CHAPTER 11 A RISK-BASED AUDIT APPROACH – PART II I Review Questions Use the model AR = IR x CR x DR to solve for different values of Audit Risk (AR) when internal control risk (CR) is given different values In all cases IR = 0.90 and DR = 0.10, therefore, AR = 0.90 x CR x 0.10 When CR is 0.10 0.50 0.70 0.90 1.00 AR is 0.009 or 0.9 percent 0.045 or 4.5 percent 0.063 or 6.3 percent 0.081 or 8.1 percent 0.090 or 9.0 percent a Risk of Assessing Control Risk Too Low or Overreliance is a matter of judgment about the importance (“key”) characteristic of a particular client control procedure An auditor can take more risk of assessing control risk too low on unimportant controls than on important (“key”) ones Alternatively, the risk of assessing control risk too low can be considered a constant (say, 0.05) and the importance of a control can be measured in terms of a smaller or larger tolerable rate (The authors prefer the latter approach.) b Risk of Assessing Control Risk Too High or Underreliance is a matter of judgment about the efficiency of an audit engagement The risk can be quite high when the audit team is willing to extensive substantive work anyway If the work budget is tight, auditors need to find objective ways (e.g., larger test of controls audit samples) to mitigate the risk c Tolerable Deviation Rate is a judgment about how many control deviations can exist in the population, yet the control can still be considered effective Auditors need to be careful about brushing aside findings of deviations d Expected Deviation Rate in the Population is an estimate, usually based on assumptions or sketchy information, of the imbedded incidence of control deviations The only use of this estimate in classical attribute sampling is to figure a sample size in advance The statistical evaluation (CUL calculation) does not use it e Population Definition might be called a judgment about identification of the population of control performances that correspond to an audit objective For example, an auditor would want to be sure he is sampling from a file of 14-2 Solutions Manual - Principles of Auditing and Other Assurance Services recorded documents if his objective is to audit the controls over transaction validity Assessing the control risk too low causes auditors to assign less control risk (CR) in planning procedures than proper evaluation would cause them to assign The result could be (1) inadvertently conducting less audit work than properly necessary and taking more audit risk (AR) than originally contemplated, perhaps to the unpleasant results of failing to detect material misstatements (damaging the effectiveness of the audit) or (2) discovering in the course of the audit work that control is not as good as first believed, causing an increase in the audit work, perhaps at a time when doing so is very costly (damaging the efficiency of the audit) The important consideration involved in judging an acceptable risk of assessing control risk too high is the efficiency of the audit Assessing control risk too high causes auditors to think they need to perform a level of substantive work which is greater than a proper evaluation of control would suggest Assessing control risk too high leads to overauditing Some auditors may be willing to accept high risks of assessing the control risk too high because they intend to overaudit anyway, and the audit budget can support the work Other auditors want to minimize their work (within acceptable professional bounds of audit risk) and thus want to minimize the risk (probability) of overauditing by mistake Technically, the risk of assessing control risk too high in relation to an attribute sample is the probability of finding in the sample (n) one deviation more than the “acceptable number” for the sampling plan For example, if the plan called for a sample of 100 units and a tolerable rate of percent at a 0.10 risk of assessing control risk too low, the “acceptable number” is zero deviations The probability of finding or more deviations when the population rate is actually percent is: Probability (x > : n = 100, r = 0.02) = = = – (1 – r) n – (1 – 0.02) 100 0.867 or 86.7 percent All the elements of the risk model are products of auditors’ professional judgments Auditors must judge: Inherent risk – the probability that material errors or irregularities have entered the accounting system used to develop financial statements Audit Working Papers 14-3 Internal control risk – the probability that client’s system of internal control policies and procedures will fail to detect material errors and irregularities, provided any enter the data accounting system in the first place Analytical procedures risk – the probability that auditors’ analytical procedures will fail to produce evidence of material errors and irregularities, provided any have entered the accounting system in the first place and have not been detected and corrected by the client’s internal control procedures Audit risk – the probability that auditors will not discover by any means errors and irregularities that cause an account balance to be materially misstated Test of detail risk appears at first glance to be the product of a formula and not a professional judgment However, everything in the risk model is a judgment, so the test of detail derived from the model is no less a judgment An incorrect acceptance decision directly impairs the effectiveness of an audit Auditors wrap up the work and the material misstatement appears in the financial statements An incorrect rejection decision impairs the efficiency of an audit Further investigation of the cause and amount of misstatement provides a chance to reverse the initial decision error Detection risk is the component of audit risk that is controllable by the auditor It may be raised or lowered by reducing or increasing the amount of substantive audit testing It is determined by the auditor’s assessment of inherent risk and control risk The auditor deals with both inherent risk and control risk during the planning phase of the audit Inquiry of