Chapter Two – Problems
Items 1 through 12 represent possible errors and irregularities that an auditor suspects are present. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to
gather evidence concerning possible errors and irregularities. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all.
Possible Errors and Irregularities
1. The auditor suspects that a kiting scheme exists because an accounting department employee who can issue and record checks seems to be leading an unusually luxurious lifestyle. (Select only 1 procedure)
2. The auditor suspects that the controller wrote several checks and recorded the cash disbursements just before the year end but did not mail the checks until after the first week of the subsequent year. (Select only 1 procedure)
3. The entity borrowed funds from a financial institution. Although the transaction was properly recorded, the auditor suspects that the loan created a lien on the entity’s real estate that is not disclosed in its financial statements. (Select only 1 procedure)
4. The auditor discovered an unusually large receivable from one of the entity’s new customers. The auditor suspects that the receivable may be fictitious because the auditor has never heard of the customer and because the auditor’s initial attempt to confirm the receivable has been ignored by the customer. (Select only 2 procedures)
5. The auditor suspects that fictitious employees have been placed on the payroll by the entity’s payroll supervisor, who has access to payroll records and to the paychecks. (Select only 1 procedure)
6. The auditor suspects that selected employees of the entity received unauthorized raises from the entity’s payroll supervisor, who has access to payroll records. (Select only 1 procedure)
7. The entity’s cash receipts of the first few days of the subsequent year were properly deposited in its general operating account after the year end. However, the auditor suspects that the entity recorded the cash receipts in its books during the last week of the year under audit. (Select only 1 procedure)
8. The auditor suspects that vouchers were prepared and processed by an accounting department employee for merchandise that was neither ordered nor received by the entity. (Select only 1 procedure)
9. The details of invoices for equipment repairs were not clearly identified or explained to the accounting department employees. The auditor suspects that the bookkeeper incorrectly recorded the repairs as fixed assets. (Select only 1 procedure)
10. The auditor suspects that a lapping scheme exists because an accounting department employee who has access to cash receipts also maintains the accounts receivable ledger and refuses to take any vacation or sick days.
(Select only 2 procedures)
11. The auditor suspects that the entity is inappropriately increasing the cash reported on its balance sheet by drawing a check on one account and not recording it as an outstanding check on that account, and simultaneously recording it as a deposit in a second account. (Select only 1 procedure)
12. The auditor suspects that the entity’s controller has overstated sales and accounts receivable by recording fictitious sales to regular customers in the entity’s books. (Select only 2 procedures)
List of Auditing Procedures
A. Compare the details of the cash receipts journal entries with the details of the corresponding daily deposit slips.
B. Scan the debits to the fixed asset accounts and vouch selected amounts to vendors’ invoices and management’s authorization.
C. Perform analytical procedures that compare documented authorized pay rates to the entity’s budget and forecast.
D. Obtain the cutoff bank statement and compare the cleared checks to the year-end bank reconciliation.
E. Prepare a bank transfer schedule.
F. Inspect the entity’s deeds to its real estate.
G. Make inquiries of the entity’s attorney concerning the details of real estate transactions.
H. Confirm the terms of borrowing arrangements with the lender.
I. Examine selected equipment repair orders and supporting documentation to determine the propriety of the charges.
J. Send requests to confirm the entity’s accounts receivable on a surprise basis at an interim date.
K. Send a second request for confirmation of the receivable to the customer and make inquiries of a reputable credit agency concerning the customer’s creditworthiness.
L. Examine the entity’s shipping documents to verify that the merchandise that produced the receivable was actually sent to the customer.
M. Inspect the entity’s correspondence files for indications of customer disputes or for evidence that certain shipments were on consignment.
N. Perform edit checks of data on the payroll transaction tapes.
O. Inspect payroll check endorsements for similar handwriting.
P. Observe payroll check distribution on a surprise basis.
Q. Vouch data in the payroll register to documented authorized pay rates in the human resources department’s files.
R. Reconcile the payroll checking account and determine if there were unusual time lags between the issuance and payment of payroll checks.
S. Inspect the file of prenumbered vouchers for consecutive numbering and proper approval by an appropriate employee.
T. Determine that the details of selected prenumbered vouchers match the related vendors’ invoices.
U. Examine the supporting purchase orders and receiving reports for selected paid vouchers.
NUMBER 11
Most of an auditor’s work in forming an opinion on financial statements consists of obtaining and evaluating evidential matter concerning the financial statement assertions.
Required:
a. What is the definition of “financial statement assertion?”
Do not list the assertions.
b. What is the relationship between audit objectives and financial statement assertions?
c. What should an auditor consider in developing the audit objectives of a particular engagement?
d. What is the relationship between audit objectives and audit procedures?
e. What are an auditor’s primary considerations when selecting particular substantive tests to achieve audit objectives?
