CH-8-11 Audit Sampling: An Overview And Application to Tests of Controls – Auditing and Assurance Services: A Systematic Approach : Book Guide

This Document Contains Chapters 8 to 11 Chapter 8 Audit Sampling: An Overview And Application to Tests of Controls Answers to Review Questions 8-1 Audit sampling is the application of audit procedures to less than 100 percent of the items in a population of audit relevance selected in such a way that the auditor expects the sample to be representative of the population and thus likely to provide a reasonable basis for conclusions about the population. When the number of items or transactions in these populations is large and the items cannot be tested via computer assisted audit techniques or audit data analytics (e.g., physical examination, confirmations), it is not economical for auditors to test 100 percent for the population; instead they use sampling to gather sufficient audit evidence. The justification for accepting some uncertainty from sampling is due to the trade-off between the cost to examine all of the data and the cost of making an incorrect decision based on a sample of the data. 8-2 Type I and Type II errors are the two types of decision errors an auditor can make when deciding that sample evidence supports or does not support a test of controls or a substantive test based on a sampling application. In reference to test of controls, Type I and Type II errors are: • Risk of incorrect rejection (Type I): the risk that the assessed level of control risk based on the sample is greater than the true operating effectiveness of the control. Also commonly referred to as the risk of assessing control risk too high or the risk of underreliance. • Risk of incorrect acceptance (Type II): the risk that the assessed level of control risk based on the sample is less than the true operating effectiveness of the control. Also commonly referred as the risk of assessing control risk too low or the risk of overreliance. In reference to substantive tests, Type I and Type II errors are as follows: • Risk of incorrect rejection (Type I): the risk that the sample supports the conclusion that the recorded account balance is materially misstated when it is not materially misstated. • Risk of incorrect acceptance (Type II): the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated. The risk of incorrect rejection relates to the efficiency of the audit because such errors can result in the auditor’s conducting more audit work than necessary in order to reach the correct conclusion. The risk of incorrect acceptance relates to the effectiveness of the audit because such errors can result in the auditor failing to detect a material misstatement in the financial statements. This can lead to litigation against the auditor by parties who relied on the financial statements. 8-3 Audit evidence types that do not involve audit sampling include: • Analytical procedures • Scanning • Inquiry • Observation This Document Contains Chapters 8 to 11 Examples of situations where audit sampling would not be used include: • Procedures applied to every item in the account or population (typically due to a small number of large items) • Classes of transactions or account balances not tested • Tests of automated information technology controls 8-4 Nonstatistical sampling is an approach in which the auditor uses a haphazard selection technique or uses judgment in any or all of the following steps: • Determining the sample size • Select the sample • Calculating the computed upper deviation rate Nonstatistical sampling doesn’t require the use of statistical theory to determine sample size or in the evaluation of sampling risk, although auditing standards require the extent of testing to be comparable for both types of sampling. Statistical sampling uses the laws of probability to determine sample size, randomly select sampling units, and to evaluate the results of an audit sample. The use of statistical theory permits the auditor to quantify the sampling risk for the purpose of reaching a conclusion about the population. The major advantages of a statistical sampling application are that it helps the auditor (1) design an efficient sample, (2) measure the sufficiency of evidence obtained, and (3) quantify sampling risk. The disadvantages of statistical sampling include the additional costs of (1) training auditors in the proper use of sampling technique, (2) added complexity in designing and conducting the sampling application, and (3) lack of consistent application across audit teams due to the complexity of the underlying concepts. An advantage of nonstatistical sampling, particularly for large firms, which is indirectly a disadvantage of a statistical sampling tool like IDEA, is that with a nonstatistical approach a firm can develop firm-specific sampling tools and templates that are based on the knowledge and expertise of national sampling experts. The tools and templates then leverage the expertise of specialists and can make decisions and application associated with audit sampling easier to use and the judgments more consistent for auditors in the field. 8-5 Attribute sampling is used to estimate the proportion of a population that possesses a specified characteristic. For tests of controls, the auditor wants to measure the deviation rate to determine whether the control procedure can be relied upon to properly process accounting transactions and therefore support the auditor’s assessed level of control risk. 8-6 The timing of testing often will determine the period to be covered by the test. For example, interim testing may involve testing transactions from the first nine months of the year. After the population has been defined, (1) the auditor must determine that the physical representation of the population is complete, and (2) if the testing was conducted at an interim date, whether to conduct additional tests in the remaining period. 8-7 The four factors that enter into the sample size decision and their relationship with sample size are: Factor Relationship to Sample Size Desired confidence level Direct Tolerable deviation rate Inverse Expected population deviation rate Direct Population size Decreases sample size only when population size is small (<500 items) 8-8 In conducting the audit procedures for tests of controls, the auditor may encounter voided, inapplicable, or missing documents. The auditor may also stop the test before completion. Each of these situations should be handled in the following manner for an attribute-sampling application: • Voided documents: If the transaction has been properly voided, it does not represent a deviation. The item should be replaced with a new sample item. • Unused or inapplicable documents: Sometimes a selected item is not appropriate for the definition of the control. In such a case, the item is not a deviation and the auditor would simply replace the item with another purchase transaction. • Missing documents: If the auditor is unable to examine a document or use an alternative procedure to test whether the control was adequately performed, the sample item is a deviation for purposes of evaluating the sample results. • Stopping the test before completion: If a large number of deviations are detected early in the tests of controls, the auditor should consider stopping the test as soon as it is clear that the results of the test will not support the planned assessed level of control risk. The client should be informed and the exceptions would be considered a control deficiency unless remediation and retesting are successful. 8-9 The auditor’s purposes in evaluating the qualitative aspects of deviations when performing error analysis involves considering (1) the nature of the deviations and their causes and (2) how these deviations may impact the other phases of the audit. 