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Read the attached Case and write a paper addressing the following issues:

  • Identify the potential ethical problem, if one exists.
  • Organize and develop a way to address or solve the problem.  Be sure to use compelling information and/or facts to support your argument/solution.

The paper should be typed in Word. Use professional language, grammatically and mechanically correct sentences, avoid spelling and punctuation mistakes.  The paper will be graded based on ethics.

The paper should be long enough to address the issue and proposed solutions.  In developing the paper, a third party should be able to identify the issues without having to read the case.  Although there is no minimum or maximum word count, whatever it takes to address the issue, most papers will probably average about 2 pages in length

 

Topic: Asset Valuation/Write-Downs

Jasmine is the first Controller ever hired at a medium-sized technology company. The firm has reacquired computers and other parts and equipment from high-tech firms who filed for bankruptcy or were seriously behind in their monthly payments during a recent two-year downturn in the economy. In addition, the firm has acquired some miscellaneous inventory from competitors experiencing the same misfortune.

One of Jasmine’s initial goals is to determine how accurately the inventory on the books reflects its fair market value. As she walks with Marcus, the inventory control clerk, through all the equipment and inventory pallets, she notices that numerous parts and machines look dated, and dusty. Marcus informs her that while only about a third of these items are repossessions, most are from overruns or the recession; “many have been sitting on these skids for years.” As Jasmine inquires further, it appears that this problem is extensive, and that this inventory moves slowly. When the inventory does sell, it is at a significant discount. Raina, the Sales Manager, indicates that these are really tough times to sell this stuff, especially because most of the “slow movers” are large-ticket items. In fact, Raina feels sorry for her sales staff since they have been forced by the company president to push these items with only 2 percent more in commission.

Finally, Jasmine approaches Terry, the Company President, about this problem and asks what he intends for her to do about the dilemma. Terry informs her that he believes that many of these items are salable given appropriate marketing and the right economic conditions. Besides, some of his major customers owe him a few favors. Terry also indicates that now is not the right time for the company to take a hit from inventory revaluation.

During the ensuing months, Jasmine did not see much movement from these stacks. She again approached Terry and asked how he would address this issue when the audit came. Terry reiterated his former response regarding product salability and stressed actual sales across all product lines to the auditors. He asked Jasmine not to point out this problem to the auditors and finally said, “just see if they notice it. And if they start nosing around in it, I hope you’ll be able to show them that some of these items are turning over.” Jasmine interpreted Terry as saying she should help falsify records if it looked like the auditors were discovering the slow movers. Jasmine didn’t know what she would do next.

 

LEARNING OBJECTIVES:

After studying this chapter you should be able to: 1 define management assertions about classes of transactions, account balances, and presentation and disclosure 2 discuss the characteristics of audit evidence 3 explain the procedures for gathering audit evidence 4 evaluate when it is appropriate for auditors to use the work of others 5 explain how auditors document the details of evidence gathered in working papers

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AUDITING AND ASSURANCE STANDARDS PCAOB AUDITING STANDARDS BOARD

AS 1105 Audit Evidence AU-C 230 Audit Documentation

AS 1205 Part of the Work Performed by Other Independent Auditors AU-C 315 Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement

AS 1210 Using the Work of a Specialist AU-C 500 Audit Evidence

AS 1215 Audit Documentation AU-C 505 External Confirmations

AS 2110 Identifying and Assessing the Risks of Material Misstatement

AU-C 600 Special Considerations — Audits of Group Financial Statements (Including the Work of Component Auditors)

AS 2310 The Confirmation Process AU-C 610 Using the Work of Internal Auditors

AS 2605 Consideration of the Internal Audit Function AU-C 620 Using the Work of an Auditor’s Specialist

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Cloud 9 At the next planning meeting for the Cloud 9 Inc. (Cloud 9) audit, Suzie Pickering presents the results of the analytical procedures performed so far and a working draft of the audit program. The audit manager, Sharon Gallagher, and the audit senior, Josh Thomas, are also involved in the planning, with special responsibility for the internal control assessment.

The meeting’s agenda is to discuss the available sources of evidence at Cloud 9 and specify these in the detailed audit program. The team members also have to make sure they have enough evidence to conduct the audit. There are two specific issues worrying members of the team. First, there are three very large asset balances on Cloud 9’s trial balance that have particular valuation issues. Suzie suggests that a specialist will be required for the derivatives, but they can handle the accounts receivable and inventory themselves. Second, Sharon is worried about how they will gather evidence regarding a subsidiary of Cloud 9 located in China. W&S LLP does not have an office in China so they must determine the most effective and efficient way to gather evidence regarding the subsidiary.

The questions the team are considering in the planning meeting include: • What evidence is available? • What criteria will the team use to choose between alternative sources of evidence? • What are the implications of using the work of specialists and other auditors?

AUDIT PROCESS IN FOCUS In Chapters 3 and 4 we considered audit risk and risk assessment. A great deal of that discussion considered the importance of risk identification to help ensure the auditor’s desired level of risk is achieved. This chapter begins the discussion of obtaining audit evidence in response to identified risks. Once auditors have identified the key risk factors for their client, they will plan “what” to test, “how” to test it, and “who” should test it. In this chapter, we explain “what” the auditors are testing by defining and describ- ing management assertions. Then we discuss characteristics of audit evidence including traits that make some types of evidence better than others.

Next we discuss the “how” of gathering audit evidence. What are the specific procedures auditors perform to gather evidence? You have already been introduced to the broad categories of risk assessment procedures, tests of controls, and substantive tests. This chapter will describe specific actions auditors perform to gather evidence at the risk assessment and risk response phases of the audit. In most audits, the audit team will perform all of the evidence gathering procedures, but “who” else may perform evi- dence gathering procedures for the audit? We discuss situations in which the auditors may use the work of others, such as special- ists in a field other than accounting or auditing, the client’s internal auditors, or auditors from another accounting firm.

Auditors document the details of their risk assessment, tests of controls, and substantive tests in their working papers. An audi- tor’s working papers provide proof of audit work completed, procedures used, and evidence gathered. Each accounting firm has its own working paper format and preferences. In this chapter, we provide some examples of a typical audit file and the types of working papers it may contain.

5.1 MANAGEMENT ASSERTIONS

1 Define management assertions about classes of transactions, account balances, and presentation and disclosure. It is the responsibility of management and those charged with governance to ensure the financial statements are fairly presented. When preparing the financial statements, management makes assertions about each account and related disclosures in the notes. An assertion is a statement or representation, explicit or implied, made by management regarding the recognition, measurement, presen- tation and disclosure of items included in the financial statements and notes. For example, when reporting inventory, management is claiming, or asserting, that the items exist, are owned by the entity, represent a complete list of the inventory owned, and are valued appropriately. When reporting sales, management is asserting that the amount represents sales of the entity that occurred

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during the accounting period. Management also asserts that sales are recorded at the correct amount, represent a complete list of all sales, and are classified correctly.

assertion statement or representation, explicit or implicit, made by management regarding the recognition, measurement, presentation and disclosure of items included in the financial statements and notes

During the risk assessment phase, auditors use management assertions as a guide when determining the different types of po- tential material misstatements that could occur, or what can go wrong (WCGW) in the financial statements. Assertions also guide auditors in the collection of evidence, as the evidence used to evaluate many assertions is unique to that assertion. For example, evidence the auditor will use to evaluate the completeness of revenues is different from the evidence used to evaluate the occur- rence of revenues. AU-C 315 Understanding the Entity Its Environment and Assessing the Risks of Material Misstatement pro- vides a summary of the assertions used by auditors. The assertions are divided into the three categories of classes of transactions and events, account balances at the period-end, and presentation and disclosure. The assertions are summarized in Illustration 5.1. Each assertion in Illustration 5.1 is numbered and the following paragraphs provide more discussion of each one.

Illustration 5.1 Assertions by category

Assertions about classes of transactions and events for the period under audit

(1) Occurrence Transactions and events that have been recorded have occurred and pertain to the entity.

(2) Completeness All transactions and events that should have been recorded have been recorded.

(3) Accuracy Amounts and other data relating to recorded transactions and events have been recorded appropriately.

(4) Cut-off Transactions and events have been recorded in the correct accounting period.

(5) Classification Transactions and events have been recorded in the proper accounts.

Assertions about account balances at the period-end

(6) Existence Assets, liabilities and equity interests exist.

(7) Rights and obligations

The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

(8) Completeness All assets, liabilities and equity interests that should have been recorded have been recorded.

(9) Valuation and allocation

Assets, liabilities and equity interests are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded.

Assertions about presentation and disclosure

(10) Occurrence and rights and obligations

Disclosed events, transactions and other matters have occurred and pertain to the entity.

(11) Completeness All disclosures that should have been included in the financial statements have been included.

(12) Classification and understandability

Financial information is appropriately presented and described, and disclosures are clearly expressed.

(13) Accuracy and valuation

Financial and other information is disclosed fairly and in appropriate amounts.

Source: AU-C 315.A128

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Let’s discuss these assertions in more detail beginning with the assertions about classes of transactions and events for the pe- riod under audit, and what can go wrong associated with each assertion. When considering (1) occurrence, auditors gather evi- dence to verify that a recorded transaction or event, such as revenue or an expense item, actually took place and relates to the en- tity. This assertion is particularly important when auditors believe there is a risk of overstatement and that some transactions are recorded but did not actually occur. For example, a client may record revenues prematurely in error, or management might record fictitious sales to overstate revenues and profit.

When considering (2) completeness, auditors gather evidence that all transactions have been recorded and the financial statements are not understated or overstated because transactions have been omitted. This assertion is particularly important when auditors believe there is a risk of understatement and that some transactions or events that should have been recorded have not been recorded. For example, a client may have incurred an expense but did not record it because the vendor’s invoice had not been received, or because management intended to understate expenses and overstate profit.

When considering (3) accuracy, auditors gather evidence that transactions and events have been recorded at appropriate amounts. This assertion is important when auditors believe there is a risk the reported amounts are not accurate. For example, a client might inadvertently use the wrong price on an invoice, or may have complex investment valuation procedures or foreign exchange calcu- lations where errors can easily occur.

When considering (4) cut-off, auditors search for evidence that transactions have been recorded in the correct accounting period. This assertion is particularly important for transactions close to year-end. For example, a client may record a sale before year-end that actually occurred after year-end. Or, a client may record an expense after year-end that was actually incurred before year-end. Unintentional cut-off mistakes may happen when internal controls are poor. The motivation for a client to record an expense or revenue in the wrong period may be to manipulate net income for the period.

When considering (5) classification, auditors gather evidence that transactions and events have been recorded in the proper ac- counts. For example, a client may have recorded a routine maintenance expense in a fixed asset account when it should be recorded in an expense account. Auditors should be alert to misstatements that result in capitalizing an amount that should be expensed.

Audit Reasoning Example – Wells Fargo Scandal Wells Fargo is an international banking giant headquartered in San Francisco. In 2016, news broke that Wells Fargo employees had participated in various fraud schemes to increase revenue. One of the schemes was charging auto loan customers for vehicle insur- ance without their knowledge. Which assertion about classes of transactions is violated with this scheme? Did these revenues actually occur? Wells Fargo was collecting actual payments from actual customers, so this wasn’t a case of fictitious customers. But charging customers without their consent is fraudulent and violates the occurrence assertion. Why did Wells Fargo employees participate in this scheme? The company had very aggressive internal sales goals with compensation tied to sales performance. Wells Fargo management encouraged cross selling to existing customers as a way to boost revenues, and employees felt pressure to meet the lofty sales goals. In July 2017, Wells Fargo announced “it would issue $80 million in refunds or account adjustments to more than 570,000 auto loan customers who were charged for vehicle insurance without their knowledge.”1

Consideration of the occurrence assertion for revenues is a relevant assertion for all audits. Historically, many accounting frauds have involved overstatement of revenues either through creation of fictitious revenue, improper period-end cutoff, and/or improper application of revenue recognition rules. Auditors spend considerable time gathering evidence to support management’s assertion that recorded revenue occurred and relates to the entity.

The next category of assertions focuses on account balances at the end of the period, which is typically fiscal year-end. When

considering (6) existence, auditors search for evidence to verify that asset, liability and equity items on the balance sheet actually exist. This assertion is important when auditors believe there is a risk of overstatement. For example, a client may miscount inventory resulting in an over count and overstatement, or a client may attempt to overstate inventory or accounts receivable to improve

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financial ratios for the period. When considering (7) rights and obligations, auditors gather evidence to verify recorded assets are owned by the entity and

recorded liabilities represent commitments of the entity. This assertion is particularly important when auditors believe there is a risk recorded assets or liabilities are not owned by the entity. This assertion is different from existence, as the assets and liabilities may exist but not be owned by the entity. An example of inventory that physically exists but does not satisfy the rights and obligations assertion is inventory held on consignment in the client’s warehouse (and therefore not owned by the entity) which is incorrectly recorded as an asset.

When considering (8) completeness, auditors search for assets, liabilities and equity items to ensure they have been recorded. This assertion is particularly important when auditors believe there is a risk of understatement and the client has omitted some items from the balance sheet. For example, a client fails to record various accrued liabilities, due to an error or an attempt to improve reported financial ratios for the period.

When considering (9) valuation and allocation, auditors search for evidence that assets, liabilities and equity items have been recorded at appropriate amounts and allocated to the correct general ledger accounts. With respect to assets, auditors need to be cognizant of both valuation at historical cost, and any fair value tests that may be relevant. This assertion is particularly important when auditors believe there is a risk of over or undervaluation. For example:

• an auditor checks that inventory has been appropriately recorded at the lower of cost or net realizable value (risk of over- statement)

• an auditor tests for the adequacy of the allowance for doubtful accounts (risk of understatement or overstatement depending on the client’s motivation)

• an auditor checks that transactions are allocated to the correct account when auditing research and development costs (risk of understatement of the expense account).

Cloud 9 Ian and Suzie have already talked in general terms about the errors that could occur in Cloud 9’s accounts receivable. For example, basic mathematical mistakes and other clerical errors could affect the customer’s total in either direction. Suzie emphasizes that Cloud 9’s management asserts this error does not exist when they prepared the financial statements — e.g., they assert that accounts receivable are valued correctly. Auditors have to gather evidence about each assertion for each transaction class, account, and note in the financial statements. Now that Ian understands this idea better, he can identify the assertions that relate to the potential errors in accounts receivable that they discussed earlier: • No mathematical mistakes or other clerical errors that could affect the total receivables in either direction — valuation and allocation. • No accounts receivable omitted when calculating the total — completeness. • Accounts receivables included in the total do exist at year-end — existence. • Accounts receivables belong to Cloud 9 and have not been sold or factored — rights and obligations. • Bad debts have been provided for — valuation and allocation. • Sales from the next period are not included in the earlier period — cut-off. Ian is a bit confused about this because cut-off is an assertion

for transactions, not assets. Suzie agrees it is a special sort of assertion that relates to transactions or events but also gives evidence about balance sheet accounts (e.g, an overstatement of revenue is also an overstatement of receivables). The last category of assertions focuses on presentation and disclosure in the financial statements and the notes. You’ve probably

noticed that most of the assertions in this category are also listed in one or both of the other categories. That makes sense considering the note disclosures and presentation in the financial statements are inherently tied with a client’s transactions and year-end balances. Auditors gather evidence that disclosed items represent events and transactions that occurred and pertain to the entity, (10) occur- rence and rights and obligations, and are recorded at appropriate amounts, (11) accuracy and valuation. Auditors search to ensure that all items that should have been disclosed are included in the financial statements, which is (12) completeness. Auditors ensure that all items included in the financial statements are appropriately presented and disclosures are clearly expressed, which is (13) classification and understandability.

