CH-7-13 Auditing Internal Control Over Financial Reporting – Auditing and Assurance Services: A Systematic Approach : Chapter Notes

This Document Contains Chapters 7 to 13 Chapter 7 Auditing Internal Control over Financial Reporting Learning Objectives Review Questions Multiple- Choice Questions Problems Discussion Cases Internet Assignments LO 7-1: Understand management’s responsibilities for reporting on internal control under Section 404 of the Sarbanes-Oxley Act. 1 19 LO 7-2: Understand the auditor’s responsibilities for reporting on internal control under Section 404 of the Sarbanes-Oxley Act. 1 19 LO 7-3: Know the definition of internal control over financial reporting (ICFR). LO 7-4: Be able to explain the differences between a control deficiency, a significant deficiency, and a material weakness. 2 20,21 35,36,37, 38 46, 47 LO 7-5: Understand management’s process for assessing ICFR. 3,4,5 37 LO 7-6: Know how auditors conduct an audit of ICFR. 6 22 34,35,36 LO 7-7: Understand how the auditor plans the audit of ICFR. 7,8 34 LO 7-8: Be able to describe the top-down, risk-based approach that auditors use to identify controls to test. 4,8,9, 10 22,23,24 , 25 34 LO 7-9: Understand how to test the design and operating effectiveness of controls. 23,24,25 , 26 LO 7-10: Understand how to evaluate identified control deficiencies. 11 20,21 35,36,37, 38,39,40, 41,42,43 46 LO 7-11: Understand how remediation affects audit reporting. 12 This Document Contains Chapters 7 to 13 LO 7-12: Know the written representations that the auditor must obtain from management. LO 7-13: Be familiar with the auditor’s documentation requirements. 13 LO 7-14: Understand auditor reporting for the audit of ICFR. 14,15,16 27,28,29 38,39,40, 41,42,43 46,47 LO 7-15: Know the auditor’s communication responsibilities on an audit of ICFR. 30,31 LO 7-16: Understand how to obtain assurance on controls at a service organization that processes transactions for the entity. 17 LO 7-17: Know management’s and the auditor’s responsibilities for controls that provide reasonable assurance for safeguarding entity assets. LO 7-18: Be familiar with computer-assisted audit techniques. 18 32,33 44,45 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 7-1 Unchanged 7-1 7-2 Revised 7-2 7-3 Revised 7-3 7-4 Unchanged 7-4 7-5 Unchanged 7-5 7-6 Unchanged 7-6 7-7 Unchanged 7-7 7-8 Unchanged 7-8 7-9 Revised 7-9 7-10 Revised 7-10 7-11 Unchanged 7-11 7-12 Revised 7-12 7-13 Unchanged 7-13 7-14 Unchanged 7-14 7-15 Unchanged 7-15 7-16 Unchanged 7-16 7-17 Unchanged 7-17 7-18 Unchanged 7-18 7-19 Revised 7-19 7-20 Unchanged 7-20 7-21 Unchanged 7-21 7-22 Unchanged 7-22 7-23 Unchanged 7-23 7-24 Unchanged 7-24 7-25 Unchanged 7-25 7-26 Unchanged 7-26 7-27 Unchanged 7-27 7-28 Unchanged 7-28 7-29 Unchanged 7-29 7-30 Unchanged 7-30 7-31 Unchanged 7-31 7-32 Unchanged 7-32 7-33 Unchanged 7-33 7-34 Updated 7-34 7-35 Unchanged 7-35 7-36 Unchanged 7-36 7-37 Unchanged 7-37 7-38 Unchanged 7-38 7-39 Unchanged 7-39 7-40 Unchanged 7-40 7-41 Unchanged 7-41 7-42 Unchanged 7-42 7-43 Revised 7-43 7-44 Unchanged 7-44 7-45 Unchanged 7-45 7-46 Revised 7-46 7-47 Unchanged 7-47 Chapter 7 covers the reporting requirements of management regarding the effectiveness of internal control and the steps required by the auditor in the testing of management’s assertion regarding the effectiveness of internal control. The material covered in this chapter applies only to companies subject to the reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002. [LO 7-1] Management Responsibilities under Section 404 We begin this chapter by asking the students what they have heard about “Section 404.” We try to elicit from them management’s responsibilities as well as the auditor’s. For management, we get the following up on the board: • Accept responsibility for the effectiveness of the entity’s ICFR. • Evaluate the effectiveness of the entity’s ICFR using suitable criteria (at this point we mention COSO again). • Support the evaluation with sufficient evidence, including documentation. • Present a written assessment regarding the effectiveness of the entity’s ICFR as of the end of the entity’s most recent fiscal year. We stress to the students that the second and third bullets are where management will spend most of its time and energy. We make sure the students understand the expectations of each bullet. [LO 7-2] Auditor Responsibilities under Section 404 and AS 2201 In regard to the auditor’s responsibilities, we stress to the students that the auditor will audit and report on the effectiveness of internal control. The auditor must integrate the audits of the financial statements and the internal control but realize the two have different objectives. In order for the audits to be integrated, both must be done by the same auditor. [LO 7-3] Internal Control over Financial Reporting Defined We take a few minutes to go over the COSO definition of internal control that we covered in Chapter 6. We also review with the students the more specific definition described by PCAOB. [LO 7-4] Internal Control Deficiencies Defined We spend significant time making sure the students understand PCAOB’s definitions of deficiency, significant deficiency, and material weakness, bringing into the discussion the concepts of likelihood and magnitude. We make sure students understand that the focus of AS 2201 is on material weaknesses, and that an audit of ICFR is not designed to identify significant deficiencies. Figure 7-1 shows how these concepts relate to each other in determining the materiality of a control deficiency and highlights the responsibility for communication of each of the different levels of control deficiency. We use Problem 7-36 to solidify their understanding after we have covered the chapter. Use Figure 7-1 [LO 7-5] Management’s Assessment Process We spend time discussing management’s assessment process because of its importance to the auditor’s work. We start by making sure the students understand that the auditor cannot participate in the assessment process since the auditor must remain independent in his or her audit of ICFR. We then discuss the elements found in the process and review Table 7-1 that describes the entity- level controls and Table 7-2, which describes the controls that are typically included for testing. Use Table 7-1 and Table 7-2 Management is required to base its assessment of the effectiveness of the entity’s ICFR on a suitable, recognized control framework established by a body of experts that follows due-process procedures. In the U.S., most entities use the framework developed by COSO (COSO Internal Control–Integrated Framework). However, companies are not required by SOX to use the COSO framework. We remind students that the COSO framework identifies three primary objectives for internal control. However, it is important for students to understand that the integrated audit focuses on only one of the objectives—reliable financial reporting. We go over the importance of management documenting its understanding. Management should document the design of controls over all relevant assertions related to all significant accounts and disclosures in the financial statements, including controls in all five components of ICFR. We explain that documentation of ICFR may take many forms, such as paper, electronic files, or other media. It includes a variety of information, such as policy manuals, process models, flowcharts, job descriptions, documents, and forms. [LO 7-6] Performing an Audit of ICFR We start this section by reminding students that the overall goal is to obtain sufficient, appropriate evidence about the design and operating effectiveness of controls over all relevant financial statement assertions relating to significant accounts and disclosures in the financial statements. The auditor does this by planning and performing the audit of internal control to obtain reasonable assurance that deficiencies rising to the level of a material weakness are identified. Figure 7-2 can be used to present to students the steps involved in this process. We spend considerable time here covering each step thoroughly. We try to show the integration of the financial statement audit to the internal control audit as we do so. Use Figure 7-2 In discussing the audit of ICFR, we emphasize the requirement that this and the financial statement audit are to be integrated. We usually discuss how the control testing from the audit of ICFR can be used in the financial statement audit; and how the results of the financial statement audit may impact the opinion on internal control. We remind the students that when an entity has effective ICFR, the auditor should be able to perform sufficient testing of controls to assess control risk for all relevant assertions at a low level. If, however, the auditor assesses control risk as other than low for certain assertions or significant accounts for purposes of the financial statement audit, the auditor should document the reasons for that conclusion. [LO 7-7] Plan the Audit of ICFR We tell the students that planning this audit is very similar to planning the financial statement audit. In planning the engagement, the auditor considers the following activities: • The role of risk assessment and the risk of fraud. • Scaling the audit. • Using the work of others. Table 7-3 may be used to show factors that may impact the planning of an ICFR audit. Table 7-3 A major consideration for the external auditor is how much the work performed by others (internal audit function or others working for management) can be relied on in adjusting the nature, timing, or extent of the auditor’s work. In determining the extent to which the auditor may use the work of others, the auditor should consider the risk; that is, as the risk associated with the control increases, the auditor should perform more of the work. [LO 7-8] Identify Controls to Test The auditor should complete the following steps when using a top-down, risk-based approach (see Figure 7-3): • Identify entity-level controls. • Identify significant accounts and disclosures and their relevant assertions. • Understand likely sources of misstatements. • Select