client personnel, study of the business and industry, application of analytical procedures, and documentation of the auditor’s initial understanding of internal control are all performed during the planning phase of the audit Further study of internal control procedures may occur after the planning phase if the auditor wishes to further reduce the assessed level of control risk, and considers it economically feasible to so An auditor would assess control risk to be at maximum when (1) effective controls for the assertion have either not been designed or not put in place, or (2) when the auditor believes performing substantive tests of the assertion is more cost effective When an auditor assesses control risk to be below the maximum, the auditor should believe that effective controls are present to prevent or detect misstatements in the financial statement assertions 10 When the auditor assesses control risk at a level lower than maximum, the auditor may generally perform fewer substantive tests 14-4 Solutions Manual - Principles of Auditing and Other Assurance Services 11 The audit risk model is useful in managing audit risk for assertions By determining planned audit risk for an assertion, assessing inherent and control risks, an auditor can determine the allowable detection risk (the amount of detection risk an auditor can allow) for an assertion Allowable detection risk is used to determine the nature, timing, and extent of audit procedures for the assertion 12 Detection risk exists because auditors (1) may use an inappropriate audit procedure, (2) may misapply an audit procedure, (3) may misinterpret the findings, or (4) not examine 100 percent of an account balance or transaction class 13 The amount of audit evidence an auditor must gather varies inversely with allowable detection risk As allowable detection risk decreases, the amount of evidence required increases, and vice versa Chapter 12 introduces audit procedures and discusses how auditors modify audit procedures to obtain sufficient competent evidential matter by changing (1) the nature, (2) the timing, or (3) the extent of procedures 14 The audit risk model is Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR) 15 Risks identified at the financial statement level may have a substantial impact on the assessment of inherent risk for specific assertions For example, concern about management integrity, identified as a risk at the financial statement level, would cause an auditor to assess a higher level of inherent risk for existence of sales II Multiple Choice Questions 10 11 d d c d a b a a b b a 12 13 14 15 16 17 18 19 20 21 22 d a d d c b a a b d a 23 24 25 26 27 28 29 30 31 32 33 c c d d c b d a a b a 34 35 36 37 38 39 40 41 42 c d b d d c a c d Audit Working Papers 14-5 III Comprehensive Cases Case Factors that will affect your evaluation of audit risk include      integrity of management – Jimenez’s reputation and lawsuit trend toward domination of operating and financial decisions by Jimenez increased management compensation based on performance aggressive attitude toward financial reporting by new personnel profitability inconsistent with the industry Case The factors that will affect Josefina’s audit risk and business risk are (a) this is a special audit, (b) the audit will be used to set the value of certain assets, (c) the auditor is to evaluate any disputed amount (although this is a common provision in purchase agreements, one might question whether auditors should agree to such terms), and (d) the materiality level is set at P50,000, even though that is considerably below an amount that might be determined using a percentage of assets and/or income These factors will increase the risk at the financial statement level and potentially increase business risk Case a The audit risk model gives the following results: AR = IR x CR x DR (or) DR x AR / (IR x CR) (1) 2.5% (2) 0.67% (3) (4) 3.33% (5) 2.5% In the third situation, the auditor does not have to accumulate any evidence because inherent risk and control risk give the appropriate level of planned audit risk b Case a b (1) (tied) (2) (3) (4) (5) (tied) (1) Medium (4) Low (2) Low (5) Low (3) Low (1) Least (2) (tied) (3) (tied) (4) (tied) (5) (tied) 14-6 Solutions Manual - Principles of Auditing and Other Assurance Services Case a b a b a b a b a b This will have an impact on audit risk for valuation of accounts receivable Accumulation of additional evidence regarding collectability of receivables will be necessary This situation may or may not affect overall audit risk, depending on the impact of the financing needed and whether the company will become so heavily leveraged that profitability becomes inadequate This situation might create increased business risk because of the potential change in ownership It would have an impact on audit risk for valuation of stockholders’ equity Additional evidence will have to be accumulated relating to stockholders’ equity, as well as any additional debt incurred The client’s changing of its accounting system will affect control risk in each cycle, primarily for existence, completeness, and valuation Additional information will have to be accumulated about the system in each cycle This will affect risk at the financial statement level, which may also have an impact on risk for assertions relating to earnings and valuation of assets For example, the volatility in the industry may indicate the potential for inadequate industry earnings or for a client’s earnings being inconsistent with the industry Additional evidence will have to be accumulated about the financial viability of the client and to provide evidence that management fraud does not exist The increase in inventory will affect existence and valuation of inventory Additional evidence will have to be accumulated about the existence and valuation assertions Case a b c Sales and collection Primarily affects existence, completeness, and valuation assertions Increase a b c Acquisitions and payments Potential impact on all assertions Increase a b c Sales and collections