8-10 An auditor using nonstatistical sampling uses judgment to consider the allowance for sampling risk. For example, when the rate of deviation from the prescribed control exceeds the expected rate used to plan the sample, the auditor usually concludes that there is unacceptably high sampling risk and he or she would typically increase the assessed level of control risk or consider further whether to rely at all on the control. Answers to Multiple-Choice Questions 8-11 c 8-16 b 8-12 a 8-17 b 8-13 a 8-18 d 8-14 c 8-19 d 8-15 a 8-20 c Solutions to Problems 8-21 a. The auditor’s justification for accepting the uncertainties that are inherent in the sampling process are based upon the premise that (1) the cost of examining all of the financial data would usually outweigh the benefit of the added reliability of a complete (100%) examination and (2) the time required to examine all of the financial data would usually preclude issuance of a timely auditor’s report. b. The uncertainties inherent in applying auditing procedures are collectively referred to as audit risk. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated. Audit risk can be controlled through the scope of the auditor’s test procedures with the audit risk model providing a framework to follow. Detection risk, which is a component of the audit risk model, is composed of two risks or uncertainties: sampling risk and nonsampling risk. c. Sampling risk arises from the possibility that, when a test of controls or a substantive test is restricted to a sample, the auditor’s conclusions may be different from the conclusions he or she would reach if the test were applied in the same way to all items in the population. Nonsampling risk includes all the aspects of audit risk that are not due to sampling and can occur because the auditor used an inappropriate audit procedure, failed to detect a misstatement when applying an appropriate audit procedure, or misinterpreted an audit result. When performing a test of controls, the auditor can commit two types of decision errors: (1) the risk of incorrect rejection or of assessing control risk too high, which is the risk that the assessed level of control risk based on the sample is greater than the true operating effectiveness of the control and (2) the risk of incorrect acceptance or of assessing control risk too low, which is the risk that the assessed level of control risk based on the sample is less than the true operating effectiveness of the control. When performing substantive tests, the related decision errors are: (1) the risk of incorrect rejection, which is the risk that the sample supports the conclusion that the recorded account balance is materially misstated when it is not materially misstated and (2) the risk of incorrect acceptance, which is the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated. 8-22 a 6, b 5, c 7, d 1, e 4, f 2, g 3 8-23 1. In this scenario, the stratum of loans greater than $1 million is tested in total. Since the entire population is tested, it does not involve sampling. Sampling is involved in the second stratum because the auditor is only examining 15 of the 450 loans in the stratum. 2. If the analytical procedures used do not include statistical techniques based on a sample (e.g., regression analysis using a subset of data), then the use of analytical procedures does not involve sampling. 3. Since the auditor has haphazardly selected less than 100% of the population’s transactions, sampling is involved in such a test. 4. In this case, the auditor has decided not to audit the account because it is immaterial. This approach does not involve sampling. 8-24 a. Table 8-2 provides 7 steps in attribute sampling. The list in Table 8-2 includes Jenny’s step 3 within the second step of attributes sampling. The remaining steps of attribute sampling are as follows: 2. Define remaining population characteristics—define the control deviation conditions. 3. Determine sample size, using the following inputs. • Determine the desired confidence level. • Determine the tolerable deviation rate. • Determine the expected population deviation rate. • Determine the population size (if $50,000 $ 3,500 NA 100% of Strata Tested $ 3,500 >$5,000 15,250 (15,250  910,000) × 3,000,000 50,275 <$5,000 1,550 (1,550  70,000) × 1,750,000 38,750 Total projected misstatement $ 92,525 Since the projected misstatement, $92,525, is significantly greater than the expected misstatement, $55,000, Gren should conclude that there is an unacceptably high risk that the true misstatement exceeds the tolerable misstatement (i.e., must consider the original allowance for sampling risk of $100,000 ($155,000 – 55,000)). 9-25 a. The calculation of the sample size for Wang’s test of Cougar Goldust is: 57 $155,000 55,000 1.2 = $4,750,000 Sample Size =       − Sample size .03, round to 44 b. The calculation of the sample results is as follows: The calculation of the mean misstatement per sampling item is: Mean Misstatement per sampling item Thus, the average misstatement in a bin based on the sample data is an overstatement of 4 ounces. Next, the mean misstatement is projected to the population: Projected population = Population size x Mean misstatement misstatement (in sampling units) per sampling item 16,000 ounces = 4,000 x 4 The allowance for sampling risk is represented by the confidence bound. To calculate the confidence bound, the auditor first calculates the standard deviation and then uses the equation shown below, using the CC value for the level of desired confidence. where N = population size (in sampling units) n = sample size CC = Confidence Coefficient SD = Standard Deviation of Audit Differences For Cougar Goldust, the confidence bound is 8,403 ounces and the confidence interval is calculated as follows: Confidence interval = Projected population misstatement + Confidence bound = 16,000 + 8,403 43 35,000 10,000 4,000 1.64 = - x x 25 = 2       = Total audit difference Sample Size = 400 100 = 4 SD = Total squared audit difference - (sample size x mean difference per samplingitem2 ) sample size - 1 ( ) = 12.81 100 - 1 17,856 - 100 4 SD = 2 Confidencebound = N(CC)SD n = 4,000 (1.64) 12.81 100 = 8,403 Thus, the Confidence Interval has a lower limit of 7,597 ounces and an upper limit of 24,403 ounces. Since the upper and lower bounds lie within the tolerable misstatement of + 35,000 ounces, the sample evidence suggests that the perpetual records are fairly stated with a 90 percent confidence level. 9-26 The calculation of the sample results for Hipp Supply Company is as follows: The calculation of the mean misstatement per sampling item is: Mean Misstatement per sampling item Thus, the average misstatement for an inventory item based on the sample data is an overstatement of $4.81. Next, the mean misstatement is projected to the population as follows: Projected population = Population size x Mean misstatement misstatement (in sampling units) per sampling item $4,618 = 960 x $4.81 The allowance for sampling risk is represented by the confidence bound. To calculate the confidence bound, the auditor first calculates the standard deviation and then uses the equation shown below, using the CC value for the level of desired confidence. where N = population size (in sampling units) CC = Confidence Coefficient SD = Standard Deviation of Audit Differences n = sample size For Hipp Supply Company, the confidence bound is $1,283 and the confidence interval is calculated as follows: Confidence interval = Projected Population Misstatement + Confidence bound = Total audit difference SampleSize = $481 100 = $4.81 SD = Total squared audit difference - (sample size x mean difference per samplingitem2 ) sample size - 1 ( ) = 8.15 100 - 1 8,895 - 100 4.81 SD = 2 ( ) (1.64) = 1,283 100 8.15 = 960 n SD Confidencebound = N CC = 4,618 + 1,283 Thus, the confidence interval has a lower overstatement limit of $3,335 and an upper limit of $5,901. Since the upper limit of $5,901 