controls to test. We cover each of these steps in detail and refer to Table 7-4 for factors to consider in identifying controls to test. Figure 7-3 Table 7-4 [LO 7-9] Evaluate the Design and Test the Operating Effectiveness of Controls This part of the chapter provides a detailed discussion of how the auditor evaluates the design and tests the operating effectiveness of the controls. We discuss the nature, timing, and extent of tests of controls, and the factors in Table 7-5 and how they affect the risks related to the controls. Table 7-5 [LO 7-10] Evaluating Identified Control Deficiencies One of the most important aspects of the audit of ICFR is the evaluation of control deficiencies. We spend considerable time discussing the two concepts that affect the classification of identified deficiencies: likelihood and magnitude. We discuss the factors and indicators presented in Tables 7-6 and 7-7. Use Tables 7-6 and 7-7 We use Exhibit 7-3 to present a detailed example of how an auditor might evaluate the design and test the operating effectiveness for a daily IT application control and a daily IT-dependent manual control. Use Exhibit 7-3 [LO 7-11] Remediation of a Material Weakness We discuss the process of remediation that is necessary to correct any material weakness. If a material weakness cannot be remediated and/or properly tested by the balance sheet date, then an adverse opinion on ICFR will be issued. [LO 7-12] Written Representations Table 7-8 lists the typical management representations made to the auditor in relation to the audit of internal control. Failure by management to provide written representations constitutes a scope limitation that would preclude an unqualified opinion. Use Table 7-8 [LO 7-13] Auditor Documentation Requirements AS5 requires that the auditor appropriately document the processes, procedures, judgments, and results relating to the audit of internal control consistent with the PCAOB’s documentation standards. The auditor’s documentation must include the auditor’s understanding and evaluation of the design of each of the components of the entity’s ICFR, documentation of the process used to determine the points at which misstatements could occur within significant accounts and disclosures, the extent to which he or she relied upon work performed by others, and the scope of testing. Finally, the auditor must describe the evaluation of any deficiencies discovered, as well as any other findings that could result in a modification to the auditor’s report. [LO 7-14] Auditor Reporting on ICFR After auditing the effectiveness of an entity’s internal control, an auditor issues an unqualified opinion if the entity’s internal control is designed and operating effectively in all material respects. We use Figure 7-4 to review the types of audit reports that the auditor may issue relating to the effectiveness of ICFR. The auditor may choose an unqualified report, an adverse report for a material weakness, or a disclaimer of opinion for a scope limitation. Use Figure 7-4 The auditor’s report on the effectiveness of internal control has a number of required elements. The auditor may choose to issue separate reports on the entity’s financial statement and ICFR or may issue a combined report. Under either approach, the date of the two reports should be the same. The auditor’s report on the effectiveness of internal control has a number of required elements. First, the report must include the title “Report of Independent Registered Public Accounting Firm” and be addressed to the shareholders and the board of directors of the entity. Second, the auditor provides an opinion on whether the entity maintained, in all material respects, effective ICFR as of the specified date, based on the control criteria. Third, the report must contain the auditor’s basis for the opinion. Fourth, the report defines ICFR and its limitations. Finally, it contains the signature of the auditor, office location, and date. [LO 7-15] Additional Required Communications in an Audit of ICFR The auditor has numerous communication responsibilities under Section 404: • Communicate in writing to management and the audit committee all significant deficiencies and material weaknesses identified during the audit. • Communicate to management, in writing, all control deficiencies (lesser magnitude than significant deficiencies) identified during the audit and inform the audit committee when such a communication has been made. • If the auditor has been made aware that fraud is taking place, it must be brought to the attention of the appropriate level of management or the audit committee (if the fraud involves senior management). • If the auditor has discovered possible illegal acts, the auditor must assure him or herself that the audit committee is adequately informed unless the matter is clearly inconsequential. The auditor’s written communications about control deficiencies state that the communication is intended solely for the information and use of the board of directors, audit committee, management, and others within the organization. When governmental authorities require the entity to furnish such a report, a specific reference to such regulatory agencies may be made in the report. Advanced Module 1: Special Considerations for an Audit of Internal Control Depending on time and your interests, you can cover the following: • Service organizations. • Safeguarding assets. [LO 7-16] Use of Service Organizations We explain to students that many companies use service organizations to process transactions. If the service organization’s services make up part of an entity’s information system, then they are considered part of the information and communication component of the entity’s ICFR. Thus, both management and the auditor must consider the activities of the service organization. We will then explain the importance of a Type 2 report. Management and the auditor should perform the following procedures with respect to the activities performed by the service organization: • obtain an understanding of the nature and significance of the services provided by the service organization and their effect on the user entity’s internal control relevant to the audit, and sufficient to identify and assess the risks of material misstatement; and • design and perform audit procedures responsive to those risks. [LO 7-17] Safeguarding of Assets Safeguarding of assets is defined in AS5 as policies and procedures that “provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the entity’s assets that could have a material effect on the financial statements.” We point out that the above definition is consistent with the definition in the COSO framework. [LO 7-18] Advanced Module 2: Using Technology in the Audit of ICFR We review each of the following technologies, using the tables and figures provided in the text: • Generalized audit software (including IDEA packaged with the text). • Custom Audit Software. • Test Data. Table 7-9 can be used to present functions performed by generalized audit software. Use Table 7-9 We like to walk the students through an example of how generalized audit software can be used. Problem 7-45 could be used here as an example. Internet Assignments Internet assignments 7-46 and 7-47 prompt the students to search for audit reports for audits of ICFR. Practice Insights Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. IDEA and Tableau The Chapter 7 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls [LO 8-5, 8-6, 8-7] Attribute Sampling Applied to Tests of Controls In this section, we define attribute sampling and walk the students through the steps in an attribute-sampling application. Table 8-2 can be used to present the steps for a sampling application. Spend considerable time going through each step. At this point, we mainly focus on the concepts that underlie the decisions that the auditor makes at each step. This is time well spent since the underlying concepts apply to the sampling techniques introduced in Chapter 9 as well. Following are the key points that we make when discussing each step: Use Table 8-2 Planning 1. Determine the test objective(s). The objective is: (1) to evaluate the operating effectiveness of the internal control(s) for the purpose of a public company internal control audit or (2) to determine the degree of reliance that can be placed on controls for a financial statement audit. 2. Define the population characteristics: a. Define the sampling population. Three issues are important: (1) all or a subset of the items that constitute the class of transactions which make up the sampling population, (2) the auditor must determine that the population from which the sample is selected is appropriate for the audit assertion being tested, and (3) the auditor must determine that the physical representation of the population (or frame) is complete. b. Define the sampling unit. Point out to the students that a sampling unit for attribute sampling is normally a document, an entry, or a line item. c. Define the control deviation conditions. Point out that it is important to have good definitions of what is a control deviation. 