Valuation, cutoff, and existence No effect a b c Production and warehousing Valuation Increase Audit Working Papers 14-7 CHAPTER 12 AUDIT PROCEDURES I Review Questions “Procedures” relate to acts to be performed “Standards” deal with measures of the quality of performance of those acts and the objectives to be attained by the use of procedures The standards are less subject to change The standards provide the criteria for rejecting, accepting, or modifying a procedure in a given circumstance An example of the relative stability of standards and procedures is found in the change from non-EDP to EDP systems New procedures were required to audit EDP systems, but auditing standards remained unchanged and were the criteria for determining the adequacy of the new procedures A “substantive audit procedure” is any action (resembling a specific variation of one of the seven general audit procedures) undertaken for the purpose of producing evidence about a peso amount of a disclosure that appears in the financial statements under audit The nature of a procedure is its description – usually associated with one of the seven general audit procedures For example, the nature of a procedure may be confirmation, document, vouching, etc The timing of a procedure is the period during which it is performed – usually distinguished as interim (before the balance sheet date), year-end (on or close to the balance sheet date), and subsequent (after the balance sheet date) The extent of a procedure is the number of details audited with it, or another measure of intensity or frequency Oftentimes, extent is measured by the sample size Inspection techniques include physical examination of assets, examination of documents and records, performance of mechanical accuracy tests, and analytical procedures Vouching and tracing are two types of commonly performed documentation Vouching involves the examination of documents that served as a basis for recording the transaction Vouching usually starts with a recorded transaction and works back to the documents and addresses existence Tracing involves determining whether source documents have been recorded properly in the 14-8 Solutions Manual - Principles of Auditing and Other Assurance Services accounting records By tracing, an auditor can obtain evidence that the recording of the transaction is complete An inquiry involves requesting information from client personnel and receiving their response The request and response may be either written or oral A confirmation is a response a third party makes directly to the auditor on the request of a client The response includes information about certain transactions, relationships, and/or balances that have an impact on a specific financial statement assertion Confirmations are usually considered more reliable because they are from outside parties, while inquiries are made of client personnel When equivalent procedures are available to satisfy the need for evidence, an auditor may consider cost in selecting among the alternatives Vouching is relevant to testing the existence of sales; tracing is not Tracing is relevant to testing the completeness of sales, but vouching is not II Multiple Choice Questions c d c a c c a d d III Comprehensive Cases Case The objectives for the audit of Wesson’s securities investments at December 31 are to obtain evidence about the assertions implicit in the financial presentation, specifically: Existence Obtain evidence that the securities are bona fide and held by Wesson or by a responsible custodian Occurrence Obtain evidence that the loan transaction and securities purchase transactions actually took place during the year under audit Completeness Obtain evidence that all the securities purchase transactions were recorded Rights Obtain evidence that the securities are owned by Wesson Obligation Obtain evidence that P500,000 is the amount actually owed on the loan Valuation Obtain evidence of the cost and market value of the securities held at December 31 Decide whether any writedowns to market are required by GAAP Measurement Presentation and Disclosure Obtain evidence of the committed nature of the assets, which should mean they should be in a non-current classification Audit Working Papers 14-9 like the loan Obtain evidence that restrictions on the use of the assets is disclosed fully and agrees with the loan documents Case Types of procedures used by auditors in general, with examples: Recalculation by the auditor * recomputing the client’s calculation of depreciation expense Observation by the auditor * observation, test-counting of client’s physical inventory-taking Confirmation by letter * obtaining accounts receivable confirmations * obtaining client’s lawyer’s letter Inquiry and written representations * ask client personnel about accounting events * complete an internal control questionnaire * obtain written client representation letter Vouching * find brokers’ invoices and cancelled checks showing agreement with record amounts for securities investments Tracing * select a sample of shipping documents and trace them to sales invoices, sales journal recording and posting to general ledger Scanning * scan expense accounts for credit entries * scan payroll check lists for unusually large checks Analytical procedures – any example that fits one of these: * compare financial information with prior periods * compare financial information with budgets and forecasts * study predictable financial information patterns (e.g., ratio analysis) * compare financial information to industry statistics * study financial information in relation to nonfinancial information Case a b An audit confirmation is a written statement to the CPA from someone outside the enterprise on a fact that a person is qualified to affirm The two main characteristics a confirmation should possess are: The party supplying the information requested must be knowledgeable and independent, i.e., he must have knowledge of information of interest to the auditor and he must be outside the scope of influence of the organization