following factors (assuming the other factors remain unchanged) will affect planned audit evidence. a. Audit risk b. Inherent risk c. Control risk d. Detection risk Audit risk is composed of inherent risk, control risk and detection risk. Inherent risk refers to the likelihood of material misstatement of an assertion. Control risk is likelihood that material misstatement will not be prevented or detected on timely basis by internal controls and the detection risk refers to the possibility that no misstatement will be found although it actually exists. A proper representation of the relationship would be: Audit risk = Inherent risk * Control Risk * Detection risk. Normally, we assign an acceptable audit risk ( arbitrarily) say at 5%. Then we have to ensure that the left-hand side of the relationship will give us an audit risk of 5%. If any of the risk elements of the left-hand side increases, then we have to ensure that another risk element decreases to keep the audit risk the same. For example, if inherent risk increases we have to increase detection efforts and therefore decrease detection risk (i.e. the risk that misstatements would not be detected.) It should be made clear that inherent risk and control risk are independent of the audit process. The audit process can also influence the detection risk. However, recommendations from the auditors can be implemented in order to decrease inherent risk and control risk. 9. Before procedures using statistical or non-statistical sampling methods begin, the auditor must determine how the sample will be selected. Discuss the various types of sample selection, when they are used and, generally, how they are used. Give examples. There are several ways that the auditor can proceed with sample selection. Block sampling: A consecutive series of items are selected for review. This is an efficient approach but the block items are not necessarily representative of the entire item group. For example, the auditor can review all sale receipts for a given month, while not reviewing sale receipts from other months. Personal judgment: The auditor uses own judgment to select items, perhaps favoring items that have larger monetary values or which appear to have a higher level of risk associated with them. For example, the auditor could restrict the sample to the top 5% of sales invoices based on their monetary value. Random sampling. A random number generator is used to make selections. This approach is the most theoretically correct, but can require more time to make selections. Random sampling allows for unequal number of items picked from different sub-categories. For example, if we are selecting 5% of sales invoices randomly, there is no guarantee that we would 5% of sales invoices per month. Haphazard sampling: There is no structured approach to how items are selected. However, the person doing the selections will probably skew the selections (even if inadvertently), so the selections are not truly random. Returning to our sales invoices example, while a random sample might not give us 5% of the invoices for each month, we would except the percentage of invoices not to be too far away from 5%. With haphazard sampling, some months may be considerable more represented than others compared to a random sampling. Stratified sampling. The auditor splits the population into different sections (such as high value and low value) and then selects from each section. For example, the auditor could split sales invoices into 5 different quintiles based on their value and then select 5% of each quintile to review. Systematic sampling. Selections are taken from the population at fixed intervals, such as every 20th sales invoice. This tends to be a relatively efficient sampling technique. 10. You are performing the financial statement audit of Maple Bank. Maple has a large number of customers with consumer loan accounts. The loan accounts have balances averaging $800 in a homogeneous population and the customers usually pay close attention to their balances. Your preliminary assessment of internal control over the loan area is that control risk is low and the results of tests of controls support that assessment. Inherent risk is deemed to be lower as well. Discuss the confirmation process and the types of confirmations that may be used for the audit of Maple Bank. Which confirmation type would you select for Maple and why? Confirmations are a generally accepted auditing procedure for accounts receivable and therefore can be applied to the loan accounts of Maple Bank. There are two main types of confirmation processes: positive confirmation and negative confirmation. Positive confirmation means that the auditor will request replies from the debtors. In other words, we will ask the loan holders of Maple Bank to reply and confrm the loan balance with Maple bank. A variation of the positive confirmation is blank confirmation, where the loan holder is requested to reply AND fill in the balance themselves. Negative confirmation means that the auditor will send the loan balance to debtors and they should reply only if they disagree it with. In other words, we would request the loan holders of Maple Bank to contact us if they see any irregularity in the amount of their loan balance. If they think the loan balance is correct, there is no need to reply. A positive confirmation process can be more time consuming. In a negative confirmation process, all missing replies are considered to be confirmations of the correctness of the loan balance. When we are missing replies in the positive confirmation process, we have to contact the loan holders again. If we are using blank confirmation, we should expect a higher nonresponse rate since it requires more effort from the loan holders. In the case of Maple Bank, we can select a negative confirmation process since: (1) the level of ineherent risk and control risk is low; (2) we are faced with a large number of small balances; (3) we have no reason to believe the recipients will not give us adequate consideration. 11. Identify at least eight sources of evidence and testing the auditor may use in the audit of marketable securities by major assertion tested. Existence/occurrence: (1) Confirm with third parties that they actually hold securities listed; (2) use vouching techniques, i.e. entails starting from the recorded document and moving back to check that the source document fully matches the recorded entry. Rights/obligations: (3) inspect and count marketable securities to ensure that the rights or obligations listed actually match the marketable securities behind these rights and obligations. Completeness: (4) reconcile dividends with published records of dividend issuer; (5) review transactions near year-end to assert correctness of cut-off Valuation: (6) reconcile summary schedules to general ledger; (7) determine the market value for trading securities. Presentation/disclosure: (8) review management’s classification of securities; (9) inquire about pledging. 