3. Determine the sample size, using the following inputs: a. The desired confidence level or risk of incorrect acceptance. The risk that the sample results will support a conclusion that the control is functioning effectively, when in truth it is not, can result in assessing control risk too low. This risk impacts the effectiveness of the audit. When the auditor intends to rely on controls, the confidence level is set at 90 or 95 percent, meaning the auditor is willing to accept a 10 to 5 percent risk of accepting the control as effective, when in fact it is not. The students should remember that there is an inverse relationship between the risk of assessing control risk too low and the size of the sample. b. The tolerable deviation rate. The tolerable deviation rate is the maximum deviation rate the auditor is willing to accept and still rely on control procedures. Table 8-3 provides suggested tolerable deviation rates for the assessed importance of controls. Again, sample size is inversely related to tolerable deviation rate. Use Table 8-3 c. The expected population deviation rate. This is the rate that the auditor expects to exist in the population. The auditor can develop this estimate based on prior years’ results or on a pilot test. There is a direct relationship between expected population deviation rate and sample size. Note: Later in the chapter it is discussed why the population size has little or no effect on the sample size unless the population is relatively small (less than 1,000). Normally, auditors sample from large populations, so population size is commonly ignored in determining sample size. For more information on what to do when the population is small, see the Advanced Module 1 in this chapter. Tables 8-5 and 8-6 illustrate sample size tables for attribute sampling at the 95 and 90 percent desired confidence levels. It is helpful to walk students through how to use the tables, why an incremental increase in the Expected Population Deviation Rate doesn’t always results in a larger sample size (see the footnote in the tables, there are no such things as “partial deviations” so the sample sizes are rather “lumpy” in that they increase only when the integer value of the tolerable number of deviations changes), and the meaning of the asterisks in the table (see explanation provided in the tables). Use Tables 8-5 and 8-6 Refer the students to Table 8-7 for a summary of how each factor affects sample size. Use Table 8-7 Performance 4. Select sample items. The key point here is that when a statistical sampling application is used, the sample selection process must allow selection of a sample that is representative of the population. Briefly discuss random versus systematic selection. 5. Perform the auditing procedures. The students should be reminded of the possibility of committing nonsampling errors. Also discuss how the following four items can affect a sampling application for tests of controls: • Voided documents. • Unused or inapplicable documents. • Inability to examine a sample item. • Stopping the test before completion. Understand and analyze deviations observed: the auditor should consider the cause and consequence of the deviation and how the deviations may impact the other phases of the audit. Evaluation 6. Calculate the sample deviation and the computed upper deviation rates. Point out that these calculations can be done using a computer program or attribute-sampling tables. Also make it clear why attribute-sampling tests are usually one-sided; the auditor is only interested in the maximum deviation rate in the population. Tables 8-8 and 8-9 illustrate sample evaluation tables for 95 and 90 percent desired confidence levels. It is helpful to walk students through how to use the tables and how to handle sample sizes between the round numbers provided (i.e., either round down in sample size or extrapolate). Use Tables 8-8 and 8-9 7. Draw final conclusions. First present the decision rules for the auditor’s decision about whether the sample evidence supports or does not support the test. Then use Table 8-10 to explain the auditor’s risks when making such decisions. Use Table 8-10 An extended example of an attribute-sampling plan is provided in the text. This example uses a hypothetical test of three controls that exist in the revenue process of Calabro Wireless Services. We walk the students through this example as a way of applying the concepts covered in the prior section. While the calculations are completed using the attribute-sampling tables, we show the students the output from the IDEA software. Use Problems 25 and 26 or 27 and 28 here to help the students with their understanding. [LO 8-8] Nonstatistical Sampling for Tests of Controls Discuss the differences between nonstatistical and statistical sampling in each of the following steps in a sampling application: • Determining the sample size. • Selecting the sample items. • Calculating the computed upper deviation rate. It is particularly important to discuss with the students how the auditor reaches a conclusion about the reliability of the tested control when nonstatistical sampling is used. Problems 29 and/or 31 could be used here. Advanced Module 1: Considering the Effect on Sample Size of a Small Population At this point, make sure the students understand that population size generally has little or no effect on the sample size and if the population contains more than 1,000 units, the effect on the sample size is negligible. Also, briefly discuss how auditors determine sample sizes when testing controls that operate infrequently, as shown in Advanced Module 1 in the chapter. Emphasize that the Small Population Sample Size Table in the text is used frequently in practice as some controls operate only on an infrequent basis. Remind the students, however, that just because a control operates infrequently (e.g., monthly or quarterly) does not mean that they automatically should use this table. For example, if a monthly reconciliation occurs for 50 bank accounts, the population is 600 (50 accounts/month times 12 months/year), not 50 and thus the table would not be used. Advanced Module 2: Comparing Terminology for Attribute Sampling between IDEA and Sampling Tables This table highlights terminology specific to IDEA and the relationship to the terms introduced in the text. Discussion Case Discussion case 8-32 is a good case for reinforcing the concepts that underlie attribute sampling. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. EarthWear Mini-Cases The Chapter 8 mini-cases can be assigned as stand-alone cases. Please go to Connect for the mini-case assignments. IDEA The Chapter 8 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 9 Audit Sampling: An Application to Substantive Tests of Account Balances Learning Objectives Review Questions Multiple- Choice Questions Problems Discussion Cases Internet Assignment s LO 9-1: Understand the similarities and differences between audit sampling for tests of controls and substantive tests of details of account balances. 7 11,12,13,14, 18,19 21 27,28 LO 9-2: Learn to apply monetary- unit sampling. 1,2,3,4,5,6 12,13,14,15, 16,17,18,20 21,22,23 27 LO 9-3: Work through an extended example of monetary-unit sampling. 5,6 15,16 22,23 LO 9-4: Learn to apply nonstatistical sampling techniques and work through an example. 7,8 13 24 28 LO 9-5: Learn to apply classical variables sampling. 9,10 11,13,17,18, 19,20 21,25,26 27 LO 9-6: Work through an example of classical variables difference estimation. 10 25,26 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 9-1 Unchanged 9-1 9-2 Unchanged 9-2 9-3 Unchanged 9-3 9-4 Unchanged 9-4 9-5 Unchanged 9-5 9-6 Unchanged 9-6 9-7 Unchanged 9-7 9-8 Unchanged 9-8 9-9 Unchanged 9-9 9-10 Unchanged 9-10 9-11 Unchanged 9-11 9-12 Unchanged 9-12 9-13 Unchanged 9-13 9-14 Unchanged 9-14 9-15 Unchanged 9-15 9-16 Unchanged 9-16 9-17 Unchanged 9-17 9-18 Unchanged 9-18 9-19 Unchanged 9-19 9-20 Unchanged 9-20 9-21 Unchanged 9-21 9-22 Unchanged 9-22 9-23 Unchanged 9-23 9-24 Unchanged 9-24 9-25 Unchanged 9-25 9-26 Unchanged 9-26 9-27 Unchanged 9-27 9-28 Unchanged 9-28 Chapter 9 focuses on sampling for substantive tests of account balances. It covers two statistical sampling techniques, monetary-unit and classical variables sampling (covered in the Advanced Module) and nonstatistical sampling. [LO 9-1] Sampling for Substantive Tests of Details of Account Balances Introduce this chapter by reminding the students of the three important determinants of sample size for testing account balances: desired confidence level, tolerable misstatement, and estimated misstatement. It is a good idea to mention that a fourth factor, population size, will also influence of the sampling techniques used for substantive tests of details. We then review the idea that misstatements discovered in the audit sample must be projected to the population and there must be an allowance for sampling risk. We then bridge these concepts to audit sampling to test account balances. Lastly, we briefly discuss why monetary-unit sampling is used for testing account balances in audit software (including IDEA) versus classical variables sampling and the fact that monetary-unit sampling is not the best approach to use for all substantive tests of details of account balances. [LO 9-2] Monetary-Unit Sampling In introducing monetary-unit sampling, we make the following points: • The conclusion will be in monetary terms rather than a rate of occurrence. • This sampling technique has many important applications in public accounting. • It is primarily designed to test for overstatement errors. We then present the advantages and disadvantages of monetary-unit sampling. We go through the sampling plan (that we covered in Chapter 8 for attribute sampling) highlighting the differences between the two. We use Table 9-1 to summarize the steps and focus on the special features that apply to the application of monetary-unit sampling: Planning 1. Determine the test objectives. 2. Define the population characteristics: • Define the population. • Defining the sampling unit. The major point here is that the sampling unit is an individual dollar (or other currency). The account or transaction that contains the selected dollar being audited is referred to as the logical unit. • Define a misstatement. 3. Determining the sample size. A monetary-unit sample size can be determined by using the attribute sampling tables shown in Chapter 8 using the inputs of the desired confidence level, the tolerable misstatement, and the expected population misstatement. When using IDEA to compute a monetary-unit sample size, the population size is also a required input to determine sample size. Performance 4. Selecting the sample items. Probability-proportional-to-size sample selection gives each individual dollar in the population an equal chance of being selected because the first selection or “seed” is randomly determined. However, because the individual dollars are selected in a systematic manner (that is, every nth dollar), large accounts or transactions have a higher probability of being selected for testing. Figure 9-1 provides an example of how probability-proportional-to-size is applied. An important point to make is that because the first item in a systematic selection plan is selected randomly, all items do, at least initially, have an equal chance of being selected, similar to pure random selection. 