is greater than tolerable misstatement of $5,000, the sample evidence suggests that the inventory is not fairly stated with a 90 percent confidence level. Solutions to Discussion Cases 9-27 The incorrect assumptions, statements, and inappropriate applications of sampling are as follows: • Classical variables sampling is not designed for tests of controls. • MUS uses each dollar in the population, not each account, as a separate sampling unit. • MUS is not efficient if many misstatements are expected because the sample size can become larger than the corresponding sample size for classical variables sampling as the expected amount of misstatement increases. • Each account does not have an equal chance of being selected; the probability of selection of the accounts is proportional to the account’s dollar amount. • MUS requires special consideration for negative (credit) balances. • Tolerable misstatement was not considered in calculating sample size. • Expected misstatement was not considered in calculating sample size. • The standard deviation of the dollar amounts is not required for MUS. • The three selected accounts with insignificant balances should not have been ignored or replaced with other accounts. • The account with the $1,000 difference (recorded amount of $4,000 and audited amount of $3,000) was incorrectly projected as a $1,000 misstatement; the projected misstatement for this difference was actually $2,500 ($1,000/$4,000 x $10,000 sampling interval). • The difference in the understated account (recorded amount of $1,900 and audited amount of $2,000) should not have been omitted from the calculation of projected misstatement. • The reasoning (the comparison of projected misstatement with the allowance for sampling risk) concerning the decision that the receivables balance was not overstated was erroneous. 9-28 a. While Doug’s selection method is not random, judgmentally “targeting” items for testing is acceptable under auditing standards and it may be preferable if there is reason to think some balances are more likely misstated than others. Doug’s reasoning for selection seems reasonably sound. b. Because the items selected were not identified randomly, Doug cannot use statistical sampling methods to quantify sampling risk or evaluate his results. His “sample” accounts for 66% ($720,000/$1,090,000) of ending inventory and even though it isn’t technically appropriate to project the results from the “sample,” in practice auditors can use their understanding of projection to verify our judgment regarding the sufficiency of the evidence. Projected misstatement using ratio projection would be $121,111 ($80,000/$720,000 x $1,090,000), which is well below the tolerable misstatement of $250,000 ($500,000 x 50 percent). Doug based his selection on the items that were most risky or most likely to be misstated. Assuming he was successful at identifying the riskiest items and the fact that he obtained relatively high coverage (the remaining items account for only 44% and are less likely to contain misstatements), it appears reasonable to conclude he has sufficient evidence to consider the balance fairly stated. Chapter 10 Auditing the Revenue Process Answers to Review Questions 10-1 FASB ASC 606 “Revenue from contracts with customers” requires the entity to follow a five-step approach: Step 1: Identify the contract(s) with a customer where a contract is an agreement between two or more parties that creates enforceable rights and obligations. Step 2: Identify the performance obligations in the contract where a contract includes promises to transfer goods or services to a customer. Step 3: Determine the transaction price where the transaction price is the amount of consideration in a contract to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. Step 4: Allocate the transaction price to the performance obligations in the contract. An entity typically allocates the transaction price to each performance obligation on the basis of the relative standalone selling prices of each distinct good or service promised in the contract. Step 5: Recognize revenue when the entity satisfies a performance obligation. An entity recognizes revenue when it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). 10-2 The credit function has the responsibility for monitoring customer payments. An aged trial balance of accounts receivable should be prepared and reviewed by the credit function. Payment should be requested from customers who are delinquent in making payments for goods or services. The credit function is usually responsible for preparing a report of customer accounts that may require write-off as bad debts. However, the final approval for writing off an account should come from an officer of the company who is not responsible for credit or collections. 10-3 When the entity does not have adequate segregation of duties or if collusion is suspected, the possibility of a defalcation is increased. An employee who has access to both the cash receipts and the accounts receivable records has the ability to steal cash and manipulate the accounting records to hide the misstatement. This is sometimes referred to as lapping. When lapping is used, the perpetrator covers the cash shortage by applying cash from one customer's account against another customer's account. If the auditor suspects that this has occurred, the individual cash receipts have to be traced to the customers' accounts receivable accounts to ensure that each cash receipt has been posted to the correct account. If the cash receipt is posted to a different account, this may indicate that someone is applying cash to different accounts to cover a cash shortage. Other possible procedures include custody and authorization of credit memos. Lastly, confirmations that include not only A/R balance, but also total sales and cash receipts are a substantive procedure to address this issue. 10-4 Industry-related factors such as the profitability and health of the industry in which the entity operates, the level of competition within the industry, and the industry's rate of technological change affect the potential for misstatements in the revenue process. The level of governmental regulation (e.g., by the Food and Drug Administration) within the industry may also affect sales activity. Finally, most states have consumer protection legislation that may affect product warranties, returns, financing, and product liability. Such industry-related factors directly impact the auditor's inherent risk assessment for the authorization and valuation assertions. The presence of misstatements in previous audits is a good indicator that misstatements are likely to be present during the current audit. If material misstatements were present in previous audits, the auditor should assess inherent risk to be high. 10-5 The auditor needs to obtain the following knowledge for each major class of transactions in the revenue process when performing a walkthrough: • How sales, cash receipts, and sales returns and allowances transactions are initiated. • The accounting records, supporting documents, and accounts that are involved in processing sales, cash receipts, and sales returns and allowances transactions. • The flow of each type of transaction from initiation to inclusion in the financial statements, including computer processing of the data. • The process used to prepare estimates for accounts such as the allowance for uncollectible accounts and sales returns. 10-6 Two important controls for processing of credit memoranda for sales returns and allowances transactions are: (1) each credit memorandum should be approved by someone other than the individual who initiated it and (2) a credit for returned goods should be supported by a receiving document indicating that the goods have been returned. 