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Recall from chapter 4 that one of the risk assessment procedures is to identify significant accounts and classes of transactions. Once these are identified, auditors assess the risk of material misstatement at the relevant assertion level for these significant clas- ses of transactions and account balances. Relevant assertions are assertions that have a reasonable possibility of containing a mate- rial misstatement that would cause the financial statements to be materially misstated and, therefore, have a meaningful impact on whether the account is fairly stated (AU-C 315.A131). All assertions may not be relevant for a particular account balance or trans- action. For example, the valuation of cash is typically not an issue, but the existence of cash is always relevant because there is risk that a client may overstate its cash balance due to the risk of misappropriation of cash. Once the relevant assertions are identi- fied for significant accounts and classes of transactions, auditors can proceed with planning their audit procedures to gather evi- dence in support of management assertions. The specific procedures auditors will use to gather evidence are detailed in the audit program. The audit program is part of the audit documentation that lists the details of the audit procedures to be used when test- ing controls and when conducting detailed substantive procedures. Audit procedures will be further discussed in section 5.3 and audit documentation is discussed in section 5.5.

relevant assertion an assertion that has a reasonable possibility of containing a material misstatement or misstatements that would cause the financial statements to be materially misstated and, therefore, has a meaningful impact on whether the account is fairly stated.

audit program A listing of details of the audit procedures to be used when testing controls and when conducting detailed substantive audit procedures

BEFORE YOU GO ON 1.1 When auditing accounts receivable, what will an auditor search for when testing for rights and obligations? 1.2 What does the accuracy assertion mean? Develop an example in the context of purchases of inventory. 1.3 What is the auditor trying to ensure when considering the cut-off assertion? Develop an example in the context of payroll transactions.

5.2 CHARACTERISTICS OF AUDIT EVIDENCE 2 Discuss the characteristics of audit evidence. Audit evidence is the information auditors use when arriving at their opinion on the fair presentation of the client’s financial state- ments (AU-C 500 Audit Evidence and AS1105 Audit Evidence). It is the responsibility of management and those charged with governance to ensure the financial statements are prepared in accordance with the appropriate financial reporting framework (usually GAAP). They are also responsible for ensuring that accurate accounting records are maintained and any potential misstatements are prevented, or detected and corrected. It is the responsibility of auditors to gather sufficient appropriate evidence to arrive at their opinion. Before considering the different procedures auditors will use for gathering evidence, we start with a discussion of what is meant by the term sufficient appropriate evidence.

audit evidence information gathered by the auditor which is used when forming an opinion on the fair presentation of a client’s financial statements

5.2.1 Sufficient audit evidence Sufficient refers to the quantity of audit evidence gathered. Essentially, auditors determine at what point they have gathered enough evidence to support their opinion on the financial statements. The quantity of evidence needed is affected by the risk of material

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misstatement in a relevant assertion for an account balance or class of transactions. In other words, as risk increases, the amount of evidence the auditor should gather also increases. For example, the existence assertion for the accounts receivable balance is typi- cally a relevant assertion because of the risk of overstatement of receivables due to premature revenue recognition which inflates revenues and receivables. In contrast, the risk of understatement of accounts receivable, which is the completeness assertion, is typically low because a client would most likely record all credit sales and related accounts receivable. In this scenario, auditors will gather more evidence in support of the existence assertion since it presents the higher risk of material misstatement. Auditors should also be alert that with some private companies needing audits, the incentive might be to understate pre-tax profits in order to minimize income tax expense.

sufficient refers to the quantity of audit evidence gathered

5.2.2 Appropriate audit evidence Appropriate refers to the quality of audit evidence gathered. The concepts of quantity and quality are interrelated as the quality of evidence gathered will affect the quantity required. Typically, the higher the quality of the evidence means less quantity is required. What contributes to the quality of audit evidence? AU-C 500.A5 and AS 1105.06 state the quality of audit evidence is determined by its relevance and reliability in providing support for the conclusions on which the auditor’s opinion is based.

appropriate refers to the quality of audit evidence gathered

Relevance of audit evidence refers to its relationship to the assertion being tested. In other words, does the evidence gathered really support the assertion being tested? For example, if auditors are testing for the completeness of the accounts payable balance, they are trying to determine if all accounts payable owed have been properly recorded. Suppose auditors inspect a sample of ac- counts payable balances from the ledger and verify they are true payables owed by the client. Have the auditors gathered evidence about completeness? No, they have not. They have gathered evidence in support of the existence assertion, that payables that have been recorded actually do exist. To gather relevant evidence for the completeness assertion, auditors must use a different procedure. Auditors could examine a client’s unpaid invoices file and determine if payables have been properly created for any unpaid invoices. This procedure would provide relevant, or appropriate, evidence in support of the completeness assertion.

relevance refers to the logical connection with the assertion being tested

Reliability of audit evidence refers to the source of the evidence and form or nature of the evidence. In general, here are some

guidelines regarding the reliability of audit evidence provided in AU-C 500.A32 and AS 1105.08: • Evidence gathered from a knowledgeable source independent of the client is more reliable than evidence gathered

solely from internal client sources. • The reliability of evidence generated internally from the client is increased when the client’s internal controls over

the information are effective. • Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly by the auditor. • Evidence provided by original documents is more reliable than evidence obtained from copies, scans, or faxes. How-

ever, this could be mitigated if internal control over the duplication of documents is effective. • Evidence that has been documented (paper or electronic form) is more reliable than strictly oral evidence obtained by

having a discussion with an individual. Some examples of these reliability guidelines are provided in Illustraton 5.2.

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reliability refers to the source, form, or nature of the audit evidence

Illustration 5.2 Examples of reliability of audit evidence

Nature/Source of Evidence Example Independent source Auditors communicate directly with a client’s bank regarding the existence of the client’s cash

account balances at year-end. The bank confirms the cash balances directly with the auditor. This is more reliable than relying solely on the client’s internal records related to its cash ac- count balances.

Effective internal controls If auditors determine that controls over the client’s accounting information system are effective, then information generated from the client’s accounting information system is deemed more re- liable than if controls were weak.

Direct knowledge by auditor Auditors visit a client’s warehouse to observe, in person, the physical count of the client’s in- ventory to support the existence assertion of inventory. This is more reliable than auditors read- ing a summary report of the physical count or interviewing client personnel about the physical count.

Original documents Auditors review the original title to verify the client’s rights to a piece of equipment. Inspect- ing the original title is more reliable than inspecting a copy because a copy can be altered and/or forged.

Documented Auditors read the minutes from a board of directors meeting. This documented evidence, either written or in electronic form, is more reliable than interviewing one of the board members about the topics covered in the meeting.

Cloud 9 Whenever Suzie’s draft audit program shows the team relying on internally generated evidence, it also includes requirements to obtain additional evidence. This is because the evidence obtained from the client is less persuasive than evidence gathered directly by an auditor or externally generated evidence that has passed through the client’s hands. Therefore, the audit program includes plans to obtain evidence from tests of controls for each assertion, to support the conclusion that internal controls are strong.

5.2.3 Audit risk and sufficient appropriate audit evidence In chapter 3, we discussed the audit risk model. Let’s discuss how the audit risk model impacts the gathering of audit evidence. Audit risk affects the quantity and quality of evidence gathered by an auditor during the risk response phase. When there is a signif- icant risk of material misstatement with an assertion and the client’s system of internal controls is not considered to be effective at reducing that risk, detection risk is set as low (See Illustration 5.3). How would this scenario impact the quality and quantity of evidence to be gathered? When detection risk is low, auditors want to decrease the risk that their audit procedures will not detect a material misstatement. Therefore, auditors would plan for audit procedures that result in higher quality evidence and possibly gather an increased quantity of evidence for that assertion. Illustration 5.3 High-risk assertion

Audit Risk =

Risk of Material Misstatement Detection Risk

Level of sufficient appropriate

evidence Inherent Risk Control Risk

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High High Low Increased

When there is a low risk of material misstatement with an assertion and the client’s system of internal controls is considered effective at reducing risk, detection risk is set as high. First, the auditor will obtain evidence through risk assessment procedures to support the low inherent risk assessment, and perform tests of controls to support the low control risk assessments. Second, since detection risk is high, that means auditors are willing to accept a higher risk that their audit procedures may not detect a material misstatement. Therefore, auditors would plan for audit procedures that may result in lower quality evidence and possibly a decreased quantity of evidence for that assertion. This scenario is demonstrated in Illustration 5.4. Illustration 5.4 Low-risk assertion

Audit Risk =

Risk of Material Misstatement Detection Risk

Level of sufficient appropriate

evidence Inherent Risk Control Risk

Low Low High Decreased

The risk patterns illustrated in Illustrations 5.3 and 5.4 are extremes. The risk of material misstatement associated with most assertions falls somewhere in between. Ultimately, the amount of evidence gathered when conducting substantive procedures is a matter for professional judgment and will vary from assertion to assertion and client to client. Nevertheless, there is a direct rela- tionship between the risk of material misstatement (inherent and control risk) and the extent of sufficient appropriate evidence gath- ered when testing transactions and balances.

Cloud 9 Ian thinks he finally understands. To limit the risk of an inappropriate audit opinion for Cloud 9, the audit team will assess inherent risk and control risk at the assertion level for account balances and transactions. They make the inherent and control risk assessments after gaining an understanding of the client because these risks are influenced by the client’s circumstances.

If inherent and control risk are assessed as high, the audit team will set detection risk as low. This means the audit team will need to gather more, better quality evidence through substantive testing than if inherent and control risk are assessed as low. In addition, planning materiality is set by considering what would be influential to users of the financial statements. The lower the detection risk and materiality level, the more sufficient appropriate evidence that needs to be gathered.

Suzie thinks the time spent having coffee with Ian has been well worth it!

BEFORE YOU GO ON 2.1 What are two characteristics of appropriate audit evidence? Develop an example of each. 2.2 What is a disadvantage of using evidence that is generated internally by the client? Explain with an example. 2.3 Describe the relationship between audit risk and sufficient appropriate audit evidence. Develop an example in the context of auditing

the occurrence of revenues.

5.3 PROCEDURES FOR GATHERING AUDIT EVIDENCE

3 Explain the procedures for gathering audit evidence.

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Auditors spend a considerable amount of total audit time on the process of obtaining and evaluating audit evidence in support of management assertions. The primary source of the evidence is the client’s accounting records. The accounting records consist of the records of initial accounting entry and supporting records such as checks, invoices, contracts, general and subsidiary ledgers, and supporting spreadsheets and cost allocations. Auditors also gather evidence from other sources independent of the client to corrob- orate, or confirm, amounts recorded in the client’s accounting records. Audit evidence consists of information that supports and corroborates management’s assertions and any information that contradicts the assertions. In some situations, the absence of infor- mation may also constitute audit evidence (AU-C 500.A1). For example, suppose a client recorded the purchase of a new piece of equipment which increased total assets. Auditors would observe the tangible asset and inspect the vendor’s invoice for the purchase in support of the existence assertion, and make inquiries about how the equipment was financed. If there is no invoice to corroborate the purchase of a new piece of equipment, then perhaps the client did not actually buy the equipment. The equipment could be a short term rental and therefore should not be recorded as an asset. The absence of an invoice would serve as audit evidence that contradicts management’s assertion.

accounting records client’s records of the initial accounting entry and supporting records

Let’s now discuss “how” auditors gather audit evidence. Audit procedures are the methods used by auditors in gathering evi- dence and they are classified into three general categories as follows:

1. Risk assessment procedures (discussed in Chapters 3 and 4) – methods used to gain an understanding of a client and its industry for the purpose of identifying risk of material misstatement. 2. Tests of controls (discussed in Chapters 3 and 7) – methods used to determine the operating effectiveness of the client’s controls in preventing, or detecting and correcting, material misstatements at the assertion level. 3. Substantive procedures (discussed in Chapters 3, 8, 10, 11, 12, and 13) – methods designed to detect material misstate- ments at the assertion level. Two categories of substantive procedures are tests of details (of account balances, transac- tions, and disclosures) and substantive analytical procedures.

We have introduced these categories in chapters 3 and 4 in the discussion of risk assessment, audit risk, and audit strategy. We now detail the specific procedures auditors perform to gather sufficient appropriate evidence. The specific procedures described in the rest of this section are used as risk assessment, tests of controls, or substantive procedures as determined by the auditors.

5.3.1 Inspection of documents and assets Inspection involves the examination of documents and physical assets. Let’s first discuss the inspection of documents. The docu- ments could be internally or externally generated and in paper or electronic form. Inspection of documents can be used as a risk assessment procedure, test of controls, or a substantive procedure. For example as a risk assessment procedure, auditors inspect the board of directors meeting minutes to become familiar with the objectives and strategies of the client. As a test of controls, auditors inspect purchase orders for proper authorization by a manager before a purchase is made. As a substantive procedure, auditors inspect vendor invoices in support of management’s assertion of the valuation of inventory.

inspection an evidence gathering procedure that involves examining documents and physical assets

When used as a substantive procedure to test management’s assertions of occurrence and completeness, the inspection procedure

can be further explained by the direction of the testing. First, auditors want to determine if transactions recorded in sales revenue actually occurred. They start by selecting transactions from the sales journal or ledger and then examining the underlying source

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documents, such as a shipping document and an invoice to the customer as illustrated in Illustration 5.5. This procedure is called vouching. Auditors are essentially working backwards from the recording of the event back to the supporting documentation. Vouching provides evidence that recorded transactions actually occurred.

vouching a type of inspection in which auditors select transactions from a journal or ledger and work backwards to examine the underlying source documents. Vouching provides evidence for the occurrence assertion.

What if auditors are gathering evidence in support of the completeness assertion for sales? They want to determine if all sales that occurred have been completely recorded. This time, auditors will start with the underlying source documents and work forward to follow the transaction through to recording in the journal and ledger (see Illustration 5.5). This process is called tracing. In the sales example, auditors would start with a sales order, then follow the transaction forward to a shipping document, to an invoice to a customer, and then to related journal entries and posting to the ledger.

tracing a type of inspection in which auditors select source documents and work forward to follow the transaction through to recording in the journal and ledger. Tracing provides evidence for the completeness assertion.