5. Perform the auditing procedures. Understand and analyze any misstatements observed. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. With monetary- unit sampling, the auditor calculates the upper limit on misstatement. We go through the extended example to demonstrate the computation and evaluation of projected and upper misstatement limit of a monetary-unit sampling. Then we go over with the students computing the upper projected misstatement using IDEA. Exhibit 9-2 shows the evaluation of the sample results using IDEA. We make sure the students understand why sample size is not used in evaluating MUS results and the effect of understatement misstatements. 7. Drawing final conclusions. We use Table 9-4 to discuss the auditor’s risks when evaluating an account based on sample evidence. Problems 21 and/or 23 could be used here. Use Tables 9-1 to 9-4 Use Figure 9-1 Use Exhibit 9-2 [LO 9-3] An Extended Example: Monetary-Unit Sampling An extended example is provided to demonstrate the computation and evaluation of projected and upper misstatement limit (UML) of a monetary-unit sampling application for the entity’s accounts receivable. [LO 9-4] Nonstatistical Sampling for Tests of Account Balances The approach that is shown in the text for nonstatistical sampling is based on the Audit Guide, Audit Sampling. Again, we focus on the differences between a nonstatistical sampling application and a statistical sampling application. The following need further explanation: • Identifying individually significant items. • Determining the sample size. • Selecting sample items. • Calculating the sample results. We then introduce the sample size formula included in LO 9-4 using the example under the heading “An Example of Nonstatistical Sampling” and discuss its components. Lastly, we discuss how a nonstatistical sampling result should be evaluated and the importance of auditor judgment when reaching a final decision. Auditor judgment is particularly important when considering the adequacy of the allowance for sampling risk. The example in the text involves the auditor's test of the fair presentation of the account receivable balance for Calabro Wireless Services. The students should find the example easy to follow. Problem 24 could be used here. [LO 9-5] Advanced Module 1: Classical Variables Sampling We cover classical variables sampling in the same manner as monetary-unit sampling. • List the advantages and disadvantages. • Discuss how to apply classical variables sampling. • Work through an example (LO 9-6). [LO 9-6] Applying Classical Variables Sampling An extended example is provided to demonstrate the special features that apply to classical variables sampling. Discussion Cases Discussion cases 9-27 and 9-28 reinforce the concepts covered in this chapter. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. IDEA The Chapter 9 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 10 Auditing the Revenue Process Learning Objectives Review Questio ns Multiple - Choice Question s Proble ms Discussi on Cases Internet Assignmen ts/ EarthWea r Mini- Cases (EWMC) LO 1: Understand why knowledge of an entity’s revenue recognition policies is important to the audit. 1 24 31 34 LO 2: Understand the revenue process. 12,13, 14, 15,16 25 33 LO 3: Know the types of transactions in the revenue process and the financial statement accounts affected. 33 LO 4: Be familiar with the types of documents and records used in the revenue process. 33 LO 5: Understand the functions in the revenue process. 2,3 25 LO 6: Know the appropriate segregation of duties for the revenue process. 3 12,14 25 IDEA LO 7: Understand the inherent risks relevant to the revenue process and related accounts. 4 LO 8: Know how to assess control risk for a revenue process. 5 13 LO 9: Know the key internal controls and develop relevant tests of controls for revenue, cash receipts, and sales returns transactions. 6 13,14,15, 16 25 LO 10: Relate the assessment of control risk to substantive testing. LO 11: Know the substantive analytical procedures used to audit 7 17,18 26 revenue-related accounts. LO 12: Know the substantive tests of transactions and the tests of details used to audit revenue- related accounts. 8 19,23 26,27,28 , 29,30 EWMC LO 13: Understand the confirmation process for accounts receivable. 9,10 20,21,22 27,28,29 EWMC LO 14: Understand how to audit other types of receivables. 11 32 LO 15: Understand how to evaluate the audit findings and reach a final conclusion on revenue-related accounts. 23 28,29,30 32 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 10-1 Unchanged 10-1 10-2 Unchanged 10-2 10-3 Unchanged 10-3 10-4 Unchanged 10-4 10-5 Unchanged 10-5 10-6 Unchanged 10-6 10-7 Unchanged 10-7 10-8 Unchanged 10-8 10-9 Unchanged 10-9 10-10 Unchanged 10-10 10-11 Unchanged 10-11 10-12 Unchanged 10-12 10-13 Unchanged 10-13 10-14 Unchanged 10-14 10-15 Unchanged 10-15 10-16 Unchanged 10-16 10-17 Unchanged 10-17 10-18 Unchanged 10-18 10-19 Unchanged 10-19 10-20 Unchanged 10-20 10-21 Unchanged 10-21 10-22 Unchanged 10-22 10-23 Unchanged 10-23 10-24 Updated 10-24 10-25 Unchanged 10-25 10-26 Updated 10-26 10-27 Unchanged 10-27 10-28 Unchanged 10-28 10-29 Unchanged 10-29 10-30 Unchanged 10-30 10-31 Revised 10-31 10-32 Unchanged 10-32 10-33 Unchanged 10-33 10-34 Unchanged 10-34 Chapter 10 re-introduces the concept of viewing businesses from a process perspective or through transaction cycles. This is important to auditors as auditing divides the financial statement components into business processes or cycles in order to better manage the audit. The revenue process is generally the first process we cover in the introductory auditing class because most students have some understanding of how entities sell products or deliver services. The chapter begins by reviewing the five-step approach required by the new revenue recognition accounting standard and then gives an overview of the revenue process. Then the audit risk model is followed as specific factors that impact inherent and control risk are introduced. This chapter also discusses the substantive audit procedures conducted by the auditor to reach the appropriate level of detection risk for accounts affected by the revenue process. An Overview of Business We begin by using Figure 10-1 to make sure all of the students are familiar with the business processes; it also helps them in our future discussions. Use Figure 10-1 [LO 10-1] Revenue Recognition We then go into revenue recognition and have found that it is useful to review the revenue recognition process that students learned in their financial accounting classes. We discuss the five- step approach required by FASB ASC 606. We indicate to the students that in many industries (e.g., software and construction) the recognition of revenue is not always easy to determine. We warn the students that the recognition of revenue can become an area of controversy between the auditee and the auditor (refer the students to the related inherent risk factors below). We refer the students to Exhibit 10-1 for an example of inappropriate revenue recognition and its impact on business decisions. Use Exhibit 10-1 [LO 10-2 through 10-6] Overview of the Revenue Process This is an important section for the students since most of them have little experience with accounting systems. We approach this material by walking the students through the flowchart shown in Figure 10-2. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections using the previously reviewed flowchart as a benchmark: • Types of transactions and financial statement accounts affected (LO 10-3). • Types of documents and records (LO 10-4). • The major functions (LO 10-5). • Key segregation of duties (LO 10-6). In covering these subsections, we refer the students to Tables 10-1 through 10-4. Use Figure 10-2 Use Tables 10-1 through 10-4 An alternative approach is to cover the material in reverse. You can review the subsections first and then walk the students through the flowchart. [LO 10-7] Inherent Risk Assessment This is a good place to reinforce the concepts concerning inherent risk assessment that were covered in Chapter 4. We discuss each of the following inherent risk factors and how they may affect the revenue process and related accounts: • Industry-related factors. • The complexity and contentiousness of revenue recognition issues. • The difficulty of auditing transactions and account balances. • Misstatements detected in prior audits. [LO 10-8] Assessment of Control Risk The control risk assessment offers an excellent opportunity for the students to apply the internal control concepts learned in Chapters 6 and 7 to a business process. We use Figure 10-3 to refresh the students' memory of the major steps in assessing control risk and then discuss each of the steps as they apply to the revenue process. Use Figure 10-3 [LO 10-9] Control Activities and Tests of Controls Revenue Transactions This section provides the details on the assertions, possible misstatements, internal control procedures, and selected tests of controls for revenue transactions. We use Table 10-5 to review the assertions about classes of transactions and events. Then we use Table 10-6 to cover this material in detail, though it is important to emphasize to the students that this table includes only a few examples and should not be construed as an exhaustive list. We generally go over each assertion, point out the possible misstatement, and the normal internal control procedures that an entity should have in its systems to minimize the possibility of such misstatements. It is a good idea to relate the control procedures back to the flowchart in Figure 10-2. Our experiences indicate that the students develop a better understanding of the revenue process and the auditor's control risk assessment if we work back and forth between Figure 10-2 and Table 10-6. The last thing we cover is the tests of controls