10-7 The analytical procedures that can be used to test revenue-related accounts and the possible misstatements that can be detected by each analytical procedure are (also see Table 10-9): Analytical Procedure Possible Misstatement Detected Revenue: Comparison of gross profit percentage by product line with previous years' and/or industry data. Comparison of reported revenue to budgeted revenue. Unrecorded (understated) revenue Fictitious (overstated) revenue Changes in pricing policies Product-pricing problems Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense: Comparison of receivables turnover and days outstanding in accounts receivable to previous years' and/or industry data. Comparison of aging categories on aged trial balance of accounts receivable to previous years. Under- or overstatement of allowance for uncollectible accounts and bad-debt expense Comparison of bad-debt expense as a percentage of revenue to previous years' and/or industry data. Comparison of the allowance for uncollectible accounts as a percentage of accounts receivable or credit sales to previous years' and/or industry data. Examination of large customer accounts individually and comparison to previous year. Sales Returns and Allowances and Sales Commissions: Comparison of sales returns as a percentage of revenue to previous years' and/or industry data. Comparison of sales discounts as a percentage of revenue to previous years' and/or industry data. Estimation of sales commissions expense by multiplication of net revenue by the average commission rate and comparison to recorded sales commission expense. Under- or overstatement of sales returns Under- or overstatement of sales discounts Under- or overstatement of sales commission expense and related accrual 10-8 The auditor verifies the accuracy of the aged trial balance using the following steps. First, a copy of the aged trial balance of accounts receivable is obtained from the entity and the total balance is compared to the accounts receivable general ledger balance. Second, a sample of customer accounts is selected from the aged trial balance. For each selected customer account, the auditor traces the customer's balance back to the subsidiary ledger detail and verifies the total amount and the amounts included in each column for proper aging. These two steps mainly describe a manual approach to testing accuracy. A second approach would involve the use of computer-assisted audit techniques. If the general controls over IT are adequate, the auditor can use a generalized audit software package to perform the steps described in the first approach to examine the accuracy of the aged trial balance generated by the entity's accounting system. 10-9 Three factors that affect the reliability of accounts receivable confirmations are: • The type of confirmation request. • Prior experience on the entity or similar engagements. • The intended respondent. The types of confirmations include positive and negative confirmations. Positive confirmations are considered more reliable because the recipient is required to respond to the auditor regardless of whether a misstatement exists or not. Prior experience with the entity in terms of confirmation response rates, misstatements identified, and the accuracy of returned confirmations should be considered when assessing the reliability of accounts receivable confirmations. For example, if response rates were low in prior audits, the auditor might consider obtaining evidence using alternative procedures. Finally, the intended respondents to accounts receivable confirmations may vary from individuals with little accounting knowledge to highly qualified accounting personnel in large corporations. The auditor should consider the respondent's competence, knowledge, ability, and objectivity when assessing the reliability of confirmation requests. 10-10 A positive accounts receivable confirmation requests that the customer indicate whether or not it is in agreement with the amount due to the entity stated in the confirmation. Thus, a response is required regardless of whether the customer believes that the amount is correct or incorrect. A negative confirmation requests that the customer respond only when it disagrees with the amount due to the entity. Positive confirmations are generally used when an account contains large individual balances or if errors are anticipated because control risk is assessed to be high. Negative confirmation requests are used when there are a large number of accounts with small balances, control risk is assessed to be low, and the auditor believes that the customers will devote adequate attention to the confirmation. 10-11 Other types of receivables that the auditor should examine include: • Receivables from officers and employees. • Receivables from related parties. • Notes receivable. The auditor would confirm and evaluate each type of receivable for collectibility. The transactions that result in receivables from related parties are examined to determine if they were at "arm's length." Notes receivable would also be confirmed and examined for repayment terms and whether interest income has been properly recognized. Answers to Multiple-Choice Questions 10-12 c 10-18 b 10-13 d 10-19 a 10-14 c 10-20 c 10-15 b 10-21 a 10-16 a 10-22 a 10-17 d 10-23 b Solutions to Problems 10-24 1. In applying the 5-step process, the auditor should obtain and review the final contracts. The auditor should determine that recognition of revenue on this transaction is precluded in the current period because Step 1 of the process is to identify the contracts with a customer where a contract is an agreement between two or more parties that creates enforceable rights and obligations. Thomson’s business practice requires a “signed” written sales agreement for this class of customer and the customer has not signed the final sales agreement. Thus, there is no enforceable contract, and no revenue recognition in the current year. 2. While a clear contract exists with clear performance obligations and agreed-upon transaction prices, Best Products should not recognize revenue from sales of its layaway program until delivery of the merchandise to the customer. Step 5 of the revenue process states that revenue should be recognized when the entity satisfies a performance obligation. An entity recognizes revenue when it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). Until then, the amount of cash received should be recognized as a liability. Because Best Products retains the risk of ownership of the merchandise, receives only a deposit from the customer, and does not have an enforceable right to the remainder of the purchase price, revenue cannot be recognized until goods are delivered. The auditor would need to review Best Products’ policies for the layaway plan and review a sample of customer installment notes. 3. Step 4 of the revenue process requires Dave’s to allocate the transaction price to the performance obligations in the contract. An entity typically allocates the transaction price to each performance obligation on the basis of the relative standalone selling price of each distinct good or service promised in the contract. In this case, Dave’s performance obligation is to provide members with access to shop at its stores throughout the duration of the individual membership. It would not be appropriate for Dave’s to recognize the membership fees as earned revenue upon billing or receipt of initial fee. This conclusion is based on Dave’s remaining and unfulfilled contractual obligation to perform services throughout the remaining period. The auditor would need to review Dave’s membership fee policies and examine the company’s estimate of customer cancellations. Thus, the initial receipt of the fees results in a liability of unearned revenue with the revenue recognized with the passage of time. 10-25 The following weaknesses were identified by Smith in the existing control system over cash admission fees along with the related recommendation for improvement: Weakness Recommendation 1. There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission. 