being audited, and 14-10 Solutions Manual - Principles of Auditing and Other Assurance Services The auditor must obtain the information directly from the informed party Case Scanning for debit balances in accounts payable Recalculation of amounts on supporting documents Vouching of account entries to supporting documents Vouching of policies from expense and prepayment entries Recalculation of expiration of insurance premium Analysis of interrelationships – compare insurance coverage to assets owned and leased Scanning inventory records for “old” last-issue dates Verbal inquiry – question inventory control personnel about slow-moving inventory Vouching – examine journal entries for evidence of actual book write-down of the specific inventory items Tracing – trace remittance amounts to appropriate customer’s account Recalculation – recalculate amount of discounts and allowances Vouching – examine authoritative documents supporting unusual discounts and/or allowances Observation and examination by the auditor – of the inventory and the inventory-taking procedures Confirmation by letter – of inventory held in outside warehouses Recalculation – of the accuracy cost-flow calculations Case a A material decline in sales may indicate unrecorded sales; a decrease in cost of goods sold may be due to unrecorded purchases; and an increase in cost of good sold may be the result of omissions from the ending inventory An increase or decrease in gross profit will result from any one or a combination of the above omissions b A decline in the miscellaneous revenue account balance, or the absence of a previously existing source of miscellaneous revenue, could be attributable to a failure to record miscellaneous revenue c Unrecorded accounts payable at year-end would cause an increase in calculated accounts payable turnover d An apparent increase in accounts receivable turnover may, in fact, be the result of failure to record credit sales transactions 11-100 Solutions Manual - Principles of Auditing and Other Assurance Services CHAPTER 25 AUDITING FAIR VALUE MEASUREMENTS AND DISCLOSURES I Review Questions Refer to page 856, paragraph of the textbook Refer to page 854, paragraph of the textbook Refer to page 856, paragraph of the textbook Refer to page 857, paragraph of the textbook Refer to pages 858 to 872 of the textbook Refer to page 861, no of the textbook Refer to page 863, no of the textbook Refer to page 864, no 9, 3rd paragraph of the textbook Refer to pages 865 to 866 of the textbook II Multiple Choice Questions b b d d c CHAPTER 26 USING THE WORK OF OTHERS 18-100 A Risk-based Audit Approach – Part II I 11-101 Review Questions An auditor who reports on the financial statements of a combined entity when he or she audited the major part of the combined entity is the principal auditor Auditing standards identify procedures to be followed by a principal auditor To be able to serve as auditor of a combined entity, an auditor must determine that he or she is able to be the principal auditor based on the materiality of the portion of the financial statements that he or she has examined, his or her knowledge of the overall financial statements, and the importance of the components he or she has audited The principal auditors must perform one or more of the following procedures:     Visit the auditor Review the audit programs Review audit work papers Perform additional audit procedures Refer to page 879 Refer to pages 879 to 880 While the external auditor has sole responsibility for the audit opinion expressed and for determining the nature, timing, and extent of external audit procedures, certain parts of internal auditing work may be useful to the external auditor The external auditor should obtain a sufficient understanding of internal audit activities to assist in planning the audit and developing an effective audit approach Effective internal auditing will often allow a modification in the nature and timing, and a reduction in the extent of procedures performed by the external auditor but cannot eliminate them entirely In some cases, however, having considered the activities of internal auditing, the external auditor may decide that internal auditing will have no effect on external audit procedures The external auditor’s preliminary assessment of the internal audit function will influence the external auditor’s judgment about the use which may be made of internal auditing in modifying the nature, timing and extent of external audit procedures II Multiple Choice Questions c b d b 18-101 b c 11-102 Solutions Manual - Principles of Auditing and Other Assurance Services III Comprehensive Cases a Tan should ask San Nicolas to authorize Andres to respond fully to her inquiries If San Nicolas refuses or limits the responses, Tan should request San Nicolas to explain the reasons After obtaining the explanation, Tan should consider whether to continue pursuing the engagement b Tan will have to (1) obtain additional information about the client and possibly about the industry, which Andres would have obtained in prior years, (2) make a more detailed evaluation of whether to accept this client, (3) obtain information about the client’s internal control, which Andres would have obtained in prior years, and (4) obtain evidence about beginning balance sheet balances, which Andres would have obtained in prior years CHAPTER 28 THE AUDITOR’S REPORT ON FINANCIAL STATEMENTS I Review Questions Scope paragraph (a) The objects of the audit are the financial statements – balance sheet(s), income statement(s), and cash flow statement(s), and related footnote disclosure, not the “books and records.” (b) The description of the audit means: (1) (2) (3) (4) (5) (6) (7) the auditors were trained and proficient the auditors were independent due professional care was exercised the work was planned and supervised internal controls was properly studied and evaluated sufficient competent evidential matter was obtained the GAAS reporting standards were followed * Professional judgment was exercised in performing the