that the auditor can conduct to test whether the controls are operating effectively. Use Tables 10-5 and 10-6 Cash Receipts Transactions We cover the material in Table 10-7 (a few examples only, not an exhaustive list) for cash receipts transactions in the same manner as we described for revenue transactions, except that we do not go into the same level of detail. Discussing the occurrence, completeness, and authorization assertions is usually sufficient. Use Table 10-7 Sales Returns and Allowances Transactions Two important issues should be covered. First, we tell the students that credit memoranda, which are used to process sales returns and allowances, can also be used to cover unauthorized shipments of goods or conceal misappropriations of cash. Second, we discuss the two controls that should be present for the proper processing of credit memoranda: (1) each credit memorandum should be approved by someone other than the individual who initiated it and (2) each credit for returned goods should be supported by a receiving document indicating that the goods have been returned. We usually point out that on most engagements, the auditor can use substantive analytical procedures to verify sales returns and allowances. If you want to cover this topic in more detail, we suggest that you use discussion Case 5-42. It provides a situation where book returns are material and difficult to estimate. Problem 10-24 could be used here as well. [LO 10-10] Relating the Assessed Level of Control Risk to Substantive Procedures This is a good place to reinforce the students' understanding of how the auditor's assessment of control risk in the revenue process impacts detection risk for revenue-related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. On the other hand, if the results of tests of controls do not support the planned level of control risk, detection risk will have to be set lower. This will normally lead to an increase in substantive tests. Auditing Accounts Receivable and Related Accounts This is the first opportunity for the students to apply the audit tests learned in Chapters 4 and 5 to a financial statement account. We use Table 10-8 to present the management assertions about account balances and related disclosures for revenue-related accounts at the period end and remind the students that there are two categories of substantive procedures: substantive analytical procedures and tests of details of classes of transactions, account balances, and disclosures. Use Table 10-8 [LO 10-11] Substantive Analytical Procedures Analytical procedures can be very effective and efficient tests for accounts receivable and related accounts. We discuss the analytical procedures shown in Table 10-9 and show how they might suggest to the auditor that an account contains a possible misstatement. Table 10-9 includes analytical procedures suggested by the AICPA’s Audit Guide, Auditing Revenue in Certain Industries. Use Table 10-9 [LO 10-12] Tests of Details of Classes of Transactions, Account Balances, and Disclosures We cover Table 10-10 completely. It provides assertions about classes of transactions and account balances along with examples of substantive tests of transactions, tests of details of account balances, and tests of details of disclosure. The students should be reminded that substantive tests of details of classes of transactions are conducted to detect monetary misstatements in the individual transactions processed through the revenue process. We also remind them that, in many cases, it is difficult to distinguish a substantive test of transactions from a test of controls. When going over the tests of details of account balances we begin with completeness using Exhibit 10-4 to show the students an example of an aged trial balance for accounts receivable. We discuss existence next and mention that confirmations are one of the primary sources of evidence for this assertion. After those two assertions, we focus on valuation. Then we cover test of details of disclosure using Table 10-11. We have found that disclosure issues do not receive sufficient emphasis in financial accounting. This is a good place to impress on the students the importance of proper financial statement disclosure. However, allay the students' fears about disclosure by telling them that most firms use a financial statement disclosure checklist. Problem 10-26 could be used here to aid in the students’ understanding of the relationship between assertions and audit procedures. Use Tables 10-10 and 10-11 Use Exhibit 10-4 [LO 10-13] The Confirmation Process–Accounts Receivable We define the confirmation process and indicate that confirmation of accounts receivable is considered a generally accepted auditing procedure. You should then present the following three circumstances where auditing standards allow the auditor to omit confirmation of accounts receivable: • The accounts receivable balance is immaterial. • External confirmations would be ineffective. • The auditor's assessed level of risk of material misstatement at the relevant assertion level is low, and the other planned substantive procedures address the assessed risk. We next discuss the reliability of accounts receivable and indicate that the auditor should consider each of the following factors when using confirmations to test accounts receivable: • The type of the confirmation request. • Prior experience with the client or similar engagements. • The intended respondent. You might consider having the students read the articles by Paul Caster (referenced in the footnote) on the reliability of accounts receivable confirmations. At a minimum, the students should be aware of the possible limitations of accounts receivable confirmations. The two types of confirmation, negative and positive, should be discussed. We mention the differences between each and when each type might be more appropriate than the other. We have the students look at Exhibits 10-7 and 10-8 for examples of positive and negative confirmations. Use Exhibits 10-7 and 10-8 We walk the students through the confirmation procedures since many of them will perform these procedures during their first year in public accounting. It is important for them to understand that the auditor must maintain control over the confirmations. Students should also understand the types and causes of exceptions that may be reported by the customer. Table 10-12 provides examples of exceptions to confirmation requests. Use Table 10-12 The last items we cover under the confirmation process are the alternative procedures followed by the auditor when confirmation requests are not returned or there are confirmation exceptions. These include examination of: • Specific subsequent cash receipts. • Shipping documentation. • Other client documentation. [LO 10-14] Auditing Other Types of Receivables Most entities have other types of receivables that must be audited. These include: • Receivables from officers and employees. • Receivables from related parties. • Notes receivable. We point out that the auditor's concerns with these types of receivables are the same as trade accounts receivable. Normally, such receivables are confirmed and assessed for collectibility. [LO 10-15] Evaluating the Audit Findings In this section, we discuss how the auditor completes the third step in applying materiality―comparing the likely misstatements to the tolerable misstatement assigned to the account. We use EarthWear’s accounts receivable balance to discuss the two possible outcomes; aggregate misstatement is either less than or more than tolerable misstatement. We discuss the auditor's options when likely misstatement is greater than tolerable misstatement. Discussion Cases Discussion Case 10-31 gives the students an opportunity to identify and discuss the types of evidence an auditor needs to examine when faced with bill and hold transactions. If you want to discuss problems with other types of receivables, the Friendly Furniture, Inc., Discussion case 10-32 covers the accounting for expected insurance proceeds and the types of audit evidence needed to verify the amount of the receivable to be recorded. Internet Assignments There are two Internet assignments in Chapter 10. Internet assignment 10-33 has the students identify how another catalog retailer processes sales transactions, recognizes revenue, and reserves for returns. Internet assignment 10-34 requires the students to search the SEC’s website for a company that has been recently cited for revenue recognition problems. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. EarthWear Mini-Cases The Chapter 10 mini-cases can be assigned as stand alone cases. Please go to Connect for the mini-case assignments. IDEA and TABLEAU The Chapter 10 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 11 Auditing the Purchasing Process Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases Internet Assignmen ts LO 11-1: Understand why knowledge of an entity’s expense and liability recognition policies is important to the audit. 1 32,33 LO 11-2: Understand the purchasing process. 2 13,14,15 25,26 32,33 LO 11-3: Know the types of transactions in the purchasing process and the financial statement accounts affected. 2 LO 11-4: Be familiar with the types of documents and records used in the purchasing process. 3 13,14,15 , 19 25 LO 11-5: Understand the functions in the purchasing process. 4 16,17,18 25,26 LO 11-6: Know the appropriate segregation of duties for the purchasing process. 4 16,17,18 25,26 LO 11-7: Understand the inherent risks relevant to the purchasing process and related accounts. 5 LO 11-8: Know how to assess control risk for a purchasing process. LO 11-9: Know the key internal controls and develop relevant tests of controls for purchasing, cash disbursements, and purchase return transactions. 6,7 13,14,15 , 16,17,18 , 19,20,21 25,26 LO 11-10: Relate the assessment of control risk to substantive testing. LO 11-11: Know the substantive analytical procedures used to audit accounts payable and accrued expenses. 8 24,27,28 LO 11-12: Know the substantive tests of transactions and tests of details of account balances and disclosures used to audit accounts payable and accrued expenses. 