Auditing and assurance services 12e by arens chapter 7 solutions manual

7-4 An audit program for accounts receivable is a list of audit procedures thatwill be used to audit accounts receivable for a given client.. 7-5 The auditor must obtain sufficient appro

Chapter 7 Audit Evidence

The nature of evidence in a legal case and in an audit of financialstatements differs because a legal case relies heavily on testimony by witnessesand other parties involved While inquiry is a form of evidence used by auditors,other more reliable types of evidence such as confirmation with third parties,physical examination, and documentation are also used extensively A legal casealso differs from an audit because of the nature of the conclusions made In alegal case, a judge or jury decides the guilt or innocence of the defendant In anaudit, the auditor issues one of several audit opinions after evaluating theevidence

7-2 The four major audit evidence decisions that must be made on every auditare:

1 Which audit procedures to use

2 What sample size to select for a given procedure

3 Which items to select from the population

4 When to perform the procedure

7-3 An audit procedure is the detailed instruction for the collection of a type ofaudit evidence that is to be obtained Because audit procedures are theinstructions to be followed in accumulating evidence, they must be wordedcarefully to make sure the instructions are clear

7-4 An audit program for accounts receivable is a list of audit procedures thatwill be used to audit accounts receivable for a given client The audit procedures,sample size, items to select, and timing should be included in the audit program

7-5 The auditor must obtain sufficient appropriate evidence by performingaudit procedures to afford a reasonable basis for an opinion regarding thefinancial statements under audit There are three major phrases of the standard

7.5 (continued)

Obtain sufficient appropriate evidence The auditor must obtain evidence that is

reliable and there must be a reasonable quantity of that evidence.

By performing audit procedures The auditor performs audit procedures to

meet audit objectives using the eight types of evidence.

To afford a reasonable basis for an

opinion regarding the financial statements

The auditor cannot expect to be completely certain that the financial statements are fairly presented but there must be persuasive evidence The collection of evidence gathered by the auditor provides the basis for the auditor's opinion

7-6 There are two primary reasons why the auditor can only be persuadedwith a reasonable level of assurance, rather than be convinced that the financialstatements are correct:

1 The cost of accumulating evidence It would be extremely costly for the

auditor to gather enough evidence to be completely convinced

2 Evidence is normally not sufficiently reliable to enable the auditor to be

completely convinced For example, confirmations from customersmay come back with erroneous information, which is the fault of thecustomer rather than the client

7-7 The two determinants of the persuasiveness of evidence areappropriateness and sufficiency Appropriateness refers to the relevance andreliability of evidence, or the degree to which evidence can be consideredbelievable or worthy of trust Appropriateness relates to the audit proceduresselected, including the timing of when those procedures are performed.Sufficiency refers to the quantity of evidence and it is related to sample size anditems to select

7.8 Following are six characteristics that determine reliability and an example

of each

FACTOR DETERMINING RELIABILITY

EXAMPLE OF RELIABLE EVIDENCE

Independence of provider Confirmation of a bank balance

Effectiveness of client's internal controls Use of duplicate sales invoices for a

large well-run company

Auditor's direct knowledge Physical examination of inventory by the

auditor

Qualifications of provider Letter from an attorney dealing with the

client's affairs

Degree of objectivity Count of cash on hand by auditor

Timeliness Observe inventory on the last day of the

fiscal year

7-9

1 Physical examination  Count petty cash on hand

 Examine fixed asset additions

2 Confirmation  Confirm accounts receivable balances of a

sample of client customers

 Confirm client’s cash balance with bank

3 Documentation  Examine cancelled checks returned with cutoff

bank statement

 Examine vendors’ invoices supporting a sample of cash disbursement transactions throughout the year

4 Analytical procedures  Evaluate reasonableness of receivables by

calculating and comparing ratios

 Compare expenses as a percentage of net sales with prior year’s percentages

5 Inquiries of the client  Inquire of management whether there is

obsolete inventory

 Inquire of management regarding the collectibility of large accounts receivable balances