Inspection is also used to gather evidence for assertions related to physical assets. For example, auditors inspect an actual piece of machinery in a client’s factory to support the existence assertion. If the machinery is not being used, perhaps it is obsolete or in need of repairs. This evidence is used to determine if assets should be written down below cost, which relates to the valuation and allocation assertion. Illustration 5.5 Vouching vs. Tracing

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Cloud 9 Suzie will head the team gathering evidence about inventory. There are some issues with Cloud 9’s inventory control, including difficulties in delivering merchandise from the warehouse to the store in a timely manner. Suzie is also concerned about the thefts at Cloud 9’s retail store. Although Cloud 9’s management has been very open in disclosing the thefts, Suzie is concerned about what this means for the effectiveness of inventory control. She plans to inspect inventory and gather evidence of its existence and quality (because obsolescence is another major concern).

Sharon will also assign a team to inspect the furniture and equipment, and the leasehold improvements, as there have been some major additions this year because of the new store opening.

Ian is a little concerned about being asked to inspect assets. “I don’t understand how inspection can sometimes relate to the existence assertion and other times relate to the completeness assertion. How do I know when the evidence relates to one assertion and not the other?” he asks Suzie.

Suzie tries to explain that it depends on the process. If you start with the accounting records and then gather evidence to support the records, you are gathering evidence about existence. For example, the furniture and equipment ledger account has a record stating that Cloud 9 owns a photocopier. The record contains information about brand, size and other details. Can you agree the records to the physical item. That is, can you find the photocopier in the office? If so, you have evidence that it exists. (You would also do separate tests for its valuation and rights and obligations.) However, if you see a photocopier in the office, your question is then whether the item is in the accounting records. That is, are the accounting records complete? In this case you start with the physical item and trace it through to the records. If the photocopier is entered in the ledger, you have evidence about the completeness of the accounting records.

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5.3.2 Observation Observation is an audit procedure that involves watching a process or procedure being carried out by client personnel or another party. For example, auditors observe the opening of the mail to determine whether the appropriate control procedures over the handling of cash receipts are being followed with appropriate segregation of duties. Keep in mind that observation only provides evidence of a process at the time auditors observe it being carried out. Auditors must determine whether there is evidence that the procedures observed have been applied consistently throughout the period under audit.

observation an evidence gathering procedure that involves watching a process or procedure being carried out by client personnel or another party

5.3.3 Inquiry Inquiry involves asking questions verbally or in written form of knowledgeable individuals internal or external to the client. In- quiry is used when gaining an understanding of the client and to corroborate other evidence gathered throughout the audit. For example, during risk assessment, auditors will inquire of client management regarding various topics such as related parties, corpo- rate governance, and major customers. The results of inquiries of client personnel and third parties are documented by the auditor. If the evidence is particularly important, auditors may document the information more formally and ask the other party (or parties) to the discussion to sign their agreement that the auditors have recorded the discussion accurately.

As a test of controls or substantive procedure, inquiry of client personnel, on its own, typically does not provide reliable evi- dence to reduce audit risk to a low enough level for a relevant assertion (AS 1105.17). Additional evidence needs to be gathered to corroborate the client’s statements. For example, auditors ask the CFO about any new or updated lease agreements. The CFO tells the auditors the company signed a lease agreement for a new manufacturing facility. The auditors will document the response, but would also need to follow up by inspecting the actual signed lease agreement. This is an example of auditors using professional skepticism by verifying statements made by the client.

inquiry an evidence gathering procedure that involves asking questions verbally or in written form to gain an understanding of various matters throughout the audit

Audit Reasoning Example – Evidence for Relevant Assertion Your client is Jane’s Apparel, a national chain of women’s clothing stores. There are 500 Jane’s stores located in malls across the United States. Inventory is a key account for Jane’s, and the existence assertion for inventory is always a relevant assertion. As part of your risk assessment procedures, you meet with the national inventory manager, Carla, to inquire about internal controls over inventory and other issues about inventory for the current year audit. Carla says, “As you know, one of our biggest problems is employee theft of our merchandise. We just recently decided to hire an outside company to perform our annual physical inventory count rather than having our own employees perform the count. Although it will be an additional cost for us, we think the benefits of an independent inventory count will be worth it. It will deter employee theft and hopefully detect instances of theft that are occurring.”

After your meeting, you document Carla’s responses to your inquiries. You are excited about the news of an independent company performing the inventory count and discuss it with another member of your audit team, John. You say to John, “Since an independent company is performing the count, I guess that means we do not have to observe the physical inventory count anymore. We can use the report from the independent company, right?” John thinks for a moment, then says, “I agree that it is an improvement in internal

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controls to have an independent company physically count the inventory. But remember, we have documented that the existence of inventory is a relevant assertion. Therefore, we must gather an increased level of sufficient, appropriate evidence to support our conclusion. Can we rely solely on inquiry of the client? Can we rely on the report from the independent company that is counting the inventory? I recommend that we still observe the physical inventory counting, even though it is being performed by an inde- pendent company. As we have done before, we will select a sample of stores from across the country and have auditors from our firm present while the inventory is being counted.” You agree with John that having your auditors observe the physical inventory count provides more relevant and reliable evidence to support the existence assertion for inventory.

5.3.4 Confirmation AU-C 505 External Confirmations and AS 2310 The Confirmation Process provide guidance on the use of external confirmations. External confirmation is an audit procedure in which the auditor corresponds directly with a third party, either in paper or electronic form. The third party is asked to respond directly to the auditor, not to the client, on the matter(s) included in the confirmation. Evidence obtained from external confirmations is considered reliable because it is obtained from an independent source outside of the client. However, auditors must maintain control over the confirmations at all times. Specifically, auditors determine the follow- ing for the confirmations: 1. What information should be confirmed or requested?

2. Who is the appropriate confirming third party?

3. How should the confirmation request be designed?

4. How will the third party respond directly to the auditor?

5. When should the confirmation request be sent?

6. If applicable, how should auditors follow-up on requests when the third party has not responded?

External confirmations can be sent to any third parties the auditors deem necessary, but the most common confirmations are with the client’s bank and customers.

external confirmation an audit procedure in which the auditor corresponds directly with a third party, either in paper or electronic form, and the third party responds directly to the auditor on the matter(s) included in the confirmation.

A bank confirmation is a request for information about the amount of cash held in the bank, details of any loans with the bank (e.g., interest rates and terms), and details of any pledges of assets made to guarantee loans. This information is used to confirm that the cash listed on the client’s balance sheet is recorded at the appropriate amount (valuation and allocation assertion), is in the client’s name (rights and obligations assertion) and that all loans with the bank are included in the liability section of the balance sheet (completeness assertion). The bank confirmation also requests details of interest rates paid on the client’s cash balances, if applicable, and interest rates charged on bank overdrafts and loans. This information is used when auditing interest income and interest expense items (accuracy assertion). We will cover the bank confirmation in depth in Chapter 13.

bank confirmation correspondence sent directly by the auditors to their client’s bank requesting information such as cash held in the bank and details of any loans with the bank and interest rates charged

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Receivable confirmations can be sent to customers to verify amounts owed to the client. Auditors select the customers to whom they will send confirmations. Criteria used when selecting the customer balances to confirm include materiality (large trade receiv- ables), age (overdue accounts) and location (if customers are dispersed, a selection from various locations). The primary assertion being tested when using receivable confirmations is existence. The confirmations provide audit evidence that the customers exist. They also provide some evidence on ownership (rights and obligations assertion), as customers confirm that they owe money to the client. Customers are only asked to confirm they owe the amount outstanding at year-end (or at an interim date). They do not confirm their intention to pay the amount due. Therefore, confirmations provide very little evidence regarding the valuation and allocation assertion.

receivable confirmation a correspondence sent directly by the auditors to their client’s customers requesting information about amounts owed to the client by the customer

There are two types of external confirmations, positive and negative confirmations. Positive confirmations ask recipients to reply in all circumstances. If a response cannot be obtained, auditors assume the receivable does not exist. Negative confirmations ask recipients to reply only if they disagree with the information provided. If a recipient does not respond to a negative confirmation, it is assumed they agree with the information provided. But could there be other reasons why there is no response? What if the customer never received the confirmation, perhaps because of an address error? What if it is sitting on someone’s desk and has not been opened? Because of these “unknowns,” this form of request is of limited benefit when the assertion being tested is existence. According to AU-C 505.15 and AS 2310.20, auditors should not use negative confirmations as the sole audit procedure unless all of the following conditions are present: 1. Auditors have assessed the risk of material misstatement for accounts receivable as low. 2. Auditors have gathered sufficient appropriate evidence that internal controls are effective. 3. The population of accounts receivable balances consists of a large number of small account balances. 4. Auditors expect a low exception rate. 5. Auditors are not aware of any circumstances that would cause the recipients to disregard the confirmation request. In practice, negative confirmations are not commonly used. Positive confirmations provide superior evidence because auditors must follow-up on any non-responses by verifying the appropriate recipient and sending a follow-up request.

positive confirmation correspondence sent directly by an auditor to a third party, who is asked to respond to the auditor on the matter(s) included in the letter in all circumstances (that is, whether they agree or disagree with the information included in the auditor’s letter)

negative confirmation correspondence sent directly by an auditor to a third party, who is asked to respond to the auditor on the matter(s) included in the letter only if the party disagrees with the information provided

When auditors send a positive receivable confirmation, they ordinarily include the amount recorded in their client’s records for each customer to confirm. There is risk that a customer may sign and return the confirmation to the auditor without checking the balance outstanding. As the primary assertion being tested when using this audit procedure is existence, rather than valuation and allocation, this issue is not of great concern. Auditors will rely on other procedures to provide evidence on the valuation and alloca- tion of the receivable balance. If auditors were to send a confirmation to customers requesting they provide the balance outstanding, there is risk that customers will not respond as locating the amount owed takes some effort to find, which would reduce the overall response rate and the amount of evidence available for the existence assertion. We will revisit the accounts receivable confirmation process in Chapter 11.

Cloud 9 Suzie explains to Ian that they use external confirmations to gather sufficient appropriate evidence about Cloud 9’s customers’ existence. However, the confirmations will not be appropriate for valuation purposes, as a reply from a customer to confirm the debt exists does not mean the customer is going to pay the debt when it is due. They will use other procedures to provide evidence about the valuation assertion

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for accounts receivable. Suzie also suggests that bank confirmations will be useful on the Cloud 9 audit for the rights and obligations, existence, and valuation

assertions for bank accounts. Because they will also ask the banks to supply any information they have about any other bank accounts or loans, bank confirmations will also be useful for gathering evidence about the completeness assertion for these accounts.

Suzie incorporates her ideas on confirmations into the draft audit program.

PROFESSIONAL ENVIRONMENT

Updating audit confirmation standards How has technology influenced audit practice and standards? According to Daniel Goelzer, a former member of the Public Company Accounting Oversight Board (PCAOB), it has impacted practice more than the standards. In 2009, Goelzer believed that changes to the US standard on audit confirmations (at the time AU Section 3302) were necessary to bring it into the twenty-first century.3 Goelzer suggested that technological innovations such as the internet and email have changed confirmation practice since AU Section 330 was written in the early 1990s.4

In the United States, the practice of audit confirmations is essentially mandatory, unlike the situation that typically prevails in the rest of the world where confirmations are an optional procedure — a tool available for auditors to select as part of a package of audit procedures.4 The US requirement to use confirmations dates back to a famous fraud case, McKesson Robbins, in the 1930s.6 In that case around $19 million of a total of $87 million in assets were entirely fictitious and the fraud would probably have been discovered if audit confirmations had been used appropriately.7 More recent scandals, such as the Madoff, Satyam and Parmalat cases, have meant that the confirmation process is back in the spotlight.8

The PCAOB believes that a new confirmation standard should take into account today’s sophisticated security and encryption tools for email and online transactions. Specifically, some confirming parties have indicated that instead of responding to confirmation requests, they prefer to allow the auditors to have electronic access to the company’s accounts so the auditor may directly check the confirming party’s records.9 Current PCAOB member Steven Harris believes “the standard should address the use and reliability of confirmations received electronically. It should address the authenticity and accuracy of direct access to online account information.”9 In addition, auditors are continually faced with disclaimers — clauses inserted into a client’s customer’s reply to a confirmation request disclaiming responsibility for any inaccuracy in the information provided. In a litigious society like the U.S., these disclaimers are routinely used to avoid legal liability for statements made. However, the auditor is then faced with a decision; that is, how much weight to place on a statement that is accompanied by a disclaimer? The PCAOB included this issue in its request for public comment on the new standard.

The comment period for the proposed rule closed in September 2010. The PCAOB received 27 comment letters, 19 of which were from accounting firms and associations of accountants. There was general acknowledgment from the respondents that the existing standard needs to be revised. However, there were two primary recommendations from the respondents. One recommendation is that the standard should be modified to be more principles and risk based rather than being a hard rule that auditors must use confirmations. With a principles and risk-based model, auditors can rely more on their professional judgment when determining if confirmations are appropriate for a given client. The second recommendation is that additional research should be conducted to determine how additional confirmation requirements will affect the confirming parties. Currently, the PCAOB has not issued any updated standard on the confirmation process.11

The clarified standards of the Auditing Standards Board include an updated standard on external confirmations that became effective for audit periods ending after December 31, 2012. Paragraph A15 of AU-C 505 addresses the issue of validating the source of replies received in electronic format, such as email. It may be possible for the auditor to establish a secure environment for electronic responses, for example, by the use of encryption, electronic digital signatures, and procedures to verify website authenticity. However, if this is not possible and the auditor has doubts about the reliability of any form of evidence obtained through the confirmation procedure, AU-C 505 requires the auditor to consider alternative procedures; for example, telephone contact with the respondent (AU-C 505.A14).

5.3.5 Recalculation Recalculation is the audit procedure of checking the mathematical accuracy of documents or records. Recalculation can be per-

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formed manually or electronically with the aid of computer software. Some recalculations are simple, such as footing (adding/sub- tracting figures) a column in a client prepared spreadsheet. Other recalculations are more complex such as foreign currency trans- lation, payroll taxes, interest on loans outstanding, and depreciation. When conducting complex recalculations, auditors agree the amounts included in the calculations to externally prepared documents, when available, and check that the formulas are used appro- priately.

recalculation an audit procedure that involves checking the mathematical accuracy of documents or records

5.3.6 Reperformance Reperformance involves the independent execution of procedures or controls that were originally performed by client personnel. In other words, the auditors will “re-do” a procedure that was performed by the client to determine if the auditors get the same result. Reperformance is commonly used as a test of controls. For example, a client’s control procedure over cash disbursements states that checks are prepared only after all source documents have been independently approved in a voucher packet. Auditors can reperform this procedure by looking at approved voucher packets awaiting check processing. Auditors reperform the act of agreeing all of the source documents and verify that an approval signature is on the packet.

reperformance an audit procedure that involves the independent execution of procedures or controls that were originally performed by client personnel

Another example is reperforming a bank reconciliation the client has prepared. Client personnel prepare bank reconciliations for all bank accounts each month as an internal control procedure. Auditors will reperform the bank reconciliation to gather evi- dence that the procedure was performed correctly.