9,10 19,20,21 , 22 27,28,29, 30 31 LO 11-13: Understand the confirmation process for accounts payable. 11 23 28,29 31 LO 11-14: Understand how to evaluate the audit findings and reach a final conclusion on accounts payable and accrued expenses. LO 11-15: Understand how to audit the tax provision and related balance sheet accounts. 12 END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 11-1 Unchanged 11-1 11-2 Unchanged 11-2 11-3 Unchanged 11-3 11-4 Unchanged 11-4 11-5 Unchanged 11-5 11-6 Unchanged 11-6 11-7 Unchanged 11-7 11-8 Unchanged 11-8 11-9 Unchanged 11-9 11-10 Unchanged 11-10 11-11 Unchanged 11-11 11-12 Unchanged 11-12 11-13 Unchanged 11-13 11-14 Unchanged 11-14 11-15 Unchanged 11-15 11-16 Unchanged 11-16 11-17 Unchanged 11-17 11-18 Unchanged 11-18 11-19 Unchanged 11-19 11-20 Unchanged 11-20 11-21 Unchanged 11-21 11-22 Unchanged 11-22 11-23 Unchanged 11-23 11-24 Unchanged 11-24 11-25 Unchanged 11-25 11-26 Unchanged 11-26 11-27 Unchanged 11-27 11-28 Unchanged 11-28 11-29 Unchanged 11-29 11-30 Unchanged 11-30 11-31 Unchanged 11-31 11-32 Unchanged 11-32 11-33 Unchanged 11-33 Chapter 11 covers the purchasing process and related accounts. It focuses on the purchase of and payment for goods and services from outside vendors. It provides another opportunity for the students to apply the concepts learned in the earlier chapters. The chapter begins by reviewing expense and liability recognition concepts. The remainder of the chapter follows the audit risk model to present the audit of the purchasing process and related accounts. [LO 11-1] Expense and Liability Recognition Again, we find that it is useful to briefly review the expense and liability recognition concepts that students learn in their financial accounting classes. We present the SFAC No. 6 definitions for expenses and liabilities. We also use SFAC No. 5 to present the three categories of expenses: (1) product costs, (2) period costs, and (3) allocable costs. Examples of each of these costs should be presented to the students. [LO 11-2 through 11-6] Overview of the Purchasing Process The students probably have little experience with the way information is processed in the purchasing process. We follow the same approach outlined in Chapter 10. We walk the students through the flowchart shown in Figure 11-1. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections, using the flowchart in Figure 11-1 as a benchmark: • Types of transactions and financial statement accounts affected (LO 11-3). • Types of documents and records (LO 11-4). • The major functions (LO 11-5). • The key segregation of duties (LO 11-6). In covering these subsections, we refer the students to Tables 11-1 through 11-4. Use Figure 11-1 Use Tables 11-1 through 11-4 [LO 11-7] Inherent Risk Assessment We discuss each of the following inherent risk factors and how they may affect the purchasing process and related accounts: • Industry-related factors. • Misstatements detected in prior audits. [LO 11-8] Control Risk Assessment Figure 11-2 summarizes the major steps in assessing control risk for the purchasing process. This offers an opportunity for the students to apply the internal control concepts learned in Chapters 6 and 7 to another accounting process. If the students have a good grasp of the material based on the coverage of Chapter 10, this material can be briefly reviewed. Use Figure 11-2 In order to set control risk for the purchasing process, the auditor must understand the five components of internal control. They include: • Control Environment. • The Entity’s Risk Assessment Process. • Control Activities. • Information Systems and Communication. • Monitoring of Controls. The auditor systematically analyzes the purchasing process in order to identify controls that ensure that material misstatements are either prevented, or detected and corrected. These controls can be relied upon by the auditor to reduce control risk. When the auditor relies on the controls, tests of controls are necessary to verify that the controls are operating effectively. After the controls are tested, the auditor sets the achieved level of control risk. When tests of controls support the planned level of control risk, no modifications are normally necessary to the planned level of detection risk, and the auditor may proceed with the planned substantive procedures. When the tests of controls do not support the planned level of control risk, the auditor must set a higher level of control risk. This results in a lower level of detection risk and leads to more substantive procedures than originally planned. The auditor should establish and document the achieved level of control risk. Documentation of the control risk for the purchasing process might include a flowchart, the results of tests of controls, and a memorandum indicating the auditor’s overall conclusion about the control risk. [LO 11-9] Control Activities and Tests of Controls Purchase Transactions This section provides the details on the assertions, possible misstatements, control procedures, and selected tests of controls for purchasing transactions. We use Tables 11-5 and 11-6 to cover this material. We generally go over each assertion and point out the possible misstatements and the normal control procedures that an entity should have in its system to minimize the possibility of these misstatements occurring. It is a good idea to relate the control procedures back to the flowchart in Figure 11-1. The students develop a better understanding of the purchasing process and the auditor's control risk assessment if we work back and forth between Figure 11-1 and Table 11-6. The last thing we cover is the tests of controls that the auditor can conduct to test whether the controls are operating effectively. Use Tables 11-5 and 11-6 Figure 11-1 Cash Disbursements Transactions We cover the material in Table 11-7 for cash disbursements transactions in the same manner as we described for purchase transactions except that we do not go into the same level of detail. We usually focus on the occurrence and authorization assertions. If Chapter 10 has been covered in depth, the students should have developed a sound understanding of how to work through the material in Table 11-7. Use Table 11-7 Purchase Return Transactions Generally, the number and magnitude of purchase return transactions are not material for most entities. However, the auditor should understand how such transactions are handled. Usually, a debit memo is processed through the purchasing process. Point out those analytical procedures can often be used to test the reasonableness of purchase returns (i.e., purchase returns as a percentage of revenue to prior years' and industry data). [LO 11-10] Relating the Assessed Level of Control Risk to Substantive Procedures In this section, we reiterate how the auditor's assessment of control risk in the purchasing process impacts detection risks for accounts payable and related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. On the other hand, if the results of tests of controls do not support the planned level of control risk, detection risk will have to be set lower. This will normally lead to an increase in substantive procedures. Auditing Accounts Payable and Accrued Expenses We use Table 11-8 to present the management assertions about account balances, and related disclosures, at the period end for accounts payable and accrued expenses. We then cover the two categories of substantive procedures: substantive analytical procedures and tests of details of account balances and disclosures. Use Table 11-8 [LO 11-11] Substantive Analytical Procedures We discuss the analytical procedures shown in Table 11-9 and the possible misstatements they may detect. Use Table 11-9 [LO 11-12] Tests of Details of Classes of Transactions, Account Balances, and Disclosures We review Table 11-10, which provides a substantive test of transactions for each assertion for purchase transactions. We cover the assertions about classes of transactions first, focusing on completeness, accuracy, and cutoff. Exhibit 11-2 provides an example of an accounts payable listing working paper, while Exhibit 11-3 shows an account analysis for accrued real estate taxes. Then we go over the account balance assertions focusing on existence, mentioning that confirmations are one source of evidence for this assertion, and the completeness assertion where we cover the steps involved in the search for unrecorded liabilities. The remaining assertions are straightforward, and the students should be able to review them on their own. Problem 11-29 could be used here. Use Table 11-10 Use Exhibits 11-2 and 11-3 [LO 11-13] Accounts Payable Confirmations We point out to the students that accounts payable confirmations are used less frequently by auditors than accounts receivable confirmations because the auditor can examine reliable external documents (e.g., vendor invoices and monthly vendor statements). It is also important to note that accounts payable confirmations mainly provide evidence on completeness and, as a result, auditors generally use a blank or zero-balance confirmation (see Exhibit 11-5). Use Exhibit 11-5 [LO 11-14] Evaluating the Audit Findings We review how the auditor completes the third step in applying materiality―comparing the aggregate misstatement to the tolerable misstatement assigned to the account. [LO 11-15] Advanced Module: Auditing the Tax Provision and Related Balance Sheet Accounts We introduce this topic first by reviewing the financial statement impact of accounting for income taxes. We discuss temporary and permanent differences, giving examples of each. We then briefly discuss accounting for uncertain tax positions as well as unique issues that must be considered with multinational corporations. We discuss the need for the auditor to be familiar with both GAAP and tax accounting in order to properly audit the tax provision and related balance sheet accounts. A tax specialist should be involved if the auditor is working with a very large entity. Indicators that suggest the use of a specialist are: • Multiple locations with significant foreign operations and related foreign tax credits/deductions • Business combinations and/or subsidiary dispositions • Material uncertain income tax positions with a governmental authority • Significant changes in ownership, business operations, or tax status • Significant deferred tax assets for which the future realization of the recorded value is in question We then discuss some of the typical procedures that might be applied to the audit of the tax provision and related balance sheet accounts. Discussion Case Discussion case 11-31 provides a good case for discussing accounts payable confirmations. Internet Assignments Internet assignments 11-32 and 11-33 parallel the assignments used in Chapter 10. Internet assignment 11-32 requires the students to determine how another catalog retailer processes purchase transactions and recognizes expenses. Internet assignment 11-33 requires a search of the SEC’s website for a case involving financial reporting problems related to the recognition of expenses. Practice Insights Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. IDEA and TABLEAU The Chapter 11 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 12 Auditing the Human Resource Management Process Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Cases Internet Assignmen ts LO 12-1: Develop an understanding of the human resource management process. 