Chapter One - Problems
Number 10 consists of 15 items. Select the best answer for each item
Number 10 consists of 15 items. Select the best answer for each item.
Field, CPA, is auditing the financial statements of Miller Mailorder, Inc. (MMI) for the year ended January 31, 1995. Field has compiled a list of possible errors and fraud that may result in the misstatement of MMI’s financial statements, and a corresponding list of internal control activities that, if properly designed and implemented, could assist MMI in preventing or detecting the errors and fraud.
Required:
For each possible error and fraud numbered 106 through 120, select one internal control activity from the answer list that, if properly designed and implemented, most likely could assist MMI in preventing or detecting the errors and fraud. Each response in the list of internal control activities may be selected once, more than once, or not at all.
Possible Errors and Fraud
106. Invoices for goods sold are posted to incorrect customer accounts.
107. Goods ordered by customers are shipped, but are not billed to anyone.
108. Invoices are sent for shipped goods, but are not recorded in the sales journal.
109. Invoices are sent for shipped goods and are recorded in the sales journal, but are not posted to any customer account.
110. Credit sales are made to individuals with unsatisfactory credit ratings.
111. Goods are removed from inventory for unauthorized orders.
112. Goods shipped to customers do not agree with goods ordered by customers.
113. Invoices are sent to allies in a fraudulent scheme and sales are recorded for fictitious transactions.
114. Customers’ checks are received for less than the customers’ full account balances, but the customers’ full account balances are credited.
115. Customers’ checks are misappropriated before being forwarded to the cashier for deposit.
116. Customers’ checks are credited to incorrect customer accounts.
117. Different customer accounts are each credited for the same cash receipt.
118. Customers’ checks are properly credited to customer accounts and are properly deposited, but errors are made in recording receipts in the cash receipts journal.
119. Customers’ checks are misappropriated after being forwarded to the cashier for deposit.
120. Invalid transactions granting credit for sales returns are recorded.
Internal Control Activities
A. Shipping clerks compare goods received from the warehouse with the details on the shipping documents.
B. Approved sales orders are required for goods to be released from the warehouse.
C. Monthly statements are mailed to all customers with outstanding balances.
D. Shipping clerks compare goods received from the warehouse with approved sales orders.
E. Customer orders are compared with the inventory master file to determine whether items ordered are in stock.
F. Daily sales summaries are compared with control totals of invoices.
G. Shipping documents are compared with sales invoices when goods are shipped.
H. Sales invoices are compared with the master price file.
I. Customer orders are compared with an approved customer list.
J. Sales orders are prepared for each customer order.
K. Control amounts posted to the accounts receivable ledger are compared with control totals of invoices.
L. Sales invoices are compared with shipping documents and approved customer orders before invoices are mailed.
M. Prenumbered credit memos are used for granting credit for goods returned.
N. Goods returned for credit are approved by the supervisor of the sales department.
O. Remittance advices are separated from the checks in the mailroom and forwarded to the accounting department.
P. Total amounts posted to the accounts receivable ledger from remittance advices are compared with the validated bank deposit slip.
Q. The cashier examines each check for proper endorsement.
R. Validated deposit slips are compared with the cashier’s daily cash summaries.
S. An employee, other than the bookkeeper, periodically prepares a bank reconciliation.
T. Sales returns are approved by the same employee who issues receiving reports evidencing actual return of goods.
NUMBER 11
Green, CPA, is considering audit risk at the financial statement level in planning the audit of National Federal Bank (NFB) Company’s financial statements for the year ended December 31, 1990. Audit risk at the financial statement level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to management, the industry, and the entity. In assessing such factors Green has gathered the following information concerning NFB’s environment.
Company profile:
NFB is a federally-insured bank that has been consistently more profitable than the industry average by marketing mortgages on properties in a prosperous rural area, which has experienced considerable growth in recent years.
NFB packages its mortgages and sells them to large mortgage investment trusts. Despite recent volatility of interest rates, NFB has been able to continue selling its mortgages as a source of new lendable funds.