5.3.7 Analytical procedures Recall from chapter 4 that analytical procedures are an evaluation of financial information by studying plausible relationships among both financial and non-financial data. Some examples of analytical procedures include data comparisons, ratio analysis, and trend analysis. During risk assessment, analytical procedures are required and are used to identify accounts at risk of material misstatement which aids in planning the audit. They can also be used as a substantive procedure during the risk response phase of the audit to gather sufficient appropriate evidence.

analytical procedures an audit procedure that consists of an evaluation of financial information by studying plausible relationships among both financial and non-financial data

When properly designed and executed, analytical procedures may provide an efficient alternative to other audit procedures and,

in some cases, may provide the most effective test of the appropriateness of account balances. For example, when auditing man- agement’s estimate of the allowance for doubtful accounts or the accrual for warranty costs, auditors compare the current year esti- mates with prior year estimates, taking into consideration any increases or decreases in sales. Based on the results, auditors may decide that no further substantive testing is needed. In other situations, analytical procedures may provide the only method of gathering evidence. For example, if the client does not maintain an effective costing system, auditors could estimate manufactur- ing overhead in finished inventory by relating actual overhead for the year to actual direct labor. The use of analytical procedures

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as a substantive procedure is covered in more depth in Chapter 8.

5.3.8 Scanning Scanning is a type of analytical procedure in which auditors use their professional judgment to review accounting data to identify unusual or significant items that may be an indication of a material misstatement. Scanning includes the identification of unusual individual items within an account balance or other accounting records such as journals, reconciliations, and detailed transaction reports. Examples of unusual items include a large dollar amount for a transaction, such as a very large cash receipt that might be evidence of a loan, or a non-standard journal entry. Once an unusual item is identified, auditors may decide to further examine the item using other audit procedures, such as inspection or recalculation.

scanning a type of analytical procedure in which auditors use their professional judgment to review accounting data to identify unusual or significant items to further examine

5.3.9 Computer assisted audit techniques (CAATs) and Audit Data Analytics (ADA) As clients have incorporated more technology into their processes, so have auditors. Auditors use computer assisted audit tech- niques, or CAATS, to assist with gathering evidence. CAATS range from simple techniques, such as electronic spreadsheets and software for a paperless audit, to more sophisticated procedures, such as the recent development of audit data analytics.

computer assisted audit techniques (CAATs) an audit procedure in which computer software is used to interrogate and examine client data

When clients use computers to maintain or process accounting data, auditors can use CAATs software to perform procedures such as calculations (for example, the summing of a report) and logic tests (for example, sorting or comparing current year amounts with prior year), and to select key items and representative samples for testing. Audit data analytics, or ADA, is using software to discover and analyze patterns, identify anomalies, and extract other useful information from client data. Auditors then use “visualization” techniques to draw conclusions and communicate the information. Visualization refers to the use of graphics to explain and communicate findings. Typical visualization techniques include graphs, charts, trend lines, scatter diagrams, and dashboards. For example, traditional audit techniques would compare aggregate figures, such as current year sales compared to prior year sales, or quarterly sales totals in the current year to quarterly sales totals from the prior year. ADA software can provide a deeper examination of sales activity by summarizing every sales transaction for the year into a graph that shows a trend line with time on the x-axis and dollars of sales on the y-axis. This deeper analysis shows more detailed trends with highs and lows of sales activity. Knowing more about their clients helps auditors plan a more effective audit.

audit data analytics (ADA) using software to discover and analyze patterns, identify anomalies, and extract other useful information in data underlying the subject matter of an audit through analysis, modelling, and visualization for the purpose of planning or performing an audit

visualization using graphics to explain and communicate findings

Using CAATs and ADA software makes the audit (1) more comprehensive because each item in a client’s file can be examined and subjected to a variety of tests and (2) more efficient because the computer can handle large volumes of data, thereby reducing time-consuming clerical tasks. Using software also allows auditors to concentrate on designing the test criteria and evaluating and interpreting the results, rather than on performing the detailed audit procedures.

CAATs and ADA can be used during risk assessment and risk response. The main considerations in deciding whether to use

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CAATs and ADA are the completeness of the client’s records and the reliability of the client’s data. As with any audit procedure, the nature and extent of the procedures performed with CAATs and ADA will largely depend on the evaluation of the effective- ness of the client’s information technology controls. The use of CAATs and ADA will be covered in more depth in Chapters 10 through 13.

Cloud 9 Suzie and Ian have already begun gathering evidence by performing the analytical procedures on Cloud 9’s interim results and prior period statements. Further evidence gathering at the risk assessment phase will be performed by Josh and Sharon when they begin their assessment of the internal controls system by inspecting the relevant documents. They will gather evidence from observing personnel performing their duties and making inquiries of members of Cloud 9’s staff and management. In addition, the partner, Jo Wadley, held discussions with the previous auditors (Ellis & Associates) before accepting the client. The record of these discussions, plus others that Jo Wadley held with Cloud 9 management, is already in the evidence files.

Ian has some questions about the evidence; in particular, why the audit team is bothering to gather verbal evidence, through inquiry, which has low persuasiveness. Suzie explains that all forms of evidence have their limitations. Observation is useful to see how staff perform their tasks (as opposed to what the manuals say they should be doing), but people often “behave” better when they are being watched. Documents can be lost or altered, or misinterpreted, and not everything is written down. Electronic evidence is hard to audit if the system does not have a “hack proof” audit trail. Signatures on documents do not mean the signor actually read the document properly, and people can pre- or post-date documents. Auditors have to judge the appropriateness and sufficiency of evidence by considering it as a whole and be prepared to follow up on any problems or discrepancies they observe until any doubts are satisfactorily resolved.

BEFORE YOU GO ON 3.1 Explain the procedures of vouching and tracing. Illustrate with an example in the context of the revenue cycle. 3.2 What is a bank confirmation? Why is it an important confirmation? 3.3 How is a positive confirmation different from a negative confirmation? What standards guide the use of each? 3.4 Explain the audit procedure of reperformance? Illustrate with an example in the context of revenue transactions.

5.4 USING THE WORK OF OTHERS

4 Evaluate when it is appropriate for auditors to use the work of others. In Chapters 3, 4, and 5, we have covered a significant amount of information regarding the planning and design of an audit. As you have probably concluded, an audit requires many hours of work by a team of auditors. The size of an audit team will vary depending on the size and complexity of the client. The composition of a typical audit team is depicted in Illustration 5.6. You can think of the composition of an audit team like a triangle, with more team members at the base of the triangle and fewer at the top. The senior and associates perform the detail testing under the supervision of the manager. The partner holds ultimate responsibility for audit decisions, supervision of the team members, and the issuance of the final audit report. Throughout the engagement as audit proce- dures are completed and documented, they are reviewed by an audit team member with seniority over the team member who did the work. Chapter 14 will provide more information about the review of audit documentation.

In Illustration 5.6, the approximate years of experience for each level of team member are also shown in the diagram. When assigning the audit team, an audit firm will make sure it assigns individuals with appropriate audit experience. An appropriate response to an identified risk may be assigning an individual with the right experience. For example, when fraud risk is high the audit firm may assign an individual with more audit experience in a particular industry to audit an assertion than when fraud risk is low.

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Illustration 5.6 Typical structure of an audit team

In some situations, the audit team will rely on the work of others during the risk assessment and/or risk response phase of the

audit. Some examples include relying on an industry or technical specialist, the client’s internal auditors, and/or other auditors. These situations will be discussed in the following sections.

5.4.1 Using the work of a specialist Some audits may require the use of a specialist when gaining an understanding of a client, testing internal controls, and/or performing substantive tests. A specialist is an individual or an organization with expertise in a field other than accounting or auditing whose work in that field is used by the auditors to assist in obtaining sufficient appropriate audit evidence. The specialist may be an employee of the accounting firm or may be contracted by the accounting firm as needed. Some examples of when a specialist may be used include estimating oil and mineral reserves for inventory reporting and performing actuarial calculations for the determina- tion of employee benefit plan liabilities. Specialists may also be used to evaluate the quality of inventory, such as taking samples of grain from a grain elevator to determine if the grain has any bacteria or other attributes that could affect its quality.

specialist an individual or organization with expertise in a field other than accounting or auditing whose work in that field is used by the auditors to assist in obtaining sufficient appropriate evidence

AU-C 620 Using the Work of an Auditor’s Specialist and AS 1210 Using the Work of a Specialist provide guidelines for audi- tors when using the work of a specialist. The first step is for auditors to determine whether a specialist is required. The need to engage the services of a specialist depends on the knowledge of the audit team, the significance and complexity of the item, the risk of material misstatement of the account or assertion, and the availability of appropriate alternative corroborating evidence. If the audit team has experience with the item being audited and can draw on their knowledge from previous audits of that client or

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similar companies in the same industry, there is less need to use a specialist. If auditors decide they do not have the expertise nec- essary to test and evaluate the accuracy of reported information, they can seek assistance in the form of a specialist’s opinion to corroborate other evidence obtained. For example, a licensed appraiser may be engaged to provide an opinion on the value of a client’s property; a geologist may be engaged to evaluate the quantity and quality of mineral deposits; a vintner may be engaged to assess the quality and value of wine stocks; or an actuary may be engaged to verify insurance premiums.

Once it has been determined that a specialist is required, the next step is for the auditors to determine the scope of the work to be carried out and agreed to by the specialist. The agreement can be in the form of a formal engagement letter with the specialist or recorded in the audit planning documents when using a specialist from another office of the audit firm. Auditors determine the nature, timing and extent of work to be completed by the specialist. It is important that auditors are involved in setting the scope of the work required because the judgment of the specialist forms part of the audit evidence upon which auditors form their audit opinion. Written instructions to the specialist can cover the (1) issues the specialist is to report upon, such as the market price of properties owned by the client; (2) the details to be included in the report, such as computations used in arriving at their conclu- sion; (3) the sources of data to be used, such as market interest rates or market prices of shares; (4) clarification of the way the au- ditors intend to use the information included in the specialist’s report; and (5) notice that the specialist’s report and the data used in compiling the report, must remain confidential.

Before contacting a specialist, auditors should assess the competence, capability, and objectivity of the specialist. Competence refers to the expertise of the specialist. What are the qualifications of the specialist? Does he or she maintain a license or certifica- tion in a relevant field? How many years of experience does the specialist have in the relevant field? Capability refers to the abil- ity of the specialist to perform the required work. For example, does the specialist have the time and resources needed to complete the work? Is the specialist located in the area or will significant travel be required? Objectivity refers to the possible effects that bias, conflicts of interest, or the influence of others may have on the professional judgement of the specialist (AU-C 620.A15). Auditors should inquire of the client and of the specialist as to whether any interests or relationships exist between the client and the specialist that would impair the specialist’s objectivity. For example, does the specialist have any financial interests or outside business relationships with the client? The specialist is not required to be completely independent of the client. If some type of relationship does exist between the client and the specialist, auditors may decide to perform some additional procedures with re- spect to the specialist’s work to determine that the findings are reasonable.

Once the specialist’s work is complete, auditors will assess the specialist’s report. The report should detail each stage of the process used in arriving at the overall conclusion in the report, including information about the data sources or estimation models used, or calculations conducted. Auditors assess the consistency of any assumptions made with those made in prior years and with other known information and with conclusions drawn with corroborating evidence gathered by the audit team.

The responsibility for arriving at an overall conclusion regarding fair presentation of a client’s financial statements rests with the auditors. When auditors decide to use a specialist, that responsibility is not reduced in any way. It is the responsibility of auditors to assess the quality of the evidence provided by a specialist and determine whether it is reliable and objective. Auditors do this by following the process outlined above. They will determine the need for a specialist, the scope of the specialist’s work and the com- petence and objectivity of the specialist. Finally, auditors will assess the quality of the specialist’s report and the reliability of the information included in it.

Cloud 9 Suzie will take responsibility for obtaining a specialist’s opinion on the derivatives. She knows that W&S Partners has other staff (who are not part of the audit team) who can provide additional expertise. However, because she believes the accounts are so material to the audit and derivatives have become such a big issue in audits in recent years, she deems an external specialist’s opinion is also required. She has some experience of using a derivatives specialist on prior audits of clients in the footwear and clothing industry, and she also plans to ask Jo Wadley (the partner) to recommend a suitable specialist.

Suzie plans to investigate any possible connections between the specialist and Cloud 9 that could adversely impact the specialist’s

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objectivity before engaging him for this audit.

PROFESSIONAL ENVIRONMENT

Working with IT auditors Specialist IT auditors are often used in audits of clients with complex information technology (IT) environments because the effective audit of the IT systems contributes to overall audit quality. Large audit firms usually have such specialists within the firm, but smaller audit firms could be forced to engage external IT consultants for this part of the financial statement audit. In general, reliance on an IT specialist is appropriate when the financial statement auditor complies with the conditions of AU-C 620.

If the IT expert and the financial statement auditor do not work well together, audit quality can be impaired. For this reason, researchers have investigated the factors that affect the way that financial statement auditors work with specialist IT auditors. Brazel12 reviewed this research evidence and drew the following conclusions. First, responses from financial statement auditors in the United States who were surveyed about their experiences with IT auditors indicated that they believe IT auditors’ competence levels vary in practice. Financial statement auditors also said that IT auditors appear to be overconfident in their abilities in some settings, and questioned the value provided by IT auditors to the financial statement audit.

Second, Brazel suggests the research shows that both financial statement auditors’ IT ability and experience and the IT auditor’s competence affect how these two professions interact on an audit engagement. This indicates that audit firms need to ensure that staff training and scheduling produce appropriate combinations of financial statement auditors and IT auditors on an engagement.

Finally, Brazel argues that the research findings demonstrated that auditors need to consider the implications of finding a balance between greater computer assisted audit techniques (CAATs) training for financial statement auditors and greater use of IT specialists for overall audit efficiency and effectiveness.

The role of IT audit specialists could grow to become even more than a support function for auditors. Some researchers suggest that in e- businesses the external financial statement auditor’s authority will be challenged by IT audit specialists because of technological change and its impact on auditing.13 In e-businesses, economic transactions are captured, measured, and reported on a real-time basis without either internal human intervention or paper documentation.14 Auditing is likely to become more real-time and continuous to reflect the pattern of the transactions. If traditional auditors are unwilling or unable to adapt to the new environment, their role could be taken over by IT specialists.

Other developments such as reporting using XBRL (eXtensible Business Reporting Language) provide challenges for auditors as they have to adapt their techniques and approaches to audit financial information that is disaggregated and tagged. Users can extract and analyze XBRL data directly without re-entry and the tag provides additional information about the calculation and source of the data. This means auditors have to recognize that their clients are reporting financial data with different levels of information and users might have greater expectations of the data. Learn more about XBRL at www.xbrl.org.