NUMBER 12
Miller, CPA, is engaged to audit the financial statements of Superior Wholesaling for the year ended December 31, 1996. Miller obtained and documented an understanding of superior’s internal control relating to accounts receivable and assessed control risk relating to accounts receivable at the maximum level. Miller requested and obtained from Superior an aged accounts receivable schedule listing the total amount owed by each customer as of December 31, 1996, and sent positive confirmation requests to a sample of the customers. Subsequently, Miller tested the accuracy of the aged accounts receivable schedule. Miller has asked Adler, the staff assistant assigned to the engagement, to follow up on the eight returned confirmations that follow. Assume that each confirmation is material if the potential misstatement is projected to the population.
Required:
a. Describe the procedure(s), if any, that Adler should perform to resolve each of the eight confirmations that were returned. Assume that Superior will record any necessary adjusting entries and that Adler will verify that they are appropriate.
b. Assume that Miller sent second requests for accounts receivable balances initially selected for confirmation for which no responses were received. Describe the alternative substantive procedures that Miller should consider applying to the accounts receivable selected for confirmation for which no responses were received to Miller’s second requests. Assume that these accounts receivable in the aggregate, when projected as misstatements to the population, would affect Miller’s decision about whether the financial statements are materially misstated.
c. In addition to performing the confirmation procedures and alternative procedures described in requirements (a) and (b) and the procedures described in the first paragraph above, what additional substantive procedures should Miller consider performing to complete the audit of Superior’s accounts receivable and related allowances? Assume that all accounts receivable are trade receivables.
Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Atom Co.
362 Main Street
Confirm #11
Anytown, USA Dear C. L. Adams:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $15,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
Yes, we ordered $15,000 worth of
merchandise from Superior in November.
However, we mailed Superior a check for
$15,000 on 12/18/96.
Name C.L. Adams Position Acctg. Mgr.
Date 1/22/97
Note to files: Blake indicates that the check was received and deposited on 12/28/96, but posted to the wrong customer’s account.
C. Miller
Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Baker Co.
18 Lakeview Drive
Confirm #28
Central City, USA Dear S. Brown:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $25,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
Sure we ordered $25,000 of merchandise on Oct. 10, 1996, but Superior was out-of-stock until recently. They back-ordered the goods and we finally received them on Jan. 6, 1997.
Name S. Brown Position A/P Supervisor Date Jan. 18, 1997
Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Clark Retailing
35 Lincoln Avenue
Confirm #34
Jackson, USA Dear J. P. Cummings:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $32,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
We received $24,000 of goods on
consignment from Superior on 12/10/96, but they’re not sold yet!
Name J. Cummings Position President Date 1/19/97
Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Delta Outlet Stores, Inc.
Sunshine Mall
Confirm #41
River City, USA Dear R. Dunn:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $45,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
No way! Superior promised these goods in 10 days on Dec. 2nd. When we didn’t receive them, I canceled the order on Dec. 12th.
General Wholesaling shipped us similar goods overnight!
Name R. Dunn Position General Manager Date Jan. 18th
Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Eagle Distributors
2700 Ocean Shore Blvd.Confirm #58 Ocean City, USA
Dear T. Engle:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $59,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
I use an accounts payable voucher system by individual invoice. I can’t verify $59,000, but Superior is one of my regular suppliers. I am sure I probably owe them something.
Name T. Engle Position Acctg. Mgr Date 1-20-97
Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Franklin Co.
17 United Street
Confirm #67
Industry City, USA Dear S. Brown:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $65,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
Name Position Date
Note to files: This confirmation was returned by the postal service as “return to sender -- no such addressee at this location.”
C. Miller
Superior Wholesaling, Inc. Superior Wholesaling, Inc.
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Grove Retailing
3838 Curtis Blvd.
Confirm #71
Union Center, USA Dear H. Gates:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $75,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
Our records show that a check for $75,000 was mailed on 12/27/96.
Name H. Gates Position Controller Date 1/22/97
123 Commercial Blvd.
Anytown, USA
January 15, 1997 Hall Enterprises, Inc.
55 Green Street
Confirm #86
Grant City, USA Dear K. Hines:
Our auditor, Miller, CPA, is currently auditing our financial statements. To facilitate this audit, please confirm the balance due us as of December 31, 1996, which is shown on our records as $80,000. Indicate in the space below whether this is in agreement with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Please mail your reply directly to Miller, CPA. A stamped, self-addressed envelope is enclosed for your convenience.
Sincerely, J. Blake
J. Blake, Controller Superior Wholesaling, Inc.
To Miller, CPA:
The amount shown above is correct as of December 31, 1996, except as follows:
Mailed that check for full amount on 1-3-97: merchandise was only received on 12-23-96.
Name K. Hines Position Accountant Date 1-18-97
NUMBER 13
Cook, CPA, is auditing the financial statements of DollarMart, a local retailer of clothes, appliances, sporting goods, and electronics. During prior years’ audits of DollarMart, Cook noticed that management was less concerned about the timely recording of expenses and liabilities than revenues and assets. As a result, very little of DollarMart’s internal control resources were expended in assuring an accurate and timely recording of accounts payable. Cook also believes that DollarMart’s management may be motivated to delay recording its liabilities at year end, so Cook is approaching the search for unrecorded liabilities with caution.