NFB's board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive officer. Management at the bank’s branch offices has authority for directing and controlling NFB's operations and is compensated based on branch profitability. The internal auditor reports directly to Harris, a minority shareholder, who also acts as chairman of the board’s audit committee.
The accounting department has experienced little turnover in personnel during the five years Green has audited NFB. NFB's formula consistently underestimates the allowance for loan losses, but its controller has always been receptive to Green’s suggestions to increase the allowance during each engagement.
Recent developments:
During 1990, NFB opened a branch office in a suburban town thirty miles from its principal place of business.
Although this branch is not yet profitable due to competition from several well-established regional banks, management believes that the branch will be profitable by 1992.
Also, during 1990, NFB increased the efficiency of its accounting operations by installing a new, sophisticated computer system.
Required:
Based only on the information above, describe the factors that most likely would have an effect on the risk of material misstatements. Indicate whether each factor increases or decreases the risk. Use the format illustrated below.
Effect on risk of Environmental factor material misstatements Branch management has authority for Increase
directing and controlling operations.
NUMBER 12
Butler, CPA, has been engaged to audit the financial statement of Young Computer Outlets, Inc., a new client.
Young is a privately-owned chain of retail stores that sells a variety of computer software and video products.
Young uses an in-house payroll department at its corporate headquarters to compute payroll data, and to prepare and distribute payroll checks to its 300 salaried employees.
Butler is preparing an internal control questionnaire to assist in obtaining an understanding of Young’s internal control and in assessing control risk.
Required:
Prepare a “Payroll” segment of Butler’s internal control questionnaire that would assist in obtaining an understanding of Young’s internal control and in assessing control risk.
Do not prepare questions relating to cash payrolls, EDP applications, payments based on hourly rates, piece-work, commissions, employee benefits (pensions, health care, vacations, etc.), or payroll tax accruals other than withholdings.
Use the format in the following example:
Question Yes No
Are paychecks prenumbered and accounted for?
NUMBER 13
Kent, CPA, is the engagement partner on the financial statement audit of Super Computer Services Co. (SCS) for the year ended April 30, 1998. On May 6, 1998, Smith, the senior auditor assigned to the engagement, had the following conversation with Kent concerning the planning phase of the audit:
Kent: Do you have all the audit programs updated yet for the SCS engagement?
Smith: Mostly, I still have work to do on the fraud risk assessment.
Kent: Why? Our "errors and irregularities" program from last year is still OK. It's passed peer review several times. Besides, we don't have specific duties regarding fraud. If we find it, we'll deal with it then.
Smith: I don't think so. That new CEO, Mint, has almost no salary, mostly bonuses and stock options. Doesn't that concern you?
Kent: No. Mint's employment contract was approved by the Board of Directors just three months ago. It was passed unanimously.
Smith: I guess so, but Mint told those stock analysts that SCS's earnings would increase 30% next year. Can Mint deliver numbers like that?
Kent: Who knows? We're auditing the '98 financial statements, not '99. Mint will probably amend that forecast every month between now and next May.
Smith: Sure, but all this may change our other audit programs.
Kent: No, it won't. The programs are fine as is. If you find fraud in any of your tests, just let me know. Maybe we'll have to extend the tests. Or maybe we'll just report it to the audit committee.
Smith: What would they do? Green is the audit committee's chair, and remember, Green hired Mint. They've been best friends for years. Besides, Mint is calling all the shots now. Brown, the old CEO, is still on the Board, but Brown's never around. Brown's even been skipping the Board meetings. Nobody in management or on the Board would stand up to Mint.
Kent: That's nothing new. Brown was like that years ago. Brown caused frequent disputes with Jones, CPA, the predecessor auditor. Three years ago, Jones told Brown how ineffective the internal audit department was then. Next thing you know, Jones is out and I'm in. Why bother? I'm just as happy that those understaffed internal auditors don't get in our way. Just remember, the bottom line is . . . are the financial statements
fairly presented? And they always have been. We don't provide any assurance about fraud. That's management's job.