5.4.2 Using the work of internal auditors The role of the internal audit function was introduced in Chapter 1. Internal auditors are employees of the client that perform assurance and consulting activities designed to evaluate and improve the effectiveness of the entity’s governance, risk manage- ment, and internal control processes. Not every client will have an internal audit function. For example, small and medium sized companies, especially private companies, may not have the resources to staff an internal audit function. But if the client does have an internal audit function, what role, if any, do the internal auditors play in the financial statement audit? According to AU-C 610 Using the Work of Internal Auditors and AS 2605 Consideration of the Internal Audit Function, auditors may (1) use the work of internal auditors in gathering audit evidence and (2) use internal auditors to provide direct assistance under the direction, supervi- sion, and review of the external auditors.

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internal auditors employees of the client that perform assurance and consulting activities designed to evaluate and improve the effectiveness of the entity’s governance, risk management, and internal control processes.

If external auditors intend to use the work of internal auditors, they must first assess the objectivity, competence, and processes of the internal audit function. The concepts of objectivity and competence discussed above in the context of a specialist also apply when considering internal auditors. Since internal auditors are employees of the client, they are not independent. However, a well-designed internal audit function can operate free of bias and avoid conflicts of interest. Illustration 5.7 lists factors for audi- tors to consider when assessing the objectivity and competence of the internal audit function. Auditors should also consider the processes of the internal audit function. Essentially, auditors want to determine if the internal auditors follow a systematic and disciplined approach to their work and have quality control procedures in place. Ideally, the internal audit function should plan, supervise, document, and review its activities in a way that is distinct from other monitoring activities within the entity. Illustration 5.7 Factors that impact objectivity and competence of internal auditors

Factors that impact objectivity of internal auditors:

• Report directly to the board of directors, audit committee, or owner-manager • No assignment of managerial or operational duties that are outside of the internal audit function • Policies prohibiting internal auditors from auditing areas where relatives are employed or areas where the internal

auditor was previously assigned before moving to the internal audit function • Internal auditors are members of a professional body that obligates compliance with professional standards re-

garding objectivity

Factors that impact competence of internal auditors:

• Technical training and proficiency that may be evidenced by education, years of experience, and professional cer- tification in a relevant field

• Membership in relevant professional bodies that require compliance with professional standards and continuing professional education

• Appropriate staffing relative to the size of the entity

• Established policies for hiring, training, and assigning internal auditors

• Quality of work documentation and reports

If auditors determine that the internal auditors are objective, competent, and follow appropriate procedures, then the next step is

to determine how the internal auditors’ work may affect the nature, timing, and extent of the audit. Procedures planned or already performed by the internal audit function may be the same as, or very similar to, audit procedures the external auditor would design and perform, particularly in the area of evaluation of the performance of internal controls. Therefore, work already performed or planned to be performed by the internal auditors can affect the auditors’ risk assessment procedures, testing of controls, and/or substantive procedures performed. Here are some examples:

• The internal auditors have developed a flowchart for a new computerized sales and receivables system. The external

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auditors obtain a copy and review the flowchart to gain an understanding of the new system. If the auditors are satis- fied with the quality of the flowchart, they will not need to prepare their own flowchart which improves the efficiency of the audit.

• The internal auditors have tested relevant controls over the completeness assertion for accounts payable. The results of the internal auditors’ procedures provide evidence that controls are operating effectively. If satisfied that the controls are operating effectively, auditors may reduce the extent of their testing of these controls.

• As part of their own work, the internal auditors confirm a sample of accounts receivable balances to ensure a new com- puterized sales and receivables system is functioning properly. Auditors may use this work as evidence obtained and then reduce the number of additional receivable balances that would be confirmed.

When determining the extent to which the internal auditors’ work will affect the auditors’ procedures, auditors consider the materi- ality of the account balance or transaction, the risk of material misstatement of the assertions related to the account balance, trans- action, or disclosure, and the amount of subjectivity involved in evaluating the evidence gathered (AU 2605.20). As these factors increase, the need for auditors to perform their own tests of the related assertions also increases. Remember, external auditors have sole responsibility for expressing an opinion on the fair presentation of the financial statements. That responsibility is not decreased by the use of work performed by internal auditors.

External auditors may also obtain direct assistance from internal auditors to carry out audit procedures the external auditors would normally do themselves. In this scenario, internal auditors would be under the direction, supervision, and review of the external auditors. When determining the nature of work to be assigned to internal auditors, external auditors should follow the same guidelines as mentioned in the previous paragraph. As the factors of materiality, risk of material misstatement, and subjec- tivity increase, the need for external auditors to perform the procedures will increase. An example might be the valuation assertion for assets that require significant accounting estimates. Areas involving less materiality, lower risk of material misstatement, and less subjectivity are more appropriate to assign to internal auditors. An example might be the existence assertion for prepaid ex- penses. External auditors should obtain written acknowledgment from management, or those charged with governance, regarding the use of internal auditors for direct assistance with the audit. This written acknowledgment can be included within the audit en- gagement letter or prepared as a separate document.

Audit evidence obtained from the internal auditors and the work performed by internal auditors providing direct assistance are included in the external auditors’ documentation as evidence of work completed. Also included is the evaluation of the objectiv- ity, competence, and procedures of the internal auditors. Audit documentation is discussed further in section 5.5.

Audit Reasoning Example – Consideration of Internal Audit Function One of your clients is Mary Lee’s Cookie Company. Mary Lee’s produces various types of cookies and sells them at grocery stores and convenience stores across the United States. Mary Lee’s is a family run, private company, and it has experienced significant growth over the last six years. The founder and chair of the board of directors, Mary Lee Nguyen, has a goal of taking the company public one day, so she wants to start preparing the company to be run more like a public company. Therefore, she has decided to create an internal audit function. Two months after the conclusion of the prior year audit, Mary Lee hired Kathy Bourgeois to lead the internal audit function. Kathy has three years of internal audit experience working at a public company, and she is a certified internal auditor (CIA). To add to her department, Kathy has hired a recent college graduate who has taken courses in internal audit, and she also has a current college student who is interning part time. Kathy and her team will report directly to Mary Lee and the board of directors.

One of Kathy’s first tasks has been to document Mary Lee’s transaction processes and internal controls. Can your audit team use the work of Kathy’s team regarding the transaction flows and internal controls documentation? Are Kathy and her team objective

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and competent? You consider objectivity. Kathy is a CIA and therefore must comply with professional standards to maintain her certification. The internal audit function reports to the board of directors, not to a member of management. No one in the internal audit function is assigned managerial duties. Therefore, based on these factors, the internal audit function seems to be objective. Now you consider competence. Kathy is a CIA, but she only has three years of work experience. The rest of her department, a recent college graduate and an intern, is not experienced. The internal audit department has only been functioning for a few months. Based on these factors, you do not consider the internal audit function highly competent at this time. Therefore, for the current year audit, you do not plan to use any of the work of Mary Lee’s internal auditors. However, over time, the internal audit function may develop more competence and you may consider using the work of the internal auditors or obtaining direct assistance from them.

5.4.3 Using the work of another auditor Sometimes auditors must rely on work performed by a separate accounting firm. For example, when auditing a consolidated com- pany, the auditors may rely on another accounting firm to audit a subsidiary that is located in a foreign country. AU-C 600 Special Considerations — Audits of Group Financial Statements (Including the Work of Component Auditors) provides guidance when using the work of another audit firm. Group financial statements include the financial information of more than one entity, or component, such as consolidated financial statements prepared by a parent company. A component is an entity or business activity that is required by the applicable financial reporting framework to prepare financial information that will be included in group financial statements. An audit of group financial statements is referred to as a group audit. The group engagement team will establish the overall group audit strategy and communicate with the component auditors. The component auditors are from a different audit firm and gather evidence on a component that will be used as audit evidence for the group audit. The group engagement partner is the partner responsible for the performance of the group audit engagement and for the auditor’s report on the group financial statements.

group financial statements financial statements that include the financial information of more than one entity, or component

component an entity or business activity whose financial information is required by an applicable financial reporting framework to be included in group financial statements

group audit an audit of group financial statements

group engagement team partners and staff who establish the overall group audit strategy, communicate with component auditors, perform work on the consolidation process, and evaluate audit evidence to form an opinion on the group financial statements

component auditor an audit firm that performs work on the financial information of a component that will be used as audit evidence for the group audit

group engagement partner the partner who is responsible for the group audit engagement and its performance and for the auditor’s report on the group financial statements that is issued on behalf of the firm

When making a client acceptance or continuance decision, auditors will consider their capacity to undertake the audit and the proportion of the financial statements for which they will rely on component auditors. The group engagement partner’s firm should audit the majority of a client’s financial statements and be knowledgeable about the components of the financial statements they do not audit themselves. For example, when accepting a new client that has a 50% interest in a joint venture in another country that is audited by another audit firm, the group engagement partner must be knowledgeable of the business of the joint venture so that he or she can evaluate the risks associated with the joint venture and how the joint venture is reported in the financial statements of the potential audit client. If this is not the case, the firm should not accept the new client.

When assigning work to a component auditor, the group engagement partner will consider the capacity of the other auditor to undertake the work. The group engagement partner will also consider the reputation of the component auditor and ensure that it is a member of a reputable professional body. It is the responsibility of the group engagement partner to ensure the work completed by a component auditor meets the group engagement partner’s requirements and standards.

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AU-C 600 sets out the responsibilities of the group engagement partner when using the work of a component auditor. The group engagement partner is responsible for the direction, supervision, and performance of the group audit engagement. The two auditors may discuss the detailed procedures to be used, and the group engagement partner then reviews the main conclusions drawn in the documentation of the component auditor. The extent of review of the component auditor’s work depends on a number of factors. The group engagement partner will spend more time when the component is material and/or at risk of mate- rial misstatement. The group engagement partner will spend less time if the component auditor has a good reputation and/or has done audit work for the group engagement partner in the past, and if the financial statements being audited by the compo- nent auditor are at low risk of material misstatement. The group engagement partner uses the evidence provided by a component auditor when drawing a final conclusion on the fair presentation of the group financial statements. Chapter 15 will discuss what modifications may be required to the independent auditor’s report when component auditors are used.

The corresponding PCAOB standard for using the work of another auditor is AS 1205 Part of the Work Performed by Other Independent Auditors. The guidance in the PCAOB standard is essentially the same as the ASB standard for private companies. The key difference is the PCAOB standard uses different terminology. The term “principal auditor” is used instead of “group en- gagement team” and “group engagement partner.” The term “other auditors” is used instead of “component auditors.”

Cloud 9 Sharon knows that Cloud 9 has production operations in China. The previous auditors, Ellis & Associates, used a Chinese based accounting firm to gather evidence regarding the inventory at the Chinese production facilities. If they want to use the same Chinese accounting firm, Sharon will need to assess the reputation of the other firm and the firm’s capacity to take on the engagement. Sharon decides to set up a meeting with the partner, Jo Wadley, to further discuss how to proceed with gathering evidence related to the Chinese operations.

BEFORE YOU GO ON 4.1 What factors may influence an auditor’s decision on the need to use a specialist? Illustrate with an example. 4.2 Why might an external auditor want to use the work of the internal audit function? Illustrate with an example. 4.3 Who is the group engagement partner? Why is this position important? 4.4 What are some of the factors that a group engagement partner will consider when assigning work to a component auditor?

5.5 DOCUMENTATION — AUDIT WORKING PAPERS

5 Explain how auditors document the details of evidence gathered in working papers. In this chapter we have discussed the characteristics of audit evidence, the procedures for gathering audit evidence, and situations when others may be used to gather audit evidence to support management assertions. Next we cover procedures for documenting all of the audit evidence that has been gathered. AU-C 230 Audit Documentation and AS 1215 Audit Documentation require audi- tors to document each stage of the audit in their working papers to provide a record of work completed and evidence gathered in forming their audit opinion. It details the names of the preparers of that documentation, and the names of the reviewers of the work performed. Documentation is cross referenced between working papers that summarize the details of an account balance and work- ing papers that provide evidence of the testing of that balance.

working papers represent paper or electronic documentation of the audit created by the audit team as evidence of the work completed.

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Auditors document each stage of the audit and the procedures used. During the risk assessment phase, auditors document their understanding of the client, the risks identified, analytical procedures used to aid in risk identification, their materiality assessment, the understanding of the client’s system of internal controls, the understanding of the client’s information technology, and related parties identified. During the risk response phase, auditors develop an audit program, and document details of tests undertaken, copies of significant documents sighted, correspondence with the client’s lawyers and bankers, confirmations received from cus- tomers and inquiries of management.

Documentation will vary from client to client. It will depend upon the audit procedures used, the risks identified, the extent of judgment used, the persuasiveness of the evidence gathered, the nature and extent of exceptions noted, and the audit methodology utilized (AU-C 230).

An audit working paper generally includes: • client name • period under audit • title describing the contents of the working paper • file reference indicating where the working paper fits in the audit file • initials identifying the preparer of the working paper together with the date the working paper was prepared • initials identifying the reviewer(s) of the working paper together with the date(s) the working paper was reviewed • cross-referencing between working papers indicating where further work and evidence is summarized elsewhere.

Working papers are used to document the details of each audit. The two main files held for each client are the permanent file and the current file.

5.5.1 Permanent file The permanent file includes client information and documentation that applies to multiple audits. In the first year of a continu-

ing audit, auditors develop information that will be relevant to future audits. The information included in the permanent file is checked and updated at the start of each annual audit. The permanent file usually contains the client’s head office address, other locations, and contact details (telephone, fax and email). Key personnel are detailed and an organizational chart is included in the permanent file. A client’s organizational chart includes details of key roles within the organization and the names of the people in those roles. The file may also include the details of the client’s bank(s) and lawyer(s).

permanent file contains client information that is relevant for more than one audit.

The permanent file includes copies of long-term contracts and agreements. These documents will be used to calculate interest payable on outstanding long-term loans, or enable the assessment of any lease obligations. Debt covenants will be included in the permanent file. Auditors can check the details of these agreements to assess the client’s compliance with covenants. If a client has long-term commitments with customers and suppliers, auditors will include the relevant documentation in the permanent file. Key long-term investments will be detailed, including the details of the broker used for these transactions.

The permanent file includes details of the client’s board of directors and its subcommittees, such as the audit committee. The file includes the minutes of significant meetings held by the client, such as its board of directors meetings. It may include details of bonus and stock option plans for the client’s senior staff.

The permanent file details a client’s primary accounting policies and methodologies. Prior financial statements and audit reports will be included in the permanent file. Details of prior analytical procedures are included and added to so auditors can observe changing trends. Flowcharts and narratives detailing a client’s system of internal controls are included in the permanent file and amended as needed during the risk assessment phase of each audit.

Reports sent to the client during previous audits will be included in the permanent file. For example, letters to management that detail weaknesses in internal controls identified by the auditors in previous years are included and referred to by the auditors. When planning future audits, auditors read these reports and discuss their contents with the client’s management.