1 LO 12-2: Be familiar with the types of transactions in the human resource management process and the financial statement accounts affected. 2 LO 12-3: Know and describe the types of documents and records used in the payroll process. 3 14,15 LO 12-4: Understand the functions in the human resource management process. 4 16 24,25 LO 12-5: Know the appropriate segregation of duties for the human resource management process. 5 15,16,17 , 18 24,25 LO 12-6: Know and evaluate inherent risks relevant to the human resource management process. 6 29 LO 12-7: Assess control risk for a human resource management process. 7 25 28 LO 12-8: Know key internal controls and develop relevant tests of controls for payroll transactions. 7,8,9,10 14,15,16 , 19,20,21 , 22 25 28 LO 12-9: Understand how to relate the assessment of 23 28 control risk to substantive procedures. LO 12-10: Be familiar with substantive analytical procedures used to audit payroll expense and payroll-related accrued expenses. 11 23 26,27 29 LO 12-11: Be familiar with substantive tests of transactions and tests of details of account balances and disclosures used to audit payroll expense and payroll- related accrued expenses. 10,12,13 23 26,27 29 LO 12-12: Understand how to evaluate the audit findings and reach a final conclusion on payroll expense and payroll- related accrued expenses. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 12-1 Unchanged 12-1 12-2 Unchanged 12-2 12-3 Unchanged 12-3 12-4 Unchanged 12-4 13-5 Unchanged 12-5 12-6 Unchanged 12-7 12-7 Unchanged 12-8 12-8 Unchanged 12-9 12-9 Unchanged 12-6 12-10 Revised 12-10 12-11 Unchanged 12-11 12-12 Unchanged 12-12 12-13 Unchanged 12-13 12-14 Revised 12-14 12-15 Unchanged 12-15 12-16 Unchanged 12-16 12-17 Unchanged 12-17 12-18 Unchanged 12-18 12-19 Revised 12-19 12-20 Unchanged 12-20 12-21 Unchanged 12-21 12-22 Revised 12-22 12-23 Unchanged 12-23 12-24 Unchanged 12-24 12-25 Revised 12-25 12-26 Revised 12-26 12-27 Unchanged 12-27 12-28 Unchanged 12-28 12-29 Revised 12-29 Chapter 12 covers the human resource management process and related financial statement accounts. The material in the chapter follows the same framework as Chapters 10 and 11. If we have covered the revenue or purchasing processes and their related accounts in depth, we can usually go through this material quickly on the assumption that the students can properly apply the concepts to any business process. [LO 12-1 through 12-5] Overview of the Human Resource Management Process We walk the students through the flowchart shown in Figure 12-1. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections, using the Figure 12-1 flowchart as a benchmark: • Types of transactions and financial statement accounts affected (LO 12-2). • Types of documents and records (LO 12-3). • The major functions (LO 12-4). • The key segregation of duties (LO 12-5). In covering these subsections, we refer the students to Tables 12-1 through 12-4. Use Figure 12-1 Use Tables 12-1 through 12-4 [LO 12-6] Inherent Risk Assessment We point out that there are generally few inherent risk factors that affect the human resource management process and related financial statement accounts and that inherent risk is usually assessed as low. We do mention the following factors as potential problems: • The supply of skilled workers and employee turnover. • The presence of labor contracts. • Legislation such as the Occupational Safety and Health Act. • Executive compensation (see Exhibit 12-1) Use Exhibit 12-1 [L0 12-7] Control Risk Assessment Figure 12-2 summarizes the major steps in assessing control risk for the human resource management process. We briefly review this material since the students should understand this process. Use Figure 12-2 [LO 12-8] Control Activities and Tests of Controls—Payroll Transactions We use Table 12-5 to cover the details on the assertions, possible misstatements, control procedures, and selected tests of controls for payroll transactions. We generally go over each assertion (Note: in the 11th edition, the assertions have been updated to be consistent with international and AICPA auditing standards) and point out the possible misstatements and the normal control procedures that an entity should have in its system to minimize the possibility of these misstatements occurring. It is a good idea to relate the control procedures back to the flowchart in Figure 12-1. The last thing we cover is the tests of controls that the auditor can conduct to test whether the controls are operating effectively. Problem 12-25 can be used here. Use Table 12-5 [LO 12-9] Relating the Assessed Level of Control Risk to Substantive Procedures In this section, we reiterate how the auditor's assessment of control risk impacts detection risk for payroll-related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. If the results of tests of controls do not support the planned level of control risk, detection risk will have to be set lower. This will normally lead to an increase in substantive tests. Auditing Payroll-Related Accounts We use Table 12-6 to present the assertions for testing payroll expense and payroll-related liabilities. We then cover the two categories of substantive tests: substantive analytical procedures and tests of details of account balances, and disclosures. Use Table 12-6 [LO 12-10] Substantive Analytical Procedures Table 12-7 presents the analytical procedures for payroll expense and payroll-related accrual accounts and the possible misstatements they may detect. We discuss these analytical procedures since such tests are used extensively on payroll-related accounts. Use Table 12-7 [LO 12-11] Tests of Details of Classes of Transactions, Account Balances, and Disclosures Table 12-8 presents examples of substantive tests of transactions, account balances, and disclosures for assertions related to payroll. We quickly go over the substantive tests of transactions. Then we cover tests of details of account balances and tests of details of disclosures, focusing on the assertions of existence, completeness, valuation and allocation and disclosure. We show Exhibit 12-3 as an example of an account analysis for accrued payroll taxes. Table 12-9 provides some disclosure items for the human resource management process and related accounts. Problems 12-26 and/or 12-27 can be used here. Use Tables 12-8 and 12-9 Use Exhibit 12-3 [LO 12-12] Evaluating the Audit Findings We review how the auditor completes the third step in applying materiality—comparing the likely misstatements to the tolerable misstatement assigned to the account. Discussion Cases Discussion case 12-28 provides a good case for discussing the types of application controls an auditor would expect in a computerized payroll system. Internet Assignment Internet assignment 12-29 deals with the issue of executive compensation and audit tests that can best be used to detect executive compensation abuse or fraud. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. This edition adds several new Practice Insights regarding the overlap between audit data analytics and the HR Cycle. IDEA AND TABLEAU The Chapter 12 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Chapter 13 Auditing the Inventory Management Process Learning Objectives Review Questio ns Multipl e- Choice Questio ns Problem s Discussi on Case Internet Assignmen ts LO 13-1: Develop an understanding of the inventory management process. 1,2 14 27,28 LO 13-2: Be able to identify and describe the types of documents and records used in the inventory management process. 3 15 LO 13-3: Understand the functions in the inventory management process. 4 14 27 LO 13-4: Know the appropriate segregation of duties for the inventory management process. 5 16,17 LO 13-5: Be able to identify and evaluate inherent risks relevant to the inventory management process. 6 LO 13-6: Know how to assess control risk for the inventory system. 7 28 LO 13-7: Know key internal controls and develop relevant tests of controls for inventory transactions. 8 15,16,17 , 18,19 27 34 LO 13-8: Understand how to relate the assessment of control risk to substantive procedures. 20 LO 13-9: Be familiar with substantive analytical procedures used to audit inventory and related accounts. 9 33 34 LO 13-10: Know how to audit standard costs. 10 LO 13-11: Know how to observe physical inventory. 11 20,21,22 , 23,24 28,29, 30,31 33 LO 13-12: Be familiar with tests of transactions and tests of details used to audit inventory and related accounts. 12,13 20,22,23 , 24,25,26 28,30, 31,32 33 34 LO 13-13: Understand how to evaluate the audit findings and reach a conclusion on inventory and related accounts. 