tests and choosing the procedures to perform in the circumstances Report and the evidence dimension Fully sufficient competent 18-102 Isolated evidence Pervasive lack A Risk-based Audit Approach – Part II Unqualified opinion Adverse opinion Opinion qualified for a departure from SFAS Paragraph for inconsistent GAAP application Paragraph for an uncertainty Disclaimer of opinion evidence X X deficiency 11-103 of evidence X X X X Major reasons for departure from the standard unqualified report Disagreement with management regarding the acceptability of the accounting policies selected, the method of their application or the adequacy of financial statement disclosure Limitation on scope of the audit (resulting in a lack of evidence) Using extra paragraph(s) to emphasize significant matters Different opinion on prior year comparative statements Relying on the work and reports of other independent auditors Required supplementary data omitted or departs from guidelines “Other information” inconsistent with financial statements or contains material misstatement of fact Auditor is not independent Students may identify more than one description of the “most important” distinction between an opinion and a disclaimer All the following are valid, although (a) is intended to be the “Most Important:” a An opinion (unqualified, qualified or adverse) is an explicit statement of the auditor’s conclusion(s), while a disclaimer is an (empty) assertion of “no conclusion.” b An (unqualified) opinion is the highest level of assurance, while a disclaimer is the lowest level (no assurance) c An opinion requires evidence as a basis, while a disclaimer results from lack of evidence d Auditors must be independent to give an opinion, while a disclaimer can result from a CPA’s lack of independence A material scope restriction occurs when the auditor is unable to gather sufficient competent evidence to support an unqualified opinion on the financial statements Scope restrictions may be client-imposed or they may result from other circumstances, e.g., appointment of the auditor after the client’s physical 18-103 11-104 Solutions Manual - Principles of Auditing and Other Assurance Services inventory has been taken A material scope restriction need not result in a modification of the auditor’s opinion provided the auditor can obtain satisfaction by alternate means A principal auditor is one who has examined the major portion of the combined entity When financial statements of the prior year are presented together with those of the current year, a continuing auditor must report on both years In “updating” the prior year’s report, the auditor must decide whether to restate the report in its same form or modify it to reflect current information not available at the date of issuance of the prior report A continuing auditor can update a previously-issued report by obtaining and evaluating information during the current engagement Thus, an updated report is a previously-issued report that has been reevaluated in light of current information and evidence (The updated report itself may be a compilation report, a review report, or an audit report) The reevaluation may cause the updated version to be different from the report previously issued (for example, a new reason to write a qualification may be found) An updated report carries a current date, not the date of the previous report A predecessor auditor usually does not have the current information necessary to update a report Either a continuing auditor or a predecessor auditor can reissue previouslyreissued report The process does not contemplate consideration of information and evidence obtained during a current engagement Thus, a reissued report is a current release of a previously-issued report without benefit of any additional examination or review of the subject financial statements The report date should be the date of the end of field work for the original issue of the report A principal auditor is the one who (a) audits a material portion of a reporting entity’s assets, liabilities, revenues and expenses (usually over 50 percent) and (b) knows enough about the whole entity to sign the audit report 10 The principal auditor’s reference in his report to another auditor is not a qualification in scope The reference only shows the divided responsibility for the audit work 11 When an auditor is not independent with respect to a client, a disclaimer of opinion must be rendered The disclaimer must be issued because the statements 18-104 A Risk-based Audit Approach – Part II 11-105 cannot be audited in accordance with generally accepted auditing standards (An accountant, not an auditor, is the person associated with compiled and reviewed financial statements An accountant can give a compilation – disclaimer – report on compiled unaudited financial statements) 12 When the “going concern assumption” is in doubt, auditors have serious reservations about the recoverability and amounts of reported assets and the amount and classification of reported liabilities These opinions may be used, depending on the circumstances: a Standard unqualified report with an uncertainty notice paragraph calling attention to the going concern problem b Disclaimer of opinion to express unwillingness to give an opinion on the presentation c Opinion qualified or adverse for departure from GAAP if all appropriate disclosures are not made 13 According to PSA 700, “In certain circumstances, an auditor’s report may be modified by adding an emphasis of matter paragraph to highlight a matter affecting the financial statements which is included in a note to the financial statements that more extensively discusses the matter The addition of such an emphasis of matter paragraph does not affect the auditor’s opinion The paragraph would preferably be included after the opinion paragraph and would ordinarily refer to the fact that the auditor’s opinion is not qualified in this respect The auditor should modify the auditor’s report by adding a paragraph to highlight a material matter regarding a going concern problem The auditor should consider modifying the auditor’s report by adding a paragraph if there is a significant uncertainty (other than a going concern problem), the resolution of which is dependent upon future events and which may affect the financial statements An uncertainty is a matter whose outcome depends on future actions or events not under the direct control of the entity but that may affect the financial statements.” 