12. Describe what is meant by asset impairment and identify the sources of inherent risks related to asset Asset impairment means that an asset on the company’s balance sheet has a market value that is less than the value for which it is listed. An asset can be impaired if there are severe changes in its physical condition that necessitate a change in its usage. For example, damaged factory equipment that can no longer produce at full capacity are impaired assets. Assets for which there is an active marketplace such as stocks and bonds can be impaired if there are significant changes in their market price. For example, changes in profits of the underlying company can decrease the value of the stock. Changes in interest rates can decrease the market value of bonds. In both these cases, the asset (financial instruments) are impaired. Changes in the projected cash flow related to an asset can also cause its value to decrease. For example, the value of medicinal patents can decrease if there are new, previously unforeseen changes in the regulatory environment restricting the sale of that particular medicine. The patent then would be an impaired asset. 13. Barley Company is a medium-sized industrial firm that has been audited by your firm for several years. The only interest-bearing debt owed by Barley is long-term notes payable of $300,000 held by First National Bank. The notes were issued four years earlier and will mature in 8 more years. Barley is highly profitable, has no pressing needs for additional financing, and has excellent internal controls of the recording of loan and related interest cost transactions. a. Based on this scenario, describe the auditing procedures that you think will be necessary for notes payable and related interest accounts. Since there are no other interest bearing debts, the table of notes payable would look very simple. We would start with the beginning balance of notes-payable of Barley. If the prior year is audited, then we can assume the amounts of the beginning balance are correct. After that we would look into the interest payments. Using vouching, we would start from the recorded entry of the interest payments and we would match them to the bank statements. For completeness, despite the low risk and excellent internal controls of Barley, we would read the contract to confirm the interest payment and due dates of the interest payments and match them to the recorded entry. Finally, and obviously we would ensure that the recorded sums add up, i.e. the beginning balance minus interest payments matches the recorded ending balance. b. How will your answer differ if instead Barley Company was unprofitable, needed additional financing, and had ineffective internal controls? Since the company has ineffective internal controls, we would start with detailed questionnaire to the Board of Directors where we would enquire on: (1) financing needs including whether they have recently acquired new debt; (2) responsibility and process for approving new loans and for signing checks of large amounts (i.e. amounts that would be necessary for interest payments). In addition to the questionnaire, we would hold interviews with senior management and review the board notes. We would match the beginning balances with the last year’s ending balances directly instead of relying on the reported amounts. We would look into the general ledger for other payments that in their amount could resemble interest payments. We would also initiate a positive confirmation process with First National Bank, perhaps following a blank confirmation process, which would allow us to get information on additional potential loans that the firm has. Furthermore, we would use a tracing forward instead of a vouching approach. By reviewing the bank statements, we would try to identify payments that resemble in their amount to interest payments and match them to recorded entries. Our analytical procedures would also be more thorough. We would read the loan contract in more detail, include terms and conditions for late payments. We would make general requests for company notes and agreements, not limited to the $300,000 held by First National Bank. Finally, we would inquire with the company if any assets are subject to lien and look into their notes and agreements for any guarantees. These are both methods that the company could have used to address its financing needs. 14. Describe the concept and the purpose of dual-dating an audit report. Dual-dating can occur when an event that requires note disclosure has occurred after the date of the audit report but before the report is issued. In these cases, the auditor can keep the original date of the report while making an explicit exception for the note referring to the subsequent event while also specifying the date for this additional note. The report would be then “dualdated”, with one date being the date of the main report and the second date referring to the date of the note. It is, in principle, possible to change the date of the report to match the date of the subsequent event and additional note. However, the preferred method is to dual-date since pushing the date of the entire report would make the auditor responsible for the other subsequent events. 15. For the past five years, Clark CPAs has audited the financial statements of a manufacturing company. During this period, the audit scope was limited by the client as to the observation of the annual physical inventory. Because Clark CPAs considers the inventories to be material and was not able to satisfy the audit requirements by using other auditing procedures, the firm was unable to express an unqualified opinion on the financial statements in each of the five years. The CPA was allowed to observe physical inventories for the current year ended December 31, 20Y8 because the client's bank would no longer accept the audit reports. However, to minimize audit fees, the client requested that the CPA not extend audit procedures to the inventory as of the beginning of the year, January 1, 20Y8. Which type of audit report would you suggest be issued this year and why? The scope of the audit has been restricted by inability to assess the inventory. Based on the information, this appears to be highly material or material, depending upon the auditor’s preliminary judgment about materiality. Because the auditor was unable to obtain sufficient appropriate evidence on the beginning inventories, it would be necessary to issue either a qualified opinion or a disclaimer of opinion on the income statement and statement of cash flows as well as the beginning of the year balance sheet. The choice of a qualified opinion or disclaimer opinion would depend upon materiality. If highly material, then a disclaimer is the best choice. If material, then a qualified scope and opinion might be more appropriate. An unqualified opinion could be issued for the current period balance sheet. Since this is a manufacturing company and inventory should be highly material, I would issue a disclaimer of opinion.
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