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Cloud 9 Cloud 9, Inc.’s permanent file contains the basic information about the company (that is, its headquarters’ address, key senior staff and their employment contracts) plus a copy of the engagement letter appointing W&S Partners and stating the scope of the audit. Sharon and Suzie have gathered copies of some of the relevant agreements and will add these and more to the permanent file. Josh’s documentation of Cloud 9’s system of internal control has also been added to the permanent file.

5.5.2 Current file The current file is developed as audit work is performed and includes client information and documentation that apply to the cur- rent year’s audit. Contents of the current file vary from client to client depending on the accounts in the client’s financial state- ments and the client’s activities. The current file includes the details of all testing and evidence gathered in preparation of the audit report.

current file contains client information that is relevant for the duration of one audit.

The current file also includes correspondence between the auditors and their client, the client’s bankers, and the client’s lawyers that pertain to the current audit period. Correspondence with other auditors, specialists and relevant third parties are also included. The engagement letter is included in the current file, along with the management letter, detailing any weaknesses uncovered in the client’s system of internal control. Representation letters, covered in Chapter 14, and confirmation letters are also included in the current file.

The current file includes extracts from the minutes of meetings, such as the board of directors’ meetings, which pertain to the current audit. The file includes details of the audit planning process and the audit program. The current file also includes detailed descriptions of evidence gathered, testing conducted and audit procedures performed. It will detail the analytical procedures, tests of controls and detailed substantive testing undertaken, as well as the conclusions drawn at the completion of testing. The current file includes testing of any subsequent events, covered in Chapter 14, and a copy of the final audit opinion.

Examples of working papers This section provides two examples of working papers. While each accounting firm has its own way of documenting evidence,

most have common elements. To aid your understanding, examples are provided of how a fictitious accounting firm, Bell & Bow- erman, LLP prepares its working papers.

Working papers are prepared and stored electronically. Once the audit is concluded, the audit firm usually retains a paper copy of working papers, as well as an electronic copy of files and working papers. An audit firm will back up electronic files and ar- chive working papers in a location that is secure. (Chapter 14 provides more details on documentation retention.) Once they are completed, working papers are typically electronically locked so they cannot be modified. Each audit has a unique file name for ease of identification, which usually includes the client’s name and the year-end of the financial statements being audited. Each current file created for an audit is divided into unique sections with each section representing a different element of the audit (e.g., cash, accounts receivable, or inventory). Each section contains (1) a lead schedule that summarizes the detail included in the financial statements for a particular account, and (2) supporting working papers that provide evidence obtained related to that ac- count. Each working paper generally includes details such as the client’s name, the period under audit, a file reference, cross refer- ences to other parts of the audit file, details of the testing conducted, comments/conclusions drawn and identification of the pre- parer and reviewers.

lead schedule summarizes the detail included in a specific account on the financial statements

For illustration, a series of working papers are presented for a fictional client of Bell & Bowerman, LLP, New Millennium Ecoproducts (NME). The working paper examples are for the audit period ending December 31, 2022. NME was created by its

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founders, brothers Tomas and Charles Delron, avid environmentalists, at the turn of the twenty-first century. The vision for the company is to produce everyday products in a sustainable way, providing an affordable alternative for environmentally conscien- tious customers. NME operates from three locations and produces a wide range of household products which it sells to supermar- kets and specialty stores.

At the front of every audit file is a copy of the client’s trial balance that supports the financial statements. The trial balance is then referenced into the appropriate lead and supporting schedules in the audit file where audit work is documented for each ac- count in the trail balance. At Bell & Bowerman, LLP, the trial balance is referenced using the letter “A,” cash and cash equiva- lents in various banks is referenced into the C Lead, accounts receivable is referenced into the E Lead, inventory accounts are ref- erenced into the F Lead, property, plant and equipment is referenced into the K Lead, and so on.

The first working paper example is the cash and cash equivalents lead schedule (Illustration 5.8). The purpose of this lead is to summarize all general ledger accounts that are combined into the cash and cash equivalents account on the financial statements. The lead schedule also has any adjusting journal entries, if any, that are proposed by the auditor. In the top left corner of the lead schedule is the client name, period end, and currency unit (in this example balances are rounded to the nearest thousand dollars). In the top center of the lead schedule is section identification (C). In the top right corner, details of the working paper preparer and reviewers are documented. In Step 1, general information about the client follows, repeating the information provided in the top left corner. In Step 2, details of the cash and cash equivalents balance follow. For each item listed in the lead schedule the follow- ing is noted:

• general ledger account number, per the client records • general ledger account name, per the client records • pre-adjusted balance, any adjustments and the audit adjusted current year balance per the client’s trial balance (TB) • the prior year balance, per the prior year audit file (PY) • variance and percentage change, the calculated difference between the prior year and current year balances • the cross reference to the working paper where supporting documentary evidence is kept for each balance (e.g, C02).

In Step 3, any analytical procedures that were conducted, or key performance indicators (KPIs) that were evaluated related to the account, are documented. In this case, analytical procedures were conducted using the cash flow statement and they were docu- mented on working paper A1.1. The final section of the lead working paper includes any relevant background information about the account and comments based upon completed testing.

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Illustration 5.8 Working paper example: Cash lead schedule

CLIENT: New Millennium Ecoproducts

Period-end: 12/31/2022

Currency Unit $000

C–LEAD

Bell & Bowerman, LLP Prepared by: KM 1/21/2023

Reviewed by: SO 1/22/2023

Reviewed by: MM 1/24/2023 Reference: C-Lead

Step 1: Enter general information.

CLIENT Period-end Currency Unit

New Millennium Ecoproducts 12/31/2023

$000

Step 2: Lead schedule

12/31/2022 12/31/2022 12/31/2021

Account No. Account Name

Pre- adjusted Adjustments

Adjusted Current

Year Prior Year Variance In % Ref

10100 Cash in Bank: Wells Fargo 11, 000 0 11, 000 TB 10, 500 PY 500 5% C02

10200 Cash in Bank: U.S. Bank 134 0 134 TB 134 PY 0 0% C02

10300 Cash in Bank: Barclays 126 0 126 TB 126 PY 0 0% C02

10400 Cash in Bank: Citigroup 56 0 56 TB 50 PY 6 12% C02

10500 Short-term deposits 5, 796 0 5, 796 TB 5, 600 PY 196 4% C05

TOTAL Cash and Cash Equivalent

17, 112 0 17, 112 16, 410 702 4%

Step 3: Account details, ratios and KPIs

No specific KPIs, see cash flow statement work for detailed analytical review A1.1

Background: No significant changes in banks or bank accounts from the prior period. Note: Analytical review on movements in the cash flows has been performed on the cash flow schedule — see A1.1

Comments: Cash and cash equivalents: in line with budget and change consistent with level of

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activity for the period (see also our review of the statement of cash flows referenced in A1.1) Short-term deposits: although the balance is very consistent with previous period, inclusion of short-term deposits within cash and cash equivalents is acceptable (refer to C5).

The second working paper example relates to accounts receivable and would be found in the “E” section of the audit file (Illus-

tration 5.9). As noted before, in the top left corner is the client name, period end and currency unit ($000). In the top center is the working paper reference (E02) and title (confirmations and related alternative procedures). The upper right corner of the working paper shows who performed and who reviewed the audit procedures. Next, the date of the interim confirmation is noted. In this case, the confirmation was conducted for the accounts receivable balance at two months prior to year-end. The balance in the ac- counts receivable account on that date is noted ($9,500) and cross referenced to the accounts receivable subsidiary ledger (SL) and another part of the accounts receivable section of the audit file (E03). Receivable balances for a sample of customers were con- firmed as of October, 31, 2022. The date the confirmations were sent is then noted. The first request was sent on November 5, 2022, and a second request was sent on December 10, 2022 to customers that did not reply to the first request. The table contains details of the customers who were sent confirmation requests. (This working paper shows audit work for only a few customers, just to provide an example). The table documents:

• the account or invoice number per the accounts receivable subsidiary ledger (SL), • the customer name per the accounts receivable subsidiary ledger (SL), • the balance at confirmation date per the accounts receivable subsidiary ledger (SL), • the date the auditor received a response from the customer, • the balance outstanding at the confirmation date according to the customer correspondence (filed and cross referenced

E02.1, E02.2, E02.3), • any variance between the client records and the customer correspondence is calculated and listed by the auditor, and • then alternative procedures are explained when a customer has not responded or if the customer’s response varies from

the client’s records. The table also includes several tick marks (✓, β) which cross reference to explanatory comments by the auditor at the bottom of the page. In this case the tick marks ✓ and β refer to audit procedures performed on customer EcoFriend and Cleanair that are explained at the bottom of the working paper.

The following discussion interprets the actual audit work documented on this working paper. The table shows the following audit work was performed to evaluate the appropriateness of the accounts receivable balances for four customers that were selected for conformation.

• Customer Greenwash confirmed the balance owing to NME as $2,000. • No response was received from EcoFriend. The auditor determined that EcoFried paid $400 on 11/18/2022 and also

vouched the remaining balance to underlying shipping documents that shows the goods had been shipped and title had passed to EcoFriend prior to the confirmation date. With this evidence, the auditor determined that $545 was the correct receivable balance as of the confirmation date.

• Customer BigSupa confirmed the balance owing to NME as $6,000. • Customer Cleanair confirmed it owed $450 to NME. The variance of $50 represented a cash receipt on 11/1/22 that was

likely in the mail to NME prior to 10/31/22. The bottom part of the working paper includes the auditor’s comments related to the last customer, Cleanair. The auditor con-

cluded the timing difference did not affect the existence of a receivable as of the end of October.

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Illustration 5.9 Working paper example – Confirmations and related alternative procedures

CLIENT: New Millennium Ecoproducts

Period-end: 12/31/2022

Currency/unit: $ 000

E02 – CONFIRMATIONS AND RELATED

ALTERNATIVE PROCEDURES

Bell & Bowerman, LLP Prepared by: DM 12/14/2022

Reviewed by: SO 12/17/2022

Reviewed by: MM 12/19/2022

Reference: E02

Confirmation/Interim date 10/31/2022

AR as of confirmation date $9,500 SL/E03

Date 1st request sent 11/5/2022

Date 2nd request sent 12/10/2022

[A] [B] [A−B] [C] [D] [CD]

Account or invoice number

Customer name

Amount as of confirmation date TM/Ref

Balance per customer as of

confirmation date TM/Ref Variance

Alternative procedures in case of no response or variance

Comments

Date Received

Subsequent cash receipts

Date or source TM/Ref

Alternative procedures other than

subsequent cash receipts TM/Ref Total

123456 Greenwash $2, 000 SL 11/28/2022 $2, 000 E02.1 – –

654321 EcoFriend $ 545 SL $ 545 $ 400 11/18/2022 ✓ $ 145 β $ 545

789789 BigSupa $6, 000 SL 11/19/2022 $6, 000 E02.2 – –

987654 Cleanair $ 500 SL 11/20/2022 $ 450 E02.3 $ 50 $ 50 11/1/2022 ✓ $ 50 A

– –

Key to audit tickmarks (TM): ✓ Agrees to check copy/remittance advice which indicates invoice was paid subsequent to the confirmation date β Agrees to shipping reports signed by external carriers which indicates item was shipped prior to the confirmation date SL Agrees to sub ledger – accounts receivable

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Comments: • A: OK payment made by customer prior to the confirmation date, but received by the client just after confirmation date. This timing difference does not affect the existence of receivables as of the end of October.

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Cloud 9 The first major item in the current file for Cloud 9 is the audit plan with the detailed audit program. The current file also contains documentation for every test performed during the audit. Ian and the other junior staff are still struggling with how to correctly complete the papers. They often forget to complete all the relevant fields and Sharon, Suzie and Josh are continually sending papers back to them with requests to clarify some of their comments. However, embedding the working papers in Excel has made life easier than in the past when everything was paper based, because an error message will be generated if certain key fields are not completed.

BEFORE YOU GO ON 5.1 What is a current file? 5.2 What is a permanent file and how does it relate to a current year’s audit? 5.3 What will an auditor document during the risk assessment phase of the audit?

Learning Objective Review 1 Define management assertions about classes of transactions, account balances, and presentation and

disclosure. When preparing the financial statements, management will make assertions about each account and related disclosures in the notes. Auditors use these assertions to assess the risk of material misstatement and design audit procedures. The assertions used when considering classes of transactions and events are occurrence, completeness, accuracy, cut-off and classification. The assertions used when considering account balances at period end are existence, rights and obligations, completeness, and valuation and allocation. The assertions used when considering presentation and disclosure are occurrence and rights and obligations, completeness, classification and understandability, and accuracy and valuation. The auditors will determine the relevant assertions for significant accounts and transactions to plan the audit procedures use to gather evidence.

2 Discuss the characteristics of audit evidence. Sufficient appropriate evidence is a core concept in auditing. Sufficient relates to the quantity and appropriate relates to the quality of audit evidence gathered. For evidence to be of high quality, it must be both relevant and reliable. The audit risk model impacts the quality and quantity of evidence to be gathered. For high risk assertions, auditors may increase the quantity and quality of evidence gathered. For low risk assertions, auditors may decrease the quantity and quality of evidence gathered. Ultimately, the determination of sufficient appropriate evidence is a matter of professional judgment.

3 Explain the procedures for gathering audit evidence. Audit procedures are the specific methods used by auditors to gather evidence to support management assertions. The audit procedures are inspection of documents (including vouching and tracing), observation, inquiry, confirmation, recalculation, reperformance, analytical procedures, scanning, and computer assisted audit techniques (CAATs) and audit data analytics (ADA). These procedures can be used during risk assessment, for testing of controls, and as substantive tests of account balances, transactions, and disclosures.

4 Evaluate when it is appropriate to use the work of others. In some situations, the audit team will rely on the work of others during the risk assessment and/or risk response phase of the audit. A specialist with expertise in a field other than accounting or auditing may be used by the auditors to assist in obtaining sufficient appropriate audit evidence. If the client has an internal audit function, the auditors may use the work of the internal auditors and/or obtain direct assistance from the internal auditors to carry out audit procedures that the external auditors would normally do themselves. A group auditor may need to use the work of a component auditor when their client operates in a number of locations or has subsidiaries spread around the country or the globe. In all cases when using the work of others, the auditors should first assess the objectivity, competence, and capability of the individuals or firms that will be used.

5 Explain how auditors document the details of evidence gathered in working papers. Audit evidence is documented in an auditor’s working papers. Audit working papers include the client’s name, the period under audit, a title describing the contents of the working paper, a file reference indicating where the working paper fits in the audit file, the initials identifying the preparer of the working paper together with the date the working paper was prepared, the initials identifying the reviewer(s) of the working paper together with the date(s) the working paper was reviewed, and cross- referencing between working papers indicating where further work and evidence is summarized elsewhere. Working papers are stored in either the permanent file or the current file. The permanent file includes client information and documentation

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that apply to multiple audits. The current file includes client information and documentation that apply to the current year’s audit.