1. One clerk (the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (the admission clerk) should authorize admission upon receipt of the ticket or proof of membership. 2. An independent count of paying patrons is not made. 2. The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub). 3. There is no proof of accuracy of amounts collected by the clerks. 3. Admission ticket stubs should be reconciled with cash collected by the treasurer each day. 4. Cash receipts records are not promptly prepared. 4. The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability. 5. Cash receipts are not promptly deposited. Cash should not be left undeposited for a week. 5. Cash should be deposited at least once each day. 6. There is no proof of accuracy of the amounts deposited. 6. Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes an analytical review of cash collections. 7. There is no record of the internal accountability for cash. 7. The treasurer should issue a signed receipt for all proceeds received from the collection clerk. These receipts should be maintained and periodically checked against cash collection and deposit records. 10-26 a. 1 b. 3 c. 4 d. 6 e. 5 f. 2 10-27 a. In addition to sending second requests, Signoff-On can perform the following audit procedures: • Examination of subsequent cash receipts. • Examination of the customer orders, shipping documents, and duplicate sales invoices. • Examination of other entity documentation. b. Of the three procedures listed, examination of subsequent cash receipts provides the highest quality evidence. If the customer has paid the accounts receivable, it provides strong evidence that the receivable was valid. 10-28 The working paper contains the following deficiencies: • The working paper was not initialed and dated by the audit assistant. • Negative confirmations not returned cannot be considered to be accounts "confirmed without exception." • The two positive confirmations that were sent but were unanswered are not accounted for. • There is no documentation of alternate procedures, possible scope limitation, or other working paper reference for the six accounts selected for confirmation that the client asked the auditor not to confirm. • The dollar amount and percentage of the six accounts selected for confirmation that the client asked the auditor not to confirm is omitted from the "Dollars" columns for the "Total selected for testing." • The "Dollars-Percent" for "Confirmation Requests-Negatives" is incorrectly calculated at 10 percent. • There is no indication of follow-up or cross-referencing of the account confirmed- related-party transaction. • The tick mark "‡" is used but is not explained in the tick mark legend. • There is no explanation for proposed disposition of the ten differences aggregating $12,000. • The overall conclusion reached is not appropriate. • There is no notation that a projection from the sample to the population was made. • There is no reference to second requests. • Cross-referencing is incomplete, such as the eighteen "Differences reported and resolved, no adjustment" and "Confirmation Requests" to the confirmation control schedule. 10-29 In order to determine whether lapping exists, Stanley would test the aging of accounts receivable and then: • Mail positive accounts receivable confirmation requests directly to all customers with old balances. • Investigate all exceptions noted on confirmations. • Obtain authenticated deposit slips directly from the bank. • Compare individual customers' names, dates, and amounts shown on the customer's remittance advices with the names, dates, and amounts recorded in the cash receipts journal, individual customer ledger accounts, and deposit slips (if practicable). • Verify the propriety of noncash credits to accounts receivable (e.g., sales discounts, sales returns, bad-debt write-offs). • Perform a surprise inspection of deposits. • Foot the cash receipts journal, the customers' ledger accounts, and the accounts receivable control account. • Reconcile the total of the individual customers' accounts with the accounts receivable control account. • Compare information in copies of monthly customers' statements with information in customers' ledger accounts. 10-30 In evaluating proper sales cutoff, three points should be noted: (1) The book-to-physical adjustment has already been made by the client, (2) all sales are made FOB shipping (title passes to the customer at the time the goods are shipped), and (3) goods on hand on December 31 are included in the physical inventory. a. Since the goods were shipped on December 31, they were included in the physical inventory at the end of the fiscal year. Since the sale should be recognized in the current fiscal year, the following adjustment is necessary: Cost of merchandise sold 2,000 Inventory 2,000 b. This sale is properly recorded as a current-fiscal-year sale. However, the auditor should inquire as to why there was such a delay in processing the sales invoice. c. The sale is properly recorded in the current year. d. Since the goods were not shipped until January 9, they would have been included in the physical inventory. However, the sale was recorded as a current-fiscal-year sale. Therefore, the sale should be reversed since title has not passed to the customer. The following adjusting entry should be made: Sales 4,000 Accounts receivable 4,000 e. Since this transaction is a shipment of merchandise to a consignee, no sale should be recognized. Since the goods were not on hand on December 31, the following entry is necessary: Sales 10,000 Inventory 5,600 Accounts receivable 10,000 Cost of merchandise sold 5,600 f. This sale should be recorded in the current fiscal year. Since the merchandise was shipped on December 30, it was not included in the physical inventory. Thus, the following adjusting entry is necessary: Accounts receivable 6,000 Sales 6,000 g. This transaction is correctly recorded as a sale in the next period. h. Since the merchandise was shipped on December 31, it should be recorded as a sale in the current fiscal year. It was also included in the physical inventory because it was on hand on that date. Thus, the following adjusting entry is necessary: Accounts receivable 8,000 Cost of merchandise sold 5,500 Sales 8,000 Inventory 5,500 Solutions to Discussion Cases 10-31 The listed conditions are the important criteria that should be used in evaluating any purported bill and hold sale. In some circumstances, a transaction may meet all the criteria listed but not meet the requirements for revenue recognition. In applying the above criteria to a purported bill and hold sale, the auditor should also consider the following factors and evidence related to each factor: 1. The date by which the seller expects payment, and whether it has modified its normal billing and credit terms for this buyer; 2. The seller's past experiences with, and pattern of, bill and hold transactions; 3. Whether the buyer has the expected risk of loss in the event of a decline in the market value of the goods; 4. Whether the seller's custodial risks are insurable and insured; and 5. Whether extended procedures are necessary in order to assure that there are no exceptions to the buyer's commitment to accept and pay for the goods sold, i.e., that the business reasons for the bill and hold have not introduced a contingency to the buyer's commitment. 