14 Whether to divide responsibility or accept full responsibility is a function of: a b Relationship of the principal auditor to the other auditors; and Materiality of the component(s) examined by other auditors 15 The auditor may decide to disclaim an opinion when confronted by a material scope limitation that precludes gathering sufficient evidence to support an opinion as to overall fairness of financial presentation The auditor may also disclaim an opinion if his/her name is associated with financial statements for 18-105 11-106 Solutions Manual - Principles of Auditing and Other Assurance Services which an audit was not intended (e.g., compilations and reviews), or if the auditor is not independent 16 Two conditions are necessary for an unqualified opinion: a b No material scope restrictions have prevented the auditor from collecting sufficient, competent evidence; and The financial statements, including footnote disclosures, contain no material departures from GAAP 17 An auditor may agree with a departure from a designated principle only when, in his/her judgment, application of the designated principle would make the financial statements materially misleading 18 The audit opinion does not extend to the other information, and therefore, the opinion is not affected by omission or inconsistency or incorrect supplemental information 19 The auditor must evaluate, on every audit, the ability of the entity to meet its obligations on a continuing basis during a reasonable period (usually 12 months) following the balance sheet date Although the auditor is not required to apply additional procedures in making the initial evaluation, if he/she has substantial doubt as to ability of the client to continue, added procedures may have to be applied to resolve the issues 20 The auditor should add an explanatory paragraph regarding a material uncertainty, provided the outcome of the events surrounding the uncertainty cannot be reasonably estimated by management If the probability of an unfavorable outcome is remote, the explanatory paragraph is not needed If a material loss is probable, but is not susceptible to reasonable measurement, and is properly footnoted, the auditor should add an explanatory paragraph directing the reader’s attention to the footnote The greater the materiality, and the higher the probability of loss, the more inclined will be the auditor to add the explanatory paragraph 21 Upon learning of a change in accounting principle, the auditor should first determine the materiality and appropriateness of the change If material and the auditor agree with the client’s justification for the change, an explanatory paragraph should be added following the opinion paragraph The paragraph will refer to the footnote describing the change If the change is not properly accounted for or is inadequately disclosed, the auditor should consider issuing a qualified or adverse opinion II Multiple Choice Questions 18-106 A Risk-based Audit Approach – Part II 10 c d a c c c c a d c 11 12 13 14 15 16 17 18 19 20 c b d a b d d a b c 21 22 23 24 25 26 27 28 29 30 c c a d c a a c c b 31 32 33 34 35 36 37 38 39 40 11-107 b c b c d b d a d b III Comprehensive Cases Case You must determine whether an unqualified opinion satisfies the GAAS reporting standard, in particular: a Determine whether the financial statements are presented in conformity with GAAP Read the footnote description of accounting policies Use a GAAP checklist Review the working papers for any indication of accounting policies not described in the footnote or ones apparently not in conformity with GAAP Determine if: (i) The accounting principles are generally acceptable, having authoritative support (ii) The accounting principles are appropriate in the circumstances (iii) The financial statements are informative (iv) The information is reasonably summarized (v) Material adjustments have not been waived without good reasons b Determine whether any accounting changes have been made and whether accounting principles have been applied consistently c Determine whether the footnote disclosures are adequate to inform users of any material information evident in the working papers Case The auditor is reporting to the body that has engaged the auditing services While the report may be read and used by others who are indirect 18-107 11-108 Solutions Manual - Principles of Auditing and Other Assurance Services beneficiaries of the audit, current custom is not to address the report to the unknown class of users The scope paragraph should specifically identify the audited statements by name so that there can be no mistake about the subject of the report The alternative language is not as precise The standard language effectively bases the audit on an extensive body of written auditing standards that are known to others and can be cited in case of controversy The alternative language, on the other hand, seems to break loose from profession-wide quality norms and make the audit quality depend more on “the circumstances,” which introduces an element of mystery and lack of definition into the report The alternative wording is similar to the typical British audit report, and they seem to be able to live with it, but American auditors believe that “opinion” connotes belief or judgment stronger than impression but less strong than positive knowledge American auditors not wish to appear to have full, positive knowledge about the statements on the grounds that it’s not feasible to know all there is to know about the financial statements Also, the standard language leans heavily on GAAP as the criteria for fair presentation