KEY TERMS Accounting records Accuracy Analytical procedures Appropriate Assertion Audit data analytics (ADA) Audit evidence Audit program Bank confirmation Classification Completeness Component Component auditor Computer assisted audit techniques (CAATs) Current file Cut-off Existence External confirmation Group audit Group engagement partner Group engagement team Group financial statements Inquiry Inspection Internal auditors Lead schedule Negative confirmation Observation Occurrence Permanent file Positive confirmation Recalculation Receivable confirmation Relevance Relevant assertion Reliability Re-performance Rights and obligations Specialist Scanning Sufficient Tracing Understandability Valuation and allocation Visualization Vouching Working papers

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CHAPTER 5: AUDIT DECISION MAKING EXAMPLE Background Information You have been assigned to the audit of a new client, Acadian Chemicals (AC), headquartered in South Louisiana. AC produces a product called carbon black. It is a black powder that is used in making other products, such as toner for printers/copy machines and vehicle tires. The powder is produced in four different grades, from very fine powder to more course powder. The finished powder is stored in a large silo that has four compartments for the four different grades of powder. The silo is about two stories tall and can store a maximum of 700,000 pounds of powder. The bot- tom of the silo can be opened to fill 20 pound bags, 50 pound sacks, or entire train cars so the powder can be shipped to customers for further production into other products. The 20 pounds bags and 50 pound sacks are stored in a large warehouse located on the production premises. You have toured the production facility and have seen the warehouse and the storage silo. There are no windows in the silo to see how much powder is inside, and no lighting inside of the silo. At the top of the silo, there is a lid for each compartment that can be opened, but when you look in, all you see is darkness. At any given time during the year, about 40% of AC’s inventory is stored in the silo, waiting to be packaged and shipped. The production facility operates continuously, 24 hours a day, 7 days a week. Identify the Audit Issue One of the issues here is determining what assertion is most at risk with the inventory that is stored in the silo. An- other issue is determining what audit procedures to use to gather sufficient appropriate evidence regarding the inven- tory that is in the silo. Gather Information and Evidence Important information includes: • A material portion (40%) of the inventory is stored in the silo, therefore it should be audited. However, there is no

way to see how much is actually in the silo. • Since the production facility operates continuously, there is always powder being loaded into at least one compart-

ment of the silo. It is not possible to stop production for purposes of determining what is in the silo. Even if pro- duction could be stopped, it is still not possible to see what or how much is in the silo.

• Fraud risk may be high because AC management could lie about how much is in the silo in an effort to overstate inventory. Management could also put something different in the silo, such as sand, and lie that the silo is filled with powder.

• Risk of theft of the powder is low because it is not a product that is easy to steal and not a product that is in de- mand for being stolen, such as jewelry or cars.

• The client has a method of determining how much is in the silo. The client uses a “strapping tool” to measure the empty part of the silo. The strapping tool is basically a tape measure on a reel with a weight on the end of the tape measure. From the top of each compartment of the silo, the client lowers, or reels, the tape measure down into each compartment. When the weight on the end of the tape hits the powder, the client stops reeling and looks at the measurement on the tape. Essentially, the client is measuring the empty part of the compartment. Once the measurement is obtained, it is entered into a client-prepared spreadsheet that contains a formula. The formula is total volume of the silo, minus the strapping tool measurement (converted into a volume amount), equals an estimate of volume of powder in the silo.

Analysis and Evaluation of Alternatives Analysis of risk and alternatives: • Risk of material misstatement is high for the existence assertion of powder stored in the silo. • Visually observing the amount of inventory in the silo is not possible in this situation. However, we can reperform

the client’s procedure of using the strapping tool to measure the empty part of the tank, and then use the client’s spreadsheet formula to determine the volume of powder in the silo.

• We may consider hiring a specialist to assist in the observation of inventory in the silo. The specialist can also inspect the client’s spreadsheet formula to ensure it is mathematically reasonable and consistent with what is used in the industry.

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Audit Conclusion Since AC is a new client with a unique inventory situation, your firm will hire a specialist in the carbon black industry to perform procedures on the client’s spreadsheet and measurement process for inventory in the silo. The specialist will summarize his or her findings in a report that will be included in the audit documentation for AC. If the specialist deter- mines that AC’s procedures are reasonable and consistent with the industry, then the specialist probably will not be needed for future audits unless the client’s process for storing the powder changes significantly.

MULTIPLE-CHOICE QUESTIONS MC5-1 The three categories of management assertions are: (LO1)

a. journal entries, ledgers, and trial balances. b. journal entries, account balances, and financial statements. c. transactions, ledgers, and account balances. d. classes of transactions, account balances, and presentation and disclosure.

MC5-2 The assertion related to recording transactions in the correct accounting period is (LO1) a. accuracy. b. completeness. c. cut-off. d. occurrence.

MC5-3 A detailed listing of the specific audit procedures to be used to gather evidence for an account is called the (LO1) a. permanent file. b. audit strategy. c. audit program. d. accounting records.

MC5-4 The quantity of evidence that an auditor will gather: (LO2) a. varies with audit risk. b. is the same for most audits because it has to be appropriate. c. depends on the size of the audit team. d. is the same for clients in the same industry.

MC5-5 Which is generally the most reliable form of evidence? (LO2) a. Internally generated evidence from the client’s IT system b. Internally generated evidence based on discussions with upper management c. Externally generated evidence held by the client d. Externally generated evidence sent directly to the auditor

MC5-6 An external confirmation sent to a bank: (LO3) a. requests information about the bank balances and loan amounts. b. requests information about interest rates paid on deposits and charged on loans. c. is relevant to the audit of interest revenue and expense. d. all of these answer choices are correct.

MC5-7 When an auditor inspects a tangible asset to support a balance in the client’s records, the auditor is gathering evidence to support the: (LO3) a. completeness assertion. b. existence assertion. c. valuation and allocation assertion. d. rights and obligations assertion.

MC5-8 When an auditor inspects tangible assets on hand and traces the details to recording in the client’s records, the auditor is gathering evidence to support the: (LO3) a. completeness assertion. b. existence assertion. c. valuation and allocation assertion. d. rights and obligations assertion.

MC5-9 Which audit procedure is being used when an auditor checks the calculations in a client-prepared spreadsheet? (LO3) a. analytical procedure. b. recalculation. c. reperformance. d. scanning.

MC5-10 If a specialist is engaged to assist with the audit: (LO4) a. it means the auditor does not have the requisite skill and knowledge to assess the item.

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b. it means the auditors should not have taken on the audit because they are not qualified. c. the PCAOB must be contacted and permission obtained before the specialist starts work. d. the auditor does not have to take responsibility for the fair presentation of the item in the financial statements.

MC5-11 Before the external auditors decide to use the work performed by the internal auditors, the external auditors must first assess (LO4) a. the size of the internal audit function relative to the client. b. the independence of the internal auditors. c. the supervision skills of the internal audit function. d. the competence and objectivity of the internal audit function.

MC5-12 The working papers for a client contain both a permanent and a current file. The difference between the two files is that (LO5) a. the permanent file is kept by the audit partner in charge and cannot be altered after the first audit engagement is completed, but

the current file can be updated. b. the copy of the permanent file must be sent to a regulator (PCAOB or State Board of Accountancy) and the current file is not. c. the permanent file includes documents that relate to the client and are relevant for more than one year’s audit, and the current file

includes the details of work completed and evidence gathered that relate to the current year’s audit. d. the permanent file cannot be altered, but the current file can be altered.

REVIEW QUESTIONS R5-1 Are financial statements considered statements of fact? Discuss in the context of management assertions. (LO1) R5-2 Explain why the quality of audit evidence is determined by the choice of audit procedure and the assertion most at risk of material

misstatement. (LO2) R5-3 Discuss why an auditor has to consider the reliability of audit evidence. (LO2) R5-4 Explain how inspecting a client’s tangible assets provides evidence about the completeness and existence assertions. (LO3) R5-5 Differentiate between the “occurrence” and “existence” assertions. How do both differ from “completeness?” (LO3) R5-6 List and describe the procedures for gathering audit evidence. At which stage(s) of the audit is each procedure appropriate? (LO3) R5-7 Differentiate between recalculation and reperformance and provide an example of each. (LO3) R5-8 If an auditor does not have sufficient knowledge and skill in an area, the auditor can ask for the assistance of a specialist. Does this

create a problem? Explain how an auditor knows if the specialist’s work is reasonable if the auditor is not also a specialist. (LO4) R5-9 Describe the general composition of an external audit team. Discuss whether a client’s internal auditors can be part of the external

audit team. (LO4) R5-10 Provide examples of situations in which an auditor would use the work of a component auditor? (LO4) R5-11 List some key elements that would be included in any working paper document. (LO5)

ANALYSIS PROBLEMS Basic Moderate Challenging AP5-1 Assertions 1 A client has a material balance in property, plant and equipment. The discussions with management indicate there is a risk the client will capitalize all repair costs to minimize the impact on expenses. Repairs are likely to be material because of the extreme weather conditions affecting operations and machinery operating conditions. Extensive repairs were scheduled to begin the month prior to year-end, with com- pletion around two months later.

Required Based on the information, evaluate which accounts and assertions are likely to be affected. Source: Adapted from the CA Program’s Audit & assurance exam, December 2010.

AP5-2 Account balances at risk  1 Tropical Cruises is a new client of MMM LLP. Tropical Cruises is a low-cost cruise ship operator, travelling between the US and five countries in the Caribbean. The planning for the first audit is underway. The auditors have become aware that police in two countries are investigating several Tropical Cruises employees for stealing food and other supplies from the ships’ kitchens and selling it at local markets. The police have charged ten cabin stewards of Tropical Cruises with theft and fraud.

Required Based on the information, evaluate which accounts and assertions are likely to be affected. Source: Adapted from the CA Program’s Audit & assurance exam, May 2010.

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AP5-3 Assertions and evidence 1 2 An auditor is planning for the audit of a specialty retail store. Inventory is material, and items range in value from $1 to over $500. The type of merchandise carried in the store changes every season, and many items are specially ordered with special branding and promotional packaging. Orders are placed six months in advance from overseas suppliers. Large deposits are required to be paid when orders are placed. The auditor believes the account balances for inventory and prepaids are at risk of material misstatement.

Required a. Identify the key assertions at risk in relation to inventory and prepaids. b. For each assertion, identify a type of evidence that would be relevant and reliable. Source: Adapted from the CA Program’s Audit & assurance exam, December 2010.

AP5-4 Misstatement risk for depreciation 1 2 Yellow Aviation is an existing client of PPP LLP. The auditors are aware that the impact of a current recession on airlines has been severe, with predictions of a prolonged downturn. Along with the entry of new competitors in the domestic and international markets, airlines have been heavily discounting flights.

The client’s policies include the following:

Aircraft maintenance costs policy

The standard cost of major airframe and engine maintenance checks is capitalized and depreciated over the shorter of the scheduled usage period to the next major inspection or the remaining life of the aircraft.

Yellow Aviation’s latest financial data show the aircraft and engines at cost (including major maintenance costs) to be at a similar level as last year while depreciation costs have decreased by 7%.

Required (a) What key assertions for the above accounts are likely to be affected? (b) Evaluate what evidence would be sufficient and appropriate in this case. Source: Adapted from the CA Program’s Audit & assurance exam, May 2010.

AP5-5 Types and persuasiveness of audit evidence 1 2 3 Jenna is working on the audit of a client’s accounts receivable. During the last few weeks she has conducted interviews with the accounts receivable manager, the chief financial officer, and staff working in the accounts receivable department. She has also overseen the external confirmations of accounts receivable, 30% of which required the recipient to respond whether or not the amount stated was correct. Jenna also inspected subsequent cash receipts from the client’s customers. She vouched a sample of accounts receivable balances back to the underlying invoices, cash receipts and sales returns, and traced a sample of these documents to the accounts receivable ledger.

Required (a) List the types of audit evidence gathered by Jenna and comment on the reliability of each type. (b) Relate each type of evidence to the relevant accounts receivable assertions.

AP5-6 Bank reconciliations 1 2 3 James Thomas is responsible for preparing bank reconciliation statements at Ajax Inc. Ajax has many bank accounts, including separate accounts for each major branch, accounts for payments of salaries and dividends, and accounts kept in foreign currency for overseas divi- sions. James maintains records including bank statements and weekly bank reconciliations for each account. In addition, there are files containing correspondence with banks about disputed transactions, dishonored checks from Ajax’s customers, and other bank-initiated trans- actions such as fees and interest.

Required (a) Comment on the appropriateness of the evidence in James’ files for Ajax’s financial statement audit. (b) Explain how an auditor would obtain more appropriate evidence for the relevant assertions for the bank accounts at Ajax.

AP5-7 Revenue assertions 1 1 2 3 The audit program for the Revenue account for a client has been drafted. The following item appears:

ITEM ASSERTION DETAILED AUDIT PROCEDURE

1 Completeness Select a sample of sales from the sales journal and ensure each sales invoice is supported by an authorized shipping document and approved customer order.

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Required (a) Evaluate whether the procedure addresses the stated assertion. (b) If your answer to (a) is no, provide the correct assertion or explain what work would be required to address the assertion. (c) Evaluate what type of evidence is obtained by performing the stated procedure. How appropriate is it? Source: Adapted from the CA Program’s Audit & assurance exam, July 2010.

AP5-8 Revenue assertions 2 1 2 3 The audit program for the Revenue account for a client has been drafted. The following item appears:

ITEM ASSERTION DETAILED AUDIT PROCEDURE

2 Cut-off Select a sample of sales invoices recorded a few days prior to the year-end and then agree dates on the invoices to the dates on the shipping documents signed by the customer.

Required (a) Evaluate whether the procedure addresses the stated assertion. (b) If your answer to (a) is no, provide the correct assertion or explain what work would be required to address the assertion. (c) Evaluate what type of evidence is obtained by performing the stated procedure. How appropriate is it? Source: Adapted from the CA Program’s Audit & assurance exam, July 2010.

AP5-9 Revenue assertions 3 1 2 3 The audit program for the Revenue account for a client has been drafted. The following item appears: ITEM ASSERTION DETAILED AUDIT PROCEDURE

3 Accuracy Select a sample of sales from the sales journal and agree the sale price to the authorized price list.

Required (a) Evaluate whether the procedure addresses the stated assertion. (b) If your answer to (a) is no, provide the correct assertion or suggest additional work. (c) Evaluate what type of evidence is obtained by performing the stated procedure. How appropriate is it? Source: Adapted from the CA Program’s Audit & assurance exam, July 2010.

AP5-10 Gathering evidence 1 2 3 Max Crowe is an associate auditor who has just started with the team conducting the audit of a new client in the construction industry. Max is shadowing Susan Wong, an experienced auditor. Susan is showing Max how to be a member of an audit team and is trying to teach Max about the benefits of getting to know the client. Susan is also trying to help Max develop experience in picking up subtle signals about the client’s problems and what the client might be trying to hide from the auditor.