 Agree sales invoice price to approved price list

 Match quantity on purchase invoice to receiving report

 Observe client employees in the process of counting inventory

 Observe whether employees are restricted from access to the check signing machine

7-10 The four characteristics of the definition of a confirmation are:

1 Receipt

2 Written or oral response

3 From independent third party

4 Requested by the auditor

A confirmation is prepared specifically for the auditor and comes from an external source External documentation is in the hands of the client at the time

of the audit and was prepared for the client's use in the day-to-day operation of the business

7-11 Internal documentation is prepared and used within the client's

organization without ever going to an outside party, such as a customer orvendor

Examples:

 check request form

 receiving report

 payroll time card

 adjusting journal entry

External documentation either originated with an outside party or was an

internal document that went to an outside party and is now either in the hands ofthe client or is readily accessible

7-12 Analytical procedures are useful for indicating account balances that may

be distorted by unusual or significant transactions and that should be intensivelyinvestigated They are also useful in reviewing accounts or transactions forreasonableness to corroborate tentative conclusions reached on the basis ofother evidence

7-13 The most important reasons for performing analytical procedures are the

following:

1 Understanding the client's industry and business

2 Assessment of the entity's ability to continue as a going concern

3 Indication of the presence of possible misstatements in the financial

statements

4 Reduction of detailed audit tests

7-14 The decrease of the current ratio indicates a liquidity problem for Harper

Company since the ratio has dropped to a level close to the requirements of thebond indenture Special care should be exercised by the auditor to determinethat the 2.05 ratio is proper since management would be motivated to hide anylower ratio The auditor should expand procedures to test all current assets forproper cutoff and possible overstatement and to test all current liabilities forproper cutoff and possible understatement

7-15 Attention directing analytical procedures occur when significant,

unexpected differences are found between current year's unaudited financialdata and other data used in comparisons If an unusual difference is large, theauditor must determine the reason for it, and satisfy himself or herself that thecause is a valid economic event and not an error or misstatement due to fraud

When an analytical procedure reveals no unusual fluctuations, theimplication is minimized In that case, the analytical procedure constitutessubstantive evidence in support of the fair statement of the related accountbalances, and it is possible to perform fewer detailed substantive tests inconnection with those accounts

Frequently, the same analytical procedures can be used for attentiondirecting and for reducing substantive tests, depending on the outcome of thetests Simple procedures such as comparing the current year account balance tothe prior year account balance is more attention directing (and provides lessassurance) than more complex analytical procedures; i.e., those which rely onregression analysis More sophisticated analytical procedures help the auditorexamine relationships between several information variables simultaneously Thenature of these tests may provide greater assurance than simple procedures

7-16 The statement is correct Except for certain accounts with small dollar

balances, analytical procedures are essential to help the auditor identify trends in

a client's business and to see the relationship between the client's performanceand industry averages However, the auditor is responsible for gatheringsufficient appropriate evidence in addition to the evidence obtained as a result ofthe analytical procedures

7-17 The purposes of audit documentation are as follows:

1 To provide a basis for planning the audit The auditor may use

reference information from the previous year in order to plan thisyear's audit, such as the evaluation of internal control, the timebudget, etc

2 To provide a record of the evidence accumulated and the results of the

tests This is the primary means of documenting that an adequateaudit was performed

3 To provide data for deciding the proper type of audit report Data are

used in determining the scope of the audit and the fairness withwhich the financial statements are stated

4 To provide a basis for review by supervisors and partners These

individuals use the audit documentation to evaluate whethersufficient appropriate evidence was accumulated to justify the auditreport

Audit documentation are used for several purposes, both during the auditand after the audit is completed One of the uses is the review by moreexperienced personnel A second is for planning the subsequent year audit Athird is to demonstrate that the auditor has accumulated sufficient appropriateevidence if there is a need to defend the audit at a later date For these uses, it isimportant that the audit documentation provide sufficient information so that theperson reviewing an audit schedule knows the name of the client, contents of theaudit schedule, period covered, who prepared the audit schedule, when it wasprepared, and how it ties into the rest of the audit files with an index code