whereas the alternative language contains no reference to authoritative accounting criteria Case Title The report needs a title referring to Rose as the independent auditor or independent accountant Notice of audit The report does not give the proper declaration of an audit of the financial statements, especially the part about “in accordance with your instructions,” which suggest that Rose surrendered some audit independence The reference to a “complete audit” is ill advised because it suggests a 100% investigation, which is contradicted by the sentence about “tests of the sales records.” Responsibilities The report says nothing about the auditor’s responsibility for the audit report Opinion The opinion sentence should not be modified with the phrase “with the explanation given above.” Opinion The opinion sentence should not mention “minor errors we consider immaterial,” but it should contain the phrase “presents fairly in all material respects.” Opinion/Identification of Financial Statements The opinion should not include reference to cash flows because the introductory paragraph did not state that the cash flow statement was audited This may be a deficiency in the identification of the financial statements that were actually audited 18-108 A Risk-based Audit Approach – Part II 11-109 Opinion The opinion paragraph refers improperly to ASC pronouncements It should refer to “generally accepted accounting principles.” Date The date accompanying Rose’s signature should be September 23 – the day the field work was completed – not the company’s fiscal year-end date Other The commentary on the economy and the strike are not generally appropriate for an audit report Even if the auditor wanted to draw attention to these matters, their relevance for understanding the financial statements and their manner of expression are both questionable 10 Other The negative assurance (concerning the recording of sales) is not permitted in audit reports Case Independent Auditor’s Report To the shareholders and board of directors of Various Fabrics, Inc.: We have audited the accompanying balance sheets of Various Fabrics, Inc as of January 31, 2004 and 2003 and the related statements of income, retained earnings, and cash flows for the years then ended These financial statements are the responsibility of the company’s management Our responsibility is to express an opinion on these financial statements based on our audits We conducted our audits in accordance with generally accepted auditing standards Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation We believe that our audits provide a reasonable basis for our opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Various Fabrics, Inc as of January 31, 2004 and 2003 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles Aya de Jesus, CPA March 2, 2004 Case F, L B, I B, Q A, J 18-109 B, I B, I E, J 11-110 Solutions Manual - Principles of Auditing and Other Assurance Services Case A B C D E F G 1, 2, H I J K L M 3, 2, 3, 1, 1, 7c 7a (Note: The change in principle should be described in the descriptive paragraph following the scope paragraph.) 7c 7b 7d (given the materiality of property, plant, and equipment) 7e 7b and 7e CHAPTER 29 PROCEDURES AND REPORTS ON SPECIAL PURPOSE AUDIT ENGAGEMENTS I Review Questions The report simply states: “The financial statements are not intended to be presented in conformity with generally accepted accounting principles.” The opinion expression thereafter refers to a description of the comprehensive basis used Non-GAAP accounting bases include: Statutory or regulatory accounting requirements Tax basis accounting Cash and modified cash bases General price level-adjusted statements Any other basis having “substantial support” (Auditing standards not explain how non-GAAP accounting can have “substantial support.” In practice, accountants will report on any reasonable accounting basis, which explains why reports exist on diverse types of current value financial statements.) The following are four comprehensive bases of accounting other than GAAP: 18-110 A Risk-based Audit Approach – Part II 11-111 A basis of accounting to comply with the requirements of a governmental regulatory agency (for example, insurance companies use a basis of accounting pursuant to the rules of the insurance commission) A basis of accounting used to file an income tax return The cash receipts and disbursements basis of accounting (cash basis) and modifications to the cash basis, such as recording depreciation on fixed assets or accruing income tax A definite set of criteria having substantial support that is applied to all material items in the financial statements, such as the price-level basis of accounting A CPA may be asked to report on the application of GAAP by another auditor’s client who disagrees with the auditor’s view of proper accounting for the transaction Auditing standards apply when a CPA in public practice, either in connection with a proposal to obtain a new client or otherwise, provides oral or written advice on the application of accounting principles to a specific transaction or the type of opinion that may be rendered on an entity’s financial statements In forming a judgment, the CPA should perform the following procedures:  Obtain an understanding of the form and substance of the transaction(s)  Review applicable GAAP  If appropriate, consult with other professionals or experts  If appropriate, perform research or other procedures to ascertain and consider the existence of creditable precedents or analogies  The reporting CPA is required to consult with an entity’s continuing CPA to ascertain all the relevant facts The continuing CPA can provide information about the form and substance of the transaction, how management has applied accounting principles to similar transactions, and whether the method of accounting recommended by the continuing CPA is disputed by management The following difficulties might arise: Prior-year statements were unaudited: The auditor should label the prior-year columns “Unaudited” and