Max is getting a little frustrated with the “shadowing” assignment. He can’t understand why Susan is spending so much time talking to the client’s staff and touring the various construction sites and offices. When Susan is not doing this, she is working on a spreadsheet of the client’s previous financial statements and unaudited interim data. Max wants to know when they are going to do some “real” work and start gathering audit evidence. Susan tells Max that they have already started.

Required (a) Discuss Susan’s comment that they have already started the audit. What evidence have they gathered so far? (b) Explain what work is being done with the spreadsheets of financial data. Give some specific examples for this client. How is this type of

work relevant to different phases of the audit? (c) When Susan is touring the client’s premises, she is taking notes of equipment and furniture items she sees, especially anything that looks

either newly purchased or older and unused. Explain why she is doing this.

AP5-11 Using the work of internal auditors 4 Theobald Inc. has an internal audit department that primarily focuses on audits of the efficiency and effectiveness of its production depart- ments. The other main role of the internal audit department is auditing compliance with various government regulations surrounding correct disposal of waste and storage of raw materials at its five factories. Theobald’s internal audit department is run by Harry Potts, a CPA and a member of the Institute of Internal Auditors. There are three other members of the department, all of whom have experience in performance auditing and, in addition, have completed industry-run training courses in waste management and handling dangerous goods. Harry meets regularly with the chief production manager and sends monthly reports to the CEO and the board of directors. Your initial investigations suggest that Harry is highly regarded within Theobald, and his reports are often discussed at board meetings. In most cases, the board authorizes the actions recommended in Harry’s reports with respect to major changes to production and logistics.

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Required Evaluate the extent of reliance the external auditor should place on the work of the internal audit department at Theobald Inc. Explain the likely impact of the internal audit department’s work on the audit plan.

AP5-12 Using a specialist Comp: Research icon 4 SolarTubeGen is a start-up company in the renewable energy sector. The founder of SolarTubeGen, Fritz Herzberg, has developed cutting- edge technology to convert the energy in the sun’s rays to electricity via a novel system of mirrors designed to focus the sun’s rays onto tubes containing a patented type of gas, which then heats and expands to drive turbines. KKK LLP has won the contract for the first audit of SolarTubeGen on the basis of its expertise in the energy sector. However, the lead partner, Ken Kennedy, recognizes the success of the audit is dependent on the correct assessment of the technology being used at SolarTubeGen. Ken specified in the successful audit bid documents that the audit will use an external specialist to help with valuation of the company’s assets.

Fritz Herzberg is very protective of his company’s intellectual property and is resistant to Ken’s first suggested specialist, Manfred Hamburg. Fritz believes that Manfred Hamburg is hostile towards him because they clashed when they both worked for a German company making photovoltaic cells in the 1990s. Fritz has suggested another specialist, Lily Beilherz, with whom he has had good working relations over the last 20 years.

Required (a) Advise Ken Kennedy about the choice of a specialist for the audit of SolarTubeGen. What must he consider when making his choice?

Refer to AU-C 620 Using the Work of an Auditor’s Specialist to support your answer. (ASB standards can be accessed at www.aicpa.org/research/standards)

(b) SolarTubeGen takes over another renewable energy company during the second year audit. The new subsidiary is based in another country and has previously been audited by a local audit firm. Evaluate how should Ken handle the new audit responsibilities brought about by the client’s expansion.

AP5-13 Documentation Comp: Research icon 3 5 Jennifer Jones is reading documents prepared by the members of the team working on the audit of receivables for a private company audit client. Jennifer is the senior manager assisting the engagement partner, Ruby Rogers. Jennifer and Ruby have worked together on many audits, and Jennifer knows the types of questions Ruby will ask about the working papers if they are not up to the standard required by AU- C 230. Jennifer is trying to make sure that all documents are up to the required standard before Ruby sees them tomorrow.

Jennifer is particularly concerned about the documents relating to the receivable confirmations. This is because the audit assistant who wrote the confirmation results recommended that no further work was required. On review of the results, Jennifer discovered the audit assistant had incorrectly treated “no reply” results as acceptable for a positive confirmation, when they are acceptable only for a negative confirmation. Jennifer had ordered further work be done to follow up these “no reply” results.

Required (a) What is the minimum standard that audit documentation must meet? (b) Propose how you would treat the corrections made to the audit assistant’s recommendations and the additional work on receivable

confirmations in the working papers. Refer to both AU-C 505 External Confirmations and AU-C 230 Audit Documentation in your answer.

AP5-14 Overstating Revenue – Satyam Computer Services, Ltd (Comp: Insert Research Icon) 5 In April 2011, the SEC charged Satyam Computer Services Ltd., an India based-company, with fraudulently overstating the company’s revenue, income and cash balances by more than $1 billion over five years. The SEC also sanctioned the company’s auditors for conducting deficient audits that allowed the fraud to go undetected for years. The auditors were five India-based affiliates of PricewaterhouseCoopers (PwC). The SEC stated that “PW India’s failure to properly execute third-party confirmation procedures resulted in the fraud at Satyam going undetected for years.”15

Required (a) Go to www.sec.gov and research the Satyam fraud scandal. Briefly summarize the fraud, such as the time period it took place, who was

involved, and how it was conducted. (b) Go to www.pcaobus.org and search for PCAOB Release No. 105-2011-002. Summarize the audit deficiencies noted by the PCAOB in

the audit of the cash and receivables balances. Also summarize how the auditors violated Auditing Standard No. 3 Audit Documentation. (Note: the Auditing Standards have since been reorganized. The documentation standard is now AS 1215.) What penalties/punishment was levied on the PwC affiliate firms?

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AUDIT DECISION CASES Featherbed C5-1 Documenting the audit 5 Featherbed Surf & Leisure Holidays, Inc. (Featherbed) is a resort company based in Hawaii. Its operations include boating, surfing, diving and other leisure activities, a backpackers’ hostel, a family hotel and a five-star resort. Justin and Sarah Morris own the majority of the shares in the Morris Group which owns 100% of Featherbed. Justin is the chairman of the board of directors of both Featherbed and the Morris Group, and Sarah is a director of both companies as well as the CFO of Featherbed.

While performing the Featherbed audit you discover that the Warm Weather Adventures Travel Agency (WWATA), which specializes in group travel to Hawaii, has an account with Featherbed. The review of the aging of accounts receivable balance shows that WWATA’s balance is large and material and is now more than 60 days overdue. However, no allowance has been made for the doubtful account. You consult Featherbed’s accounts staff, Kristen and Peter, about the account and they mention there are rumours that the WWATA is suffering financial difficulties.

You have recently completed the Auditing & Attestation section of the CPA Exam and are aware that AU-C 230 has specific requirements about documenting audit work. In particular, paragraph 9 states:

“In documenting the nature, timing and extent of audit procedures performed, the auditor should record: (a) the identifying characteristics of the specific items or matters tested; (b) who performed the audit work and the date such work was completed; and (c) who reviewed the audit work performed and the date and extent of such review.”

In addition, paragraph 11 states:

“The auditor shall document discussions of significant findings or issues with management, those charged with governance, and others, including the nature of the significant finding or issues discussed, and when and with whom the discussions took place.”

Required Describe how you would apply the mandatory requirements of AU-C 230 in relation to the potential bad debt.

Securimax

C5-2 Considering the work of internal auditors Comp: Public Company icon, Research icon 4 Securimax Inc. (Securimax) has been an audit client of Leo & Lee, LLP for the past 15 years. Securimax is a publicly traded company based in Cleveland, Ohio, where it manufactures high-tech armour-plated personnel carriers. Securimax often has to go through a competitive bid process to win large government contracts. Its main product, the small but powerful Terrain Master, is highly specialized and Securimax only does business with nations that have a recognized, democratically elected government. Securimax maintains a highly secure environment, given the sensitive and confidential nature of its vehicle designs and its clients.

Clark Field has been the engagement partner on the Securimax audit for the last four years. Clark is a specialist in the defense industry and will rotate off the audit next year when a new partner leads the audit.

Securimax has a small internal audit department that is headed by an ex-partner of Leo & Lee, Rydell Creek. Rydell joined Securimax after leaving Leo & Lee six years ago. Rydell is assisted by three junior internal auditors, of which two are CPA’s and one is a Certified Internal Auditor (CIA).

Securimax’s fiscal year-end is June 30.

Required Analyze the effect, if any, of AS 2605 on Clark Field’s consideration of Securimax’s internal audit department for the financial statement audit. (PCAOB auditing standards can be accessed at www.pcaobus.org) Goodfellow and Perkins Questions C5-3 and C5-4 are based on the following case. Goodfellow and Perkins, CPAs is a successful mid-tier accounting firm with a large range of clients across Texas. During 2022, Goodfellow and Perkins gained a new client, Health Care Holdings Group (HCHG), which owns 100% of the following entities: • Shady Oaks Hospital, a private hospital group • Gardens Nursing Home Pty Ltd, a private nursing home

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• Total Cancer Care Limited (TCCL), a private oncology clinic that specialises in the treatment of cancer. Fiscal year-end for all HCHG entities is June 30. You are performing the audit field work for the 2023 fiscal year for Shady Oaks Hospital. The field work must be completed in time for the

audit report to be signed on August 21, 2023. You have been asked to circulate the receivable confirmations. Shady Oaks Hospital’s trade receivables arise from the use of hospital facilities (including the provision of nurses, anaesthetists, operating theatres and supplies) by medical practitioners in private practice. The trade receivables balance was $3,974,569 at June 30, 2023 and was considered material.

The hospital’s payment terms are 14 days from the date of the invoice. Sixty percent of the balance is represented by invoices outstanding from five different medical practitioners. The remaining 40% consists of numerous smaller amounts, most of which have been outstanding for more than 60 days. Any allowance for doubtful accounts is netted directly against the trade receivables account and not shown separately on the balance sheet. Source: Adapted from the CA Program’s Audit & assurance exam, December 2008.

C5-3 Confirmation evidence 1 2 3 Analyze the strengths and weaknesses of receivable confirmations as audit evidence for HCHG.

C5-4 Adequacy of audit evidence 1 2 3 Is it possible for Goodfellow and Perkins to use only receivable confirmations as audit evidence? Defend your answer, being sure to include a discussion of the relevant assertions for accounts receivable.

CASE STUDY — CLOUD 9

W&S LLP will need the assistance of auditors in China and a derivatives specialist to complete the Cloud 9 audit. The other auditors will be asked to provide evidence about the inventory shipped to the US from the production plants in China. Although

the inventory is shipped FOB (free on board), there have been several occasions in which the shipping agent was unable to place the inventory on a ship. In these cases, the inventory is stored in the shipping agent’s warehouse until a vessel is made available. Suzie has some concerns about the quality of the warehouses because if the goods are damaged they could become worthless and the value of goods in transit will be overstated.

In addition, Suzie has asked Jo Wadley (the partner) for help in choosing a specialist to help with valuation aspects of the audit of deriva- tives. Jo has provided her with three names of specialists in the field, but she has had no personal experience with any of them. Suzie must make a choice and engage the specialist soon to be sure the specialist’s opinion will be received in time to complete the audit.

Answer the following questions based on the information presented for Cloud 9 in the appendix to this book and the current and earlier chapters. You should also consider your answers to the case study questions in earlier chapters.

Required (a) Explain the procedures for engaging component auditors to perform the work on the inventory in China. (b) Advise Suzie on engaging the derivatives specialist. Discuss the qualities the specialist must possess. What steps must Suzie perform?

What should she tell the specialist about the engagement? What must the specialist provide to Suzie so that she can be sure she has sufficient appropriate evidence about the derivatives? Can the specialist do all the work on derivatives, or must Suzie perform any other procedures?

CPA EXCEL CPA Excel multiple choice questions, simulations, and video are available in your auditing course.

NOTES  1. McCoy, Kevin. “Wells Fargo’s legal challenges accumulate,” USA Today, August 9, 2017, page 2B. 2. Public Company Accounting Oversight Board (PCAOB), AU Section 330 The Confirmation Process, www.pcaobus.org.  3. Goelzer, DL 2009, Statement on consideration of concept release on possible revisions to the standard on audit confirmations,

14 April, www.pcaobus.org; WebCPA 2009, PCAOB mulls revising audit confirmation standards, 14 April, www.webcpa.com.  4. Goelzer 2009.  5. Goelzer 2009.  6. Goelzer 2009.  7. Harris, SB 2010, Statement on proposed auditing standard on confirmation, 13 July, www.pcaobus.org.  8. WebCPA 2009.

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9. Harris 2010. 10. WebCPA 2009. 11. Public Company Accounting Oversight Board (PCAOB), Transcript Excerpt & Slides: Standing Advisory Group Meeting,

Docket 28, October 14, 2010, www.pcaobus.org. 12. Brazel, JF 2008, ‘How do financial statement auditors and IT auditors work together?’, The CPA Journal, November, pp. 38–

41. 13. Kotb A, Roberts, C & Sian, S 2012, ‘E-business audit: Advisory jurisdiction or occupational invasion?’, Critical Perspectives

on Accounting, vol. 23, iss. 6, pp. 468–82. 14. Kotb et al. 2012. 15. Securities Exchange Commission (SEC), SEC Charges India-Based Affiliates of PWC for Role in Satyam Accounting Fraud,

Release 2011-82, April 5, 2011. www.sec.gov.

 

ACCT 4117 Auditing Ethics Paper Expectations – Grading Rubric

  Exceeds Expectations Meets Expectations Partially Meets Expectations Fails to Meet Expectations
Identifies potential ethical problem Student clearly and concisely identifies the purpose of the writing, or the potential ethical dilemma/issue to be solved Student adequately identifies the purpose of the writing, or the potential ethical dilemma/issue to be solved Student partially identifies the purpose of the writing, or the potential ethical dilemma/issue to be solved Student’s purpose, issue or the problem to be solved is not evident
Organization and development of purpose or problem solving Student addresses the appropriate topic and goes beyond the assignment by significantly developing each aspect of the requirements Student addresses the appropriate topic and clearly fulfills each aspect of the assignment requirements Student addresses the appropriate topic but only superficially addresses the assignment requirements Student is off topic and/or omits most or all of the assignment requirements
Use of Supporting Evidence, Information or Facts Student uses compelling information and/ or facts to inform the writing in a manner that clearly advances the writer’s argument Student uses relevant information and/ or facts to inform the writing in a manner that advances the writer’s argument Student uses some relevant information and/ or facts to advance the writer’s argument, but the argument is weak The support is weak, leaving Student’s argument unclear
Professional Writing and Style Student uses highly professional or discipline specific language that indicates an understanding of the target audience Student uses professional or discipline specific language that indicates an understanding of the target audience Student uses some professional or discipline specific language but fails to show a full understanding of the target audience Student does not use professional or discipline specific language and fails to show an understanding of the target audience
Convention and Mechanics All sentences are grammatically and mechanically correct. Consistent use of language conventions and effective use of vocabulary. Rare grammatical and mechanical errors exist but do not affect clarity or readability A variety of grammatical or mechanical errors exist, affecting clarity and readability Multiple grammatical or mechanical errors exist, negatively affecting clarity and readability

 

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