33 34 NOTE: References to auditing standards in the instructor manual follow a similar convention to that followed in the text: AICPA standards will be referenced by clarified AU section and PCAOB standards will be referenced by Auditing Standard (AS) number. END OF CHAPTER MATERIALS COMPARISON CHART Number in 10th edition Comparison Number in 11th edition 13-1 Unchanged 13-1 13-2 Unchanged 13-2 13-3 Unchanged 13-3 13-4 Unchanged 13-4 13-5 Unchanged 13-5 13-6 Unchanged 13-6 13-7 Unchanged 13-7 13-8 Unchanged 13-8 13-9 Unchanged 13-9 13-10 Unchanged 13-10 13-11 Unchanged 13-11 13-12 Unchanged 13-12 13-13 Unchanged 13-13 13-14 Unchanged 13-14 13-15 Unchanged 13-15 13-16 Unchanged 13-16 13-17 Unchanged 13-17 13-18 Unchanged 13-18 13-19 Unchanged 13-19 13-20 Unchanged 13-20 13-21 Unchanged 13-21 13-22 Unchanged 13-22 13-23 Unchanged 13-23 13-24 Unchanged 13-24 13-25 Unchanged 13-25 13-26 Unchanged 13-26 13-27 Unchanged 13-27 13-28 Unchanged 13-28 13-29 Unchanged 13-29 13-30 Revised 13-30 13-31 Unchanged 13-31 13-32 Unchanged 13-32 13-33 Unchanged 13-33 13-34 Unchanged 13-34 Chapter 13 covers the inventory management process and related accounts, and it follows the same framework as earlier business process chapters. This is a topic that is usually not covered in the first auditing class but can be included in a second or graduate auditing class. The material can be covered quickly on the assumption that the students can properly apply the concepts learned in the first course to any business process. The chapter material can be supplemented in a graduate class with a written assignment that requires the students to research some legal cases (e.g., MiniScribe) that involved inventory fraud. This type of material impresses upon the students the importance of the audit of inventory. [LO 13-1 through 13-4] Overview of Inventory Management Process We use Figure 13-1 to show the students how the inventory management process is related to other business processes. We then walk the students through the flowchart of the inventory management process shown in Figure 13-2, which is based on EarthWear Clothiers. We try to get the students to understand the flow of information and where important control procedures should exist. We then review each of the following subsections, using the Figure 13-2 flowchart as a benchmark: • Types of documents and records (LO 13-2). • The major functions (LO 13-3). • The key segregation of duties (LO 13-4). In covering these subsections, we refer the students to Tables 13-1 through 13-4. Use Figures 13-1 and 13-2 Use Tables 13-1 through 13-4 [LO 13-5] Inherent Risk Assessment Inherent risk factors that affect the inventory management process include many of the fraud risk factors discussed in Chapter 3 and include: • Industry-related factors, such as competition and rapid technological changes (see Exhibit 13-2). • Engagement and operating characteristics, including: o Susceptibility of the product to theft (e.g., computer memory chips). o Valuation issues may lead to disagreements with the entity. o Possible related-party transactions for acquisition of raw material and sales of finished product. Use Exhibit 13-2 [LO 13-6] Control Risk Assessment Figure 13-3 summarizes the major steps in assessing control risk for the inventory management process. We briefly review this material since the students should already understand this process. Use Figure 13-3 [LO 13-7] Control Activities and Tests of Controls—Inventory Transactions We use Table 13-5 to cover the details on the assertions and how they relate to possible misstatements, control procedures, and selected tests of controls for inventory transactions (Note: in the 11th edition, the assertions have been updated to be consistent with international and AICPA auditing standards). We generally limit the discussion to the most important assertions. We point out the possible misstatements and the normal internal control procedures that an entity should have in its system to minimize the possibility of these misstatements occurring. We relate the internal control procedures back to the flowchart in Figure 13-2. Lastly, we cover the tests of controls that the auditor can conduct to test whether the controls are operating effectively. Problem 13-27 can be used here. Use Table 13-5 [LO 13-8] Relating the Assessed Level of Control Risk to Substantive Procedures In this section, we reiterate how the auditor’s assessment of control risk in the inventory process impacts detection risks for inventory and related accounts. If the results of the tests of controls support the planned level of control risk, no revisions to the audit plan are necessary. On the other hand, if the results of tests of controls do not support the planned level of control risk, detection of risk will have to be set lower. This will normally lead to an increase in substantive procedures. Auditing Inventory We use Table 13-6 to present the assertions for classes of transactions, account balances, and disclosures for inventory. We go over Table 13-6 to make sure the students understand each of the important assertions. Use Table 13-6 [LO 13-9] Substantive Analytical Procedures Then we use Table 13-7 to present examples of analytical procedures used for inventory and related accounts and the possible misstatements they may detect. We discuss these analytical procedures since such tests are used extensively to audit inventory. We generally focus on the gross profit percentage and inventory turnover ratio. The students should be reminded of the importance of industry averages for comparison purposes. Use Table 13-7 [LO 13-10] Auditing Standard Costs Since many manufacturing companies use some type of standard cost system to value inventory, it is important to discuss how an auditor would verify the entity's standard costs. We approach this material by using the manufacture of wireless devices by Calabro Wireless Services as an example (we have also used the manufacture of lawnmowers and woolen cloth as examples). The students know from their cost accounting class that standard costs are developed by three components (materials, labor, and overhead). We get the class to think about how they would verify each of those types of costs for a wireless device. For example, the students eventually realize that they will have to look at some type of engineering specifications for a particular wireless device. These specifications can be used to determine what materials or parts are used in the device. [LO 13-11] Observing Physical Inventory The students should be told that the auditor's observation of inventory is a generally accepted auditing procedure and that the primary reason for observing inventory is to establish the existence of the inventory. They should also learn that the observation of the physical inventory could provide evidence on the rights and obligations and valuation assertions. The audit procedures performed by the auditor during the physical inventory count should be covered in some depth. We find that it is helpful for the students if the instructor covers each of the procedures listed in the discussion entitled “Observing Physical Inventory.” This is normally a good place to tell some “war stories” about inventory observation and remind the students that they will likely be involved in inventory counts as an intern or first-year staff. [LO 13-12] Tests of Details of Classes of Transactions, Account Balances, and Disclosures We use Table 13-8 to cover assertions about classes of transactions, account balances, and disclosures as well as substantive tests of transactions, tests of details of account balances, and tests of details of disclosure. Generally, the substantive tests of transactions that affect inventory are conducted as part of testing the revenue, purchasing, and human resource management process. Transactions that affect the receipt of raw materials, shipment of goods, or assignment of labor costs are tested as part of those processes. We discuss how the more important assertions are tested. We use Table 13-9 to provide examples of disclosures for inventory. Problem 13-31 can be used here. Use Tables 13-8 and 13-9 [LO 13-13] Evaluating the Audit Findings We review how the auditor completes the third step in applying materiality—comparing the likely misstatements to the tolerable misstatement assigned to the account for the purpose of determining whether the inventory account is fairly stated. Discussion Case Discussion case 13-33 provides a good case for reviewing issues related to inventory observation. Additional Case Assignment When we cover this material in the second auditing course, we have the students complete the following assignment in teams before the lecture on inventory. In the past, there have been a number of lawsuits (e.g., possible audit failures) that have involved some type of inventory manipulation. Five such cases are: (1) Comptronix, (2) Leslie Fay, (3) MiniScribe, (4) Phar-Mor, and (5) Woolworth. Instructions: Each group has been assigned one of these cases for analysis. Your group is to prepare a summary of the case with particular emphasis on the issues related to inventory. We suggest that you have two sections in your summary: (1) a general overview of the case and issues and (2) a section devoted specifically to the inventory problems. Your summary of the case should be no longer, than three typed double-spaced pages, plus at least three sources for your information. Internet Assignments Internet assignment 13-34 requests the students to research a recent SEC case that involves inventory. This is a good current events type project. Practice Insight Practice Insights provide real-world integration. Practice Insight scenarios are included in each chapter to highlight important and interesting real-world trends and practices. These self-contained insights or scenarios focus on current events, student decision-making, and professional problem solving. This edition includes a new practice insight that discusses how audit data analytics and technology are being used in the inventory cycle. IDEA AND TABLEAU The Chapter 13 IDEA and TABLEAU problems are an excellent hands-on supplement to the textbook material. Please go to Connect for chapter assignments. Instructor Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312