modify the report by adding a paragraph that disclaims an opinion on the statements Audited by another auditor:  Alternative 1: Predecessor auditor reissues report 18-111 11-112 Solutions Manual - Principles of Auditing and Other Assurance Services  Alternative 2: If predecessor’s report is not presented, the auditor indicates in the introductory paragraph (1) that the financial statements of the prior period were audited by another auditor (but does not name the predecessor auditor), (2) the date of the report, (3) the type of report issued by the predecessor auditor, and (4) if the report was not a standard unqualified report, the substantive reasons therefor When the predecessor auditor’s report is not presented, the audit report would have an added sentence at the end of the first paragraph, and the opinion paragraph would refer only to the current-year statements Different reports on comparative statements: An auditor may issue modified reports on either of the financial statements reported on comparatively In this situation, the auditor must exercise care to relate the opinion to the appropriate year’s financial statements II Multiple Choice Questions b a c a b a a a 10 11 12 a a d d 13 14 15 16 d a a a 17 18 19 20 b c b a III Comprehensive Cases Case To the Board of Directors of Neiny Ltd.: We have reviewed the accompanying balance sheet of Neiny Ltd as of December 31, 2004, and the related statements of income, retained earnings, and cash flows for the year then ended, in accordance with standards established by the Auditing Standards and Practices Council All information included in these financial statements is the representation of the management of Neiny Ltd A review consists principally of inquiries of company personnel and analytical procedures applied to financial data It is substantially less in scope than an examination in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole Accordingly, we not express such an opinion Based on our review, we are not aware of any material modifications that should be made to the accompanying 2004 financial statements in order for them to be in conformity with generally accepted accounting principles The financial statements for the year ended December 31, 2003, were audited by us, and we expressed an unqualified opinion on them in our report dated February 27, 2004, but we have not performed any auditing procedures since that date 18-112 A Risk-based Audit Approach – Part II 11-113 Modelle & Co March 3, 2006 Case a The assertions that are incorrect and should otherwise be deleted are the following: Report should be addressed to Ms Clean Corporation’s Board of Directors Delete the entire paragraph describing the scope except for the reference to cash in banks and accounts receivable Delete the opinion rendered on cash in banks and accounts receivable Delete the recommendation to acquire Ajacks b The assertions that are missing and should be inserted are the following: Date of the report Statement limiting the distribution of the report to Ms Clean’s management Description of the procedures performed Statement that the agreed-upon procedures applied are not adequate to constitute a GAAS audit Description of the accountant’s findings Disclaimer of an opinion concerning cash in banks and accounts receivable Statement limiting the report only to cash in banks and accounts receivable and indicating that the report does not extend to the financials taken as a whole Case Independent Auditor’s Report [Addressee] We have audited the statement of assets, liabilities, and capital (income tax [cash] basis) of Vanda & Corona, a partnership, as of December 31, 2004, and the related statements of revenue and expenses (income tax [cash] basis) and statement of changes in partners’ capital accounts (income tax [cash] basis) for the year then ended These financial statements are the responsibility of the company’s management Our responsibility is to express an opinion on these financial statements based on our audits We conducted our audits in accordance with generally accepted auditing standards Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation We believe that our audits provide a reasonable basis for our opinion 18-113 11-114 Solutions Manual - Principles of Auditing and Other Assurance Services As described in Note X, the partnership’s policy is to prepare its financial statements on the accounting basis used for income tax purposes; consequently, certain revenue and related assets are recognized when received rather than when earned, and certain expenses are recognized when paid rather than when the obligation is incurred Accordingly, the accompanying financial statements are not intended to present financial position and results of operations in conformity with generally accepted accounting principles In addition, the company is involved in continuing litigation relating to patent infringement The amount of damages resulting from this litigation, if any, cannot be determined at this time In our opinion, the financial statements referred to above present fairly the assets, liabilities, and capital of the Vanda & Corona partnership as of December 31, 2004, and its revenue and expenses and changes in its partners’ capital accounts for the year then ended, on the income tax (cash) basis of accounting as described in Note X, which basis has been applied in a manner consistent with that of the preceding year [Sterling & Co.] [Date] 18-114 ... INVENTORY CLERK Start STORES Clerk Prepares Requisition Goods from Supplier Stock-in Report Storeskeep er Prepares Stock-in Report Posts Perpetual Inventory Records Stock-in Report 1 Filed by date... data 14-21 Solutions Manual - Principles of Auditing and Other Assurance Services FOURTH PACIFIC COMPANY A/C # 110 – NOTE RECEIVABLE 12/31/03 Schedule Prepared by Approved by Account # 110 – Notes... suggest Assessing control risk too high leads to overauditing Some auditors may be willing to accept high risks of assessing the control risk too high because they intend to overaudit anyway, and the