7.18 The two criteria used by auditors of public companies when determining

whether memos, correspondence, and other documents must bemaintained in the audit files are as follows:

1 The materials are created, sent, or received in connection with theaudit or review

2 The materials contain conclusions, opinions, analyses, or financialdata related to the audit or review

7-19 The Sarbanes-Oxley Act of 2002 requires auditors of public companies to

prepare and maintain audit schedules and other information related to any auditreport in sufficient detail to support the auditor’s conclusions, for a period of notless than 7 years

7-20 Audit schedules should include the following:

Name of the client Enables the auditor to identify the appropriate file to

include the audit schedule in if it is removed from the files

Period covered Enables the auditor to identify the appropriate year to

which an audit schedule for a client belongs if it is removed from the files

7-20 (continued)

Description of the contents A list of the contents enables the reviewer to

determine whether all important parts of the audit schedule have beenincluded The contents description is also used as a means of identifyingaudit files in the same manner that a table of contents is used

Initials of the preparer Indicates who prepared the audit schedule in case

there are questions by the reviewer or someone who wants informationfrom the files at a later date It also clearly identifies who is responsible forpreparing the audit documentation if the audit must be defended

Date of preparation Helps the reviewer to determine the sequence of the

preparation of the audit schedules It is also useful for the subsequent year

in planning the sequence of preparing audit schedules

Indexing Helps in organizing and filing audit schedules Indexing also

facilitates in searching between related portions of the auditdocumentation

7-21 The permanent file contains data of an historical and continuing nature

pertinent to the current audit Examples of items included in the file are:

1 Articles of incorporation

2 Bylaws, bond indentures, and contracts

3 Analysis of accounts that have continuing importance to the auditor

4 Information related to the understanding of internal control:

a flowcharts

b internal control questionnaires

5 Results of previous years' analytical procedures, such as various ratios

and percentages compiled by the auditors

By separating this information from the current year's audit files, it becomeseasily accessible for the following year's auditors to obtain permanent file data

7-22 The purpose of an analysis is to show the activity in a general ledger

account during the entire period under audit, tying together the beginning and

ending balances The trial balance includes the detailed make-up of an ending

balance It differs from an analysis in that it includes only those items comprising

the end of the period balance A test of reasonableness schedule contains

information that enables the auditor to evaluate whether a certain accountbalance appears to be misstated One example of a test of reasonablenessschedule is a schedule that compares current year expenses to prior years'amounts This type of schedule is intended to show which accounts needinvestigation due to significant variances

7-23 Unanswered questions and exceptions may indicate the potential for

significant errors or fraud in the financial statements These should beinvestigated and resolved to make sure that financial statements are fairlypresented

7-23 (continued)

The audit files can also be subpoenaed by courts as legal evidence.Unanswered questions and exceptions may indicate lack of due care by theauditor

7-24 Tick marks are symbols adjacent to information in audit schedules for the

purpose of indicating the work performed by the auditor An explanation of thetick mark must be included at the bottom of the audit schedule to indicate whatwas done and who did it

7-25 Audit files are owned by the auditor They can be used by the client if the

auditor wants to release them after a careful consideration of whether there might

be confidential information in them The audit files can be subpoenaed by a courtand thereby become the property of the court They can be released to anotherCPA firm without the client's permission if they are being reviewed as a part of avoluntary peer review program under AICPA, state CPA society, or state Board

of Accountancy authorization The audit files can be sold or released to other

users if the auditor obtains permission from the client.

7-26 It is a violation unless the CPA obtains permission from each client before

the audit files for that client are released

7-27 When evidence can be examined only in machine-readable form, auditors

use computers to read and examine evidence There are commercial auditsoftware programs designed specifically for use by auditors, such as ACLSoftware and Interactive Data Extraction and Analysis (IDEA) Spreadsheetsoftware packages can also be used by auditors to perform audit tests on datathat is available only in machine-readable form

7-28 The purposes of audit documentation software are to convert traditional

paper-based documentation into electronic files and to organize the auditdocumentation The benefits of audit documentation software, such asAutomated Client Engagement (ACE), are as follows:

 The auditor can more efficiently prepare a trial balance, lead

schedules, supporting audit documentation, financial statements,and ratio analysis using the computer rather than by hand

 The effects of adjusting journal entries are automatically carried

through to the trial balance and financial statements, making minute adjustments easier to make

last- Tick marks and review notes can be entered directly into computerized

files

 Data can be imported and exported to other applications For example,

a client’s general ledger can be downloaded into ACE and taxinformation can be downloaded into a commercial tax preparationpackage after the audit is completed

 Multiple Choice Questions From CPA Examinations

 Discussion Questions And Problems

7-31 a.

1 External 7 Internal 13 Internal

2 Internal 8 Internal 14 External

3 External 9 External 15 Internal

4 External 10 Internal* 16 External

5 Internal* 11 External 17 External

6 Internal 12 External** 18 External

* Even though these may be signed or initialed by employees, they arestill internal documents

** Bills of lading are ordinarily signed by the freight company Thatsignature will be included on the top of the bill of lading, therefore, it is

an external document

b External evidence is considered more reliable than internal evidence

because external evidence has been in the hands of both the clientand another party, implying agreement about the information andthe conditions stated on the document

7-33 Examples of audit evidence the auditor can use to support each of the

functions are:

a Examine invoice from vendor

Direct confirmation with vendor

b Physical examination

Direct confirmation with custodian

c Direct confirmation with customer

Examine cash receipts journal and bank deposits for subsequent cash receipts

d Examine title for ownership of asset

Examine invoice from vendor

e Direct confirmation with vendor

Examine client's copy of vendor's statement

f Physical examination

Examine sales invoice of subsequent sale of goods showing marked down sale price

g Count petty cash

Direct confirmation with custodian

7-34 a. Confirmations are normally more reliable evidence than inquiries of

the client because of the independence of the outside partyconfirming the information

b Confirmation of bank balances is considered highly reliable whereas

confirmation of a department store charge account is often notconsidered reliable Banks are accustomed to confirmations fromauditors and normally maintain excellent accounting records,whereas most customers of department stores have neithercharacteristic

c If an auditor is not qualified to distinguish between valuable inventory

(e.g., diamonds) and worthless inventory (e.g., glass), the physicalexamination of inventory would not be considered to be reliableevidence

d Recalculation tests are highly reliable because the auditor is able to

gain 100% assurance of the accuracy, but the tests only verifywhether the recorded amounts are accurately totaled These tests

do not uncover omissions or fictitious amounts

e Relatively reliable documentation examples include: vendor

statements, bank statements, and signed lease agreements.Relatively unreliable documentation examples may be: copies ofcustomer invoices, internal memoranda and other communications,and a listing of fixed asset additions

The difference between reliable and unreliabledocumentation examples above is whether they originate fromoutside or inside the client's organization External information isconsidered more reliable than internal documentation

7-34 (continued)

f

1 Confirmation of accounts receivable - Corporation

accustomed to confirmations compared to a member of thegeneral public

2 Examination of the corporate minutes - Experienced partner

compared to a new assistant

3 Physical observation of inventory - Auditor knowledgeable in

the client's inventory compared to one who is not

4 Attorney's letter - General counsel compared to an attorney

involved only with patents

g Analytical procedures are evidence of the likelihood of

misstatements in the financial statements, but they are rarelysufficient by themselves to conclude that the statements aremisstated Other supportive evidence is needed to determinewhether apparent misstatements are actually material

CASH IN BANK All banks in which Star

had deposits during the year including those which may have had an account that was closed out during the year.

 Name and address of the bank.

 The amount on deposit for each account as of the balance sheet date plus the name of each account, the account number, whether or not the account is subject to withdrawal by check, and the interest rate if the account is interest bearing.

 The amount for which Star was directly liable to the bank for loans as of the balance sheet date plus the date of the loan, the due date, the interest rate, the date to which interest is paid, and description of the liability and collateral.

 If internal controls over cash are weak, the auditor may wish to request that the bank include a list of authorized signatures with the confirmation.