Required:
a. What substantive auditing procedures would Cook most likely consider performing in searching for DollarMart’s unrecorded liabilities?
b. How would the nature, timing, and extent of Cook’s substantive auditing procedures most likely be affected by DollarMart’s deficient control environment?
NUMBER 14
Smith, CPA, is the supervising partner of the financial statement audit of Digit Sales Co., a publicly-held entity that files reports with the SEC. Hall, the senior auditor assigned to the engagement, had the following conversation with Smith at the end of the field work:
Smith: Don’t you think that Digit’s board of directors would be surprised with those huge inventory adjustments that we had Digit book last week?
Hall: I guess so, but what about that new assistant controller, Green? What incompetence!
Smith: Well, I suppose Green has a bit to learn about GAAP, but I was really upset when Dodd, the controller, contacted that other CPA firm about the contingent liability I wanted booked.
Hall: Which one was that?
Smith: You know, the employment discrimination suit filed by the union.
Hall: Oh, now I remember. Digit’s going to lose that one big time.
Smith: Right! You know it. I know it. The lawyer knows it. Even Dodd knows it. But it wasn’t booked until the other CPAs agreed with me.
Hall: Well, the important thing is that they did book it. I was more upset about their two-week delay in having the financial statements completed on time.
Smith: I know it cost us a lot of time, but Dodd was never late on that before. Maybe I should change the dates on next year’s engagement letter rather than complain to the board.
Hall: How about that large receivable?
Smith: What a joke! Dodd wouldn’t write that overdue account off and Digit doesn’t even sell that model anymore. At least Green was on our side.
Hall: They never did collect a penny on that account.
Smith: I heard that the customer finally filed for bankruptcy last month.
Hall: At least Dodd finally booked the write-off after that poorly-timed vacation.
Smith: I suppose so, but I still can’t believe that Dodd took two weeks off near the end of our field work.
Hall: Actually, that was great. With Dodd gone, Green booked that inventory adjustment without much of a battle.
Smith: Sure, but we couldn’t finish the field work until Dodd signed the rep letter and booked that receivable write-off. The report was late and it caused me grief with our managing partner.
Hall: But that’s not fair. It wasn’t our fault. The bottom line is they got a clean opinion and this job is history.
Smith: Not really. We haven’t communicated with the audit committee yet.
Hall: What do we have to tell them? They got an unqualified opinion . . . and remember, there were only a few reportable conditions. I’m out of here.
Required:
a. From the discussion above, what specific matters is Smith required to communicate to Digit’s audit committee? Do not include matters that are not required to be communicated under GAAS.
b. What other matters (omitted from the discussion above) is Smith required to communicate to Digit’s audit committee under GAAS?
NUMBER 15
The following Accounts Receivable—Confirmation Statistics working paper (indexed B-3) was prepared by an audit assistant during the calendar year 1991 audit of Lewis County Water Co., Inc., a continuing audit client. The engagement supervisor is reviewing the working papers.
Lewis County Water Co., Inc.
ACCOUNTS RECEIVABLE—CONFIRMATION STATISTICS 12/31/91
Index B-3
Accounts Dollars
Number Percent Amount Percent Confirmation Requests
Positives 54 2.7% $ 260,000 13.0%
Negatives 140 7.0% 20,000 10.0%
Total sent 194 9.7% 280,000 23.0%
Accounts selected/client asked us not to confirm 6 0.3%
Total selected for testing 200 10.0%
Total accounts receivable at 12/31/91, confirm date 2,000 100.0% $2,000,000
*
100.0%RESULTS
Replies received through 2/25/92
Positives -- no exception 44 C 2.2% 180,000 9.0%
Negatives -- did not reply or replied “no exception” 120 C 6.0% 16,000 .8%
Total confirmed without exception 164 8.2% 196,000 9.8%
Differences reported and resolved, no adjustment
Positives 6 .3% 30,000 1.5%
Negatives 12 .6% 2,000 .1%
Total 18 ‡ .9% 32,000 1.6%
Differences found to be potential adjustments
Positives 2 CX .1% 10,000 .5%
Negatives 8 CX .4% 2,000 .1%
Total -- .6% adjustment, immaterial 10 .5% 12,000 .6%
Accounts selected/client asked us not to confirm 6 .3%
Tickmark Legend
Agreed to accounts receivable subsidiary ledger Agreed to general ledger and lead schedule
Includes one related party transaction C Confirmed without exception, W/P B-4 CX Confirmed with exception, W/P B-5
Overall conclusion -- The potential adjustment of $12,000 or .6% is below materiality threshold; therefore, the accounts receivable balance is fairly stated.
Required: Describe the deficiencies in the working paper that the engagement supervisor should discover.
Assume that the accounts were selected for confirmation on the basis of a sample that was properly planned and documented on working paper B-2.