Smith: But what about the lack of segregation of duties in the cash disbursements department? That clerk could write a check for anything.
Kent: That's a reportable condition every year and probably will be again this year. But we're talking cost-effectiveness here, not fraud. We just have to do lots of testing on cash disbursements and report it again.
Smith: What about the big layoffs coming up next month? It's more than a rumor. Even the employees know it's going to happen, and they're real uptight about it.
Kent: I know, it's the worst kept secret at SCS, but we don't have to consider that now. Even if it happens, it will only improve next year's financial results. Brown should have let these people go years ago. Let's face it, how else can Mint even come close to the 30% earnings increase next year?
Required:
Begin the answer to each requirement (i.e., A, B, and C) on the top of a new page.
a. Describe the fraud risk factors that are indicated in the dialogue above.
b. Describe Kent's misconceptions regarding the consideration of fraud in the audit of SCS's financial statements that are contained in the dialogue above and explain why each is a misconception.
c. Describe an auditor's working paper documentation requirements regarding the assessment of the risk of material misstatement due to fraud.
NUMBER 14
A number of procedures are performed by the auditor in the assessment of control risk.
Procedures:
1. The auditor tests the effectiveness of the controls.
2. The auditor prepares flowcharts, narratives, questionnaires, or other material.
3. The auditor considers the factors affecting the risk of material misstatement.
4. The auditor documents the reasons for assessing control risk at the maximum.
5. The auditor designs substantive tests.
6. The auditor collects evidence on the operating effectiveness of the procedures.
7. The auditor records the basis for determining that the controls are working as designed.
8. The auditor considers whether the evidence supports a lower assessed level of control risk.
9. The auditor applies limited substantive tests to determine whether a control is operational.
10. The auditor identifies the types of potential misstatement.
Required:
Match the statement that most closely relates to the procedures that an auditor may perform in this process. A statement may be used more than once or not at all.
Statements:
A. Describes a reason for the auditor to obtain an understanding of internal control.
B. Describes what is required for an auditor to assess control risk below the maximum.
C. Describes the documentation requirements for the understanding of internal control and assessment of control risk.
D. Describes a procedure that would not be performed.
NUMBER 15
AUDITING SIMULATION
During the course of an audit of an entity’s financial statement, the auditor may become aware of matters related to internal control that may be of interest to the audit committee of the Board of Directors or others of equivalent authority.
Deficiencies in internal control design
x Inadequate overall internal control design
x Absence of appropriate segregation of duties consistent with appropriate control objectives
x Absence of appropriate reviews and approvals of transactions, accounting entries, or systems output x Inadequate procedures for appropriately assessing and applying accounting principles
x Inadequate provisions for the safeguarding of assets
x Absence of other control techniques considered appropriate for the type and level of transaction activity x Evidence that a system fails to provide complete and accurate output that is consistent with objectives and
current needs because of design flaws x
Failures in the operation of internal control
x Evidence of failure of identified controls in preventing or detecting misstatements of accounting information
x Evidence that a system fails to provide complete and accurate output consistent with the entity’s control objectives because of the misapplication of control procedures
x Evidence of failure to safeguard assets from loss, damage or misappropriation
x Evidence of intentional override of the internal control structure by those in authority to the detriment of the overall objectives of the system
x Evidence of failure to perform tasks that are part of the internal control structure, such as reconciliations not prepared or not timely prepared
x Evidence of willful wrongdoing by employees or management
x Evidence of manipulation, falsification, or alteration of accounting records or supporting documents x Evidence of intentional misapplication of accounting principles
x Evidence of misrepresentation by client personnel to the auditor x
Required: Compose an internal control letter for the ABC Corporation for the year ended December 31, 20XX.
Select at least three internal control deficiencies and/or failures that you would communicate to the client.