10-32 a. Friendly Furniture carried insurance coverage for property loss at replacement value and business interruption insurance for lost production. Because the property loss is covered at replacement value, which exceeds carrying value, the recognition of both a reimbursement for costs incurred and a gain contingency should be considered. Before deciding on when to recognize proceeds from insurance coverage, it is necessary to consider whether the amount of proceeds is a gain contingency, which generally cannot be recognized under GAAP. The gain must be realized before recognition is permitted. FASB ASC Topic 450, "Contingencies," reaffirms the principle on the recognition of gain contingencies. The first issue that needs to be considered is the timing of recognition for some or all of the insurance proceeds that Friendly Furniture is entitled to and expects to receive. There is no specific guidance in the authoritative literature on when it is appropriate to recognize insurance proceeds. SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises," provides some conceptual guidance. The company will likely want to recognize the estimated proceeds from insurance coverage at the earliest possible date to offset losses, if any, from the destruction of fixed assets and inventory as well as from lost production. There are a number of points in time when the insurance proceeds may be recognized. The most conservative approach—the one likely to be least favored by the company and the least likely to be a gain contingency—would be when the proceeds are received. This would result in a cash basis of accounting and would not be supported by SFAC No. 6, "Elements of Financial Statements." The other extreme would be recognition of the insurance proceeds before verification of coverage or admission of liability by the insurance carrier. This is the most aggressive approach and the most likely to result in recognition of a gain contingency. There are two other alternatives: (1) recognition when the company has been able to determine that coverage exists and has been able to develop a minimum estimate of the amount to be recovered or (2) when the insurance carrier has admitted liability. A decision as to which of those alternatives should be used needs to be based on the company's ability to estimate the proceeds as reliably as possible. If the insurance company has admitted to a liability, Friendly Furniture would have a good basis for recognizing the minimum amounts subject to an evaluation of the reliability of the estimates and the probability of collection. One possible answer is to recognize insurance proceeds (a receivable from the insurance company) in Friendly Furniture's financial statements at June 30 in the following manner: credit a portion of business interruption insurance to cost of sales and recognize in other income a gain that consists of the estimated minimum amount that the replacement cost insurance proceeds exceed the net book value of equipment and inventory destroyed and unallocated proceeds from business interruption insurance. b. The auditor can perform the following procedures to support the amount recorded for the receivable: • Examine the inventory records, including the perpetual and physical inventory, to determine the cost of the inventory destroyed by the flood. • Examine the appraisal reports to test the fair market value of the inventory destroyed. • Examine the property, plant, and equipment subsidiary records to determine the cost (book value) of the equipment destroyed. • Examine the appraisal reports to test the fair market value of the equipment destroyed. • Examine the entity's and insurance company's calculation of the amount of income to be recognized as a result of the business interruption. Solution to Internet Assignments 10-33 It is difficult to get information directly on some of EarthWear’s competitors. Lands’ End is a public company and states that “Revenues include sales of merchandise and delivery revenues related to merchandise sold. Net revenues are reported net of estimated returns and allowances and exclude sales taxes. Estimated returns and allowances are recorded as a reduction of sales and cost of sales. The reserve for sales returns and allowances is calculated based on historical experience and future expectations and is included in Other current liabilities on the Consolidated Balance Sheets.” Eddie Bauer is part of The Spiegel Group. The Spiegel Group’s annual report states that revenue from catalog and e-commerce sales is recognized at time of shipment. Spiegel also states that it reserves for returns at the time of sale based on projected returns. Timberland reports that it recognizes revenue at the time of shipment, but there is no disclosure on returns. L.L. Bean and Patagonia are privately held companies and there are no publicly available financial statements. 10-34 A search of the SEC’s website should identify a recent company that has been cited by the SEC for revenue recognition issues. Chapter 11 Auditing The Purchasing Process Answers to Review Questions 11-1 Expenses can be classified into three categories: 1. Product costs are expenses that can be matched directly with specific transactions or events and are recognized upon recognition of the revenues. An example of a product cost would be the expensing of inventory through cost of goods sold. 2. Period costs are expenses that are recognized during the period in which cash is spent or liabilities incurred for goods and services that are used up at that time or shortly thereafter. Such expenses cannot be directly related to specific transactions and are assumed to provide no future benefit. Examples of such expenses are administrative salaries, rent expense, and interest expense. 3. Allocable costs are allocated by systematic and rational procedures to the periods during which the related assets are expected to provide benefits. Depreciation of plant and equipment is an example of such an expense. 11-2 The three types of transactions that are processed through the purchasing process are: • Purchase of goods and services for cash or credit • Payment of the liabilities arising from such purchases • Return of goods to suppliers for cash or credit The more common accounts affected by each major type of transaction are: Purchase transaction: • Accounts payable • Inventory • Purchases or cost of goods sold • Various asset and expense accounts Cash disbursement transaction: • Cash • Accounts payable • Cash discounts Purchase return transaction: • Purchase returns • Purchase allowances • Accounts payable • Various asset and expense accounts 11-3 A purchase requisition is a request for goods and services by an authorized individual or department within the entity. A purchase order contains the description, quality, quantity, and other information on the goods and services being purchased. A receiving report is used to record the receipt of goods. A vendor invoice is the bill from the vendor that includes the description and quantity of the goods shipped or services provided, the price including freight, the terms of trade including cash discounts, and the date billed. A voucher is a document that is frequently used by entities to control the payment of acquired goods and services. An entity would combine all these documents into a "voucher packet" because such a packet would contain all the information on a particular purchase transaction. If there are questions about the transaction at a later time, the entity can obtain access to all the documents and information more easily. 11-4 The key segregation of duties and the errors or fraud that can occur if such duties are not segregated are: Segregation of Duties Possible Errors or Fraud Resulting from Conflicts of Duties The purchasing function should be segregated from the requisitioning and receiving functions. Theft of goods and possible payment for unauthorized purchases. The invoice-processing function should be segregated from the accounts payable function. Overpayment for goods and services or theft of cash. The disbursement function should be segregated from the accounts payable function. Theft of cash. The accounts payable function should be segregated from the general ledger function. A defalcation that would normally be detected by reconciling subsidiary records with the general ledger control account. 11-5 Two inherent risk factors that directly affect the purchasing process are (1) industry-related factors, and (2) misstatements detected in prior audits. If the entity deals with a large number of vendors and prices tend to be relatively stable, there is less risk that the entity's operations will be affected by raw-material shortages or that production costs will be difficult to control. However, if an entity is dependent on a single vendor to supply a critical component and the vendor is unable to provide the component, the entity may suffer production shortages and shipping delays that significantly affect financial performance. Additionally, industries that use commodities such as oil, coal, and precious metals may be subject to both shortages and price instability that significantly affect their financial results. The presence of misstatements in previous audits is a good indicator that misstatements are likely to be present during the current audit. If misstatements were present in previous audits, the auditor should assess inherent risk to be high. 11-6 The following controls and related tests are utilized to ensure that the occurrence, authorization, and completeness assertions are met for purchase transactions: Assertion Control Activity Tests of Controls Occurrence Segregation of duties Purchase not recorded without approved purchase order and receiving report Accounting for numerical sequences of receiving reports and vouchers Observe and evaluate proper segregation of duties. Test of a sample of vouchers for the presence of an authorized purchase order and receiving report; if IT application, examine application controls; if data are available and reliable, use audit data analytics to match the population of vouchers to related purchase orders and receiving reports. Review and test entity procedures for accounting for numerical sequence of receiving reports and vouchers; if IT application, examine application controls. Authorization Approval of acquisitions consistent with the entity's authorization dollar limits Approved purchase requisition and purchase order Competitive bidding procedures followed Review entity's dollar limits authorization for acquisitions. Examine purchase requisitions or purchase orders for proper approval; if IT is used for automatic ordering, examination of application controls. Review entity's competitive bidding procedures. Completeness Accounting for numerical sequences of purchase orders, receiving reports, and vouchers Receiving report matched to vendor invoices and entered in purchases journal Review and test entity's procedures for accounting for numerical sequence of purchase orders, receiving report, and vouchers; if IT application, examine application controls. Trace a sample of receiving reports to their respective vendor invoices and vouchers. If data are available and reliable, use audit data analytic to trace the population of receiving reports to the related invoices. Disclosure checklist Trace a sample of vouchers to the purchases journal. Review financial statement disclosure checklist. 11-7 CAATs can be used to test numerous controls in the purchasing process. For example, a generalized audit software package can be used to account for the numerical sequence of purchase orders, receiving reports, and vouchers. Another example involves the use of a CAAT to test programmed controls over approval of purchase orders when IT is used for automatic ordering (e.g., electronic data interchange). 11-8 The analytical procedures that can be used to test accounts payable and accrued expenses and the possible misstatements that can be detected by each analytical procedure are: Substantive Analytical Procedure Possible Misstatement Detected Compare payable turnover and days outstanding in accounts payable with previous years’ and industry data. Compare current-year balances in accounts payable and accruals with prior years' balances. Compare amounts owed to individual vendors in the current year's accounts payable listing to amounts owed in prior years. Compare purchase returns and allowances as a percentage of revenue or cost of sales to prior years' and industry data. Under- or overstatement of liabilities and expenses Under- or overstatement of liabilities and expenses Under- or overstatement of liabilities and expenses Under- or overstatement of purchase returns 11-9 The following audit procedures may be used as part of the search for unrecorded liabilities: • Ask management about control activities used to identify unrecorded liabilities and accruals at the end of an accounting period. • Obtain copies of vendors' monthly statements and reconcile the amount to the entity's accounts payable records. • Confirm vendor accounts, including accounts with small or zero balances. • Vouch large dollar items from the purchases journal and cash disbursements journal for a limited time after year-end; examine the dates on each receiving report or vendor's invoice to determine if the liability relates to the current audit period. • Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any unrecorded liabilities. 11-10 The following are examples of disclosures for the purchasing process and related accounts: • Payables by type (trade, officers, employee, affiliate, etc.). • Short- and long-term payables. • Long-term purchase contracts, including any unusual or adverse purchase commitments. • Purchases from and payables to related parties. • Dependence on a single vendor or small number of vendors. • Costs by reportable segment of the business. 11-11 Accounts payable confirmations are generally used less frequently than accounts receivable confirmations because the auditor can test accounts payable by examining vendor invoices and monthly vendor statements. Since these documents originate from sources external to the entity, this evidence is viewed as reliable. Accounts payable confirmations primarily provide evidence on the completeness assertion, while accounts receivable confirmations primarily provide information on the validity (occurrence/existence) assertion. When confirming accounts payable, auditors generally use a form of positive confirmation referred to as a "blank or zero-balance" confirmation. This type of positive confirmation does not state the balance owed. Instead, the confirmation requests that the recipient fill in the amount or furnish other information. Both positive and negative confirmations are used for accounts receivable. Lastly, accounts payable confirmations are generally mailed at year-end rather than at an interim date because of the auditor's concerns about unrecorded liabilities. Accounts receivable confirmations are sent at both dates. 11-12 Some of the typical procedures that might be applied to the audit of the tax provision by the auditors and/or tax specialist include: • Compare the size and trend in the tax provision and related balance sheet accounts over time. • Perform walkthroughs and test the design and operating effectiveness of internal controls over the income tax provision (required for an integrated audit). Identify issues that should be given particular attention in substantive testing and evaluate the entity’s documentation. • Document the testing performed to evaluate the design and operating effectiveness of internal controls over the income tax process (primarily integrated audits). • Test the mathematical accuracy of the computations supporting the tax provision and related balance sheet accounts and vouch underlying data to supporting documentation. • Identify and test significant permanent and temporary differences in the tax provision calculation. • Review and evaluate management’s position on significant uncertain tax positions for appropriate disclosure and accounting under FASB ASC Topic 740. • Consider the realizability of net deferred tax assets and adequacy of related valuation allowances. • Test the reconciliation of income taxes payable, deferred income tax assets/liabilities (including any related valuation allowances), and tax liabilities to supporting documentation, including the general ledger, financial statements, and related footnote disclosure. • Ensure proper documentation in the audit working papers to allow for reperformance of the audit procedures applied to the tax accounts. Answers to Multiple-Choice Questions 11-13 c 11-19 c 11-14 c 11-20 d 11-15 b 11-21 c 11-16 d 11-22 c 11-17 b 11-23 a 11-18 b Solutions to Problems 11-24 This is a relatively straightforward analytical procedures problem. Here are some of the concerns the auditor might have about potential misstatements in both accounts: • Both inventory and accounts payable have increased significantly in absolute dollar terms from 2017 to 2018. • The inventory increase is 69 percent, while the accounts payable increase is 28 percent. • An auditor would have expected the increase in inventory to be approximately the same as the increase in accounts payable. • Based on the auditor’s expectations and the entity’s data, the auditor might suspect that there are at least two possible misstatements: (1) inventory is overstated because obsolete and/or slow-moving products have not been written down to fair market value and (2) there are unrecorded accounts payable. Other misstatements are possible. 11-25 The internal control activities that most likely would provide reasonable assurance that specific control objectives for management assertions regarding purchases and accounts payable will be achieved are: • The purchasing, receiving, and accounts payable functions are segregated. Requisitioning Department: • Proper authorization of requisitions by department head is required before purchase orders are prepared. • The requisitioning department head independently verifies the quantity and quality of the goods received. Purchasing Department: • The purchasing department ensures that requisitions are within budget limits before purchase orders are prepared. • The adequacy of each vendor's past record as a supplier is verified. Receiving Department: • Secure facilities limit access to the goods during the receiving activity. • The receiving department makes a blind count of the goods received, independently of any other department. Accounts Payable Department: • Requisitions, purchase orders, and receiving reports are matched with vendor invoices as to quantity and price. • The accounts payable department recomputes the mathematical accuracy of each invoice. • The voucher register is independently reconciled to the control accounts monthly. • All supporting documentation is required for payments and is made available to the treasurer. 11-26 a. The flowchart for Kida Company is shown below: b. Kida Company's major internal control weaknesses are: Purchasing: • The buyer does not verify that the department head's request is within budget limitations. • No procedures have been established to ensure that the best price is obtained. Large- dollar requisitions should be ordered after receiving quotes and/or sealed bids. • Prior to placing an order, the buyer does not determine the adequacy of the vendor's past record as a supplier to Kida. Receiving: • Receiving clerk does not make blind counts for all special equipment or at least for large-dollar items. • Written notice of equipment received is not sent to the purchasing department. • Written notice of equipment received is not sent to accounts payable department. Accounts Payable: • The mathematical accuracy of the invoice is not recomputed. • Invoice quantity is not compared with a report of quantity received. • Notification of the acceptability of the equipment from the requisitioning department is not obtained before the payable is recorded. • No alphabetic file of vendors from which purchases are made is maintained. Treasurer: • Documentation supporting the checks is not sent by the accounts payable department to the cashier in order for the cashier or treasurer to be assured that the check is for properly authorized and received equipment. • Checks for large-dollar purchases are not signed by two officers of Kida Company to ensure that material expenditures are proper. • All documentation to support a check is not canceled by the check signer and returned to the accounts payable department. • The cashier alone has custody of the key, the signature plate, and record of usage. • The controller is authorized to sign checks. 11-27 1. Test of details of transactions (substantive test of transactions). 2. Tests of details of transactions (cutoff test). 3. Tests of details of account balances. 4. Analytical procedure. 5. Tests of details of account balances. 6. Analytical procedure. 11-28 The substantive audit procedures Coltrane should apply to Jang's trade accounts payable balances include the following: • Foot the schedule of the trade accounts payable. • Agree the total of the schedule to the general ledger trial balance. • Compare a sample of individual account balances from the schedule with the accounts payable subsidiary ledger. • Compare a sample of individual account balances from the accounts payable subsidiary ledger with the schedule. • Investigate and discuss with management any old or disputed payables. • Investigate debit balances and, if significant, consider requesting positive confirmations and propose reclassification of the amounts. • Review the minutes of the board of directors' meetings and any written agreements and inquire of key employees as to whether any assets are pledged to collateralize payables. • Perform cutoff tests. • Perform analytical procedures. Confirm or verify recorded accounts payable balances by: • Reviewing the voucher register or subsidiary accounts payable ledger and consider confirming payables for a sample of vendors. • Requesting a sample of vendors to provide statements of account balances as of the date selected. • Investigating and reconciling differences discovered during the confirmation procedures. • Testing a sample of unconfirmed balances by examining the related vouchers, invoices, purchase orders, and receiving reports. Perform a search for unrecorded liabilities by: • Examining files of receiving reports unmatched with vendors' invoices and searching for items received before the balance sheet date but not yet billed or on the schedule. • Inspecting files of unprocessed invoices, purchase orders, and vendors' statements. • Reviewing support for the cash disbursements journal, the voucher register, or canceled checks for disbursements after the balance sheet date to identify transactions that should have been recorded at the balance sheet date but were not. • Inquiring of key employees about additional sources of unprocessed invoices or other trade payables. 11-29 a. 3 b. 4 c. 5 d. 1 11-30 a. No adjustment is needed. The goods were received before December 31, 2018 and recorded in the Purchases Journal in December. b. An adjustment is required. The $45,000 payment covers a 3-month period starting on December 1, 2018. The total amount was charged to consulting expenses, while only 1 month of services was used by year-end. The entry to correct is: Prepaid Consulting Expenses 30,000 Consulting Expenses 30,000 c. No adjustment is needed. The goods were received before December 31, 2018 and recorded in the Purchases Journal in December. d. No adjustment is needed. The forklift was received in 2019 as evidenced by RR# 49746 and recorded in the Purchases Journal in January. e. An adjustment is required. The paper products were received in December 2018 as evidenced by the RR# 49743 (RR #49745 is the last receiving report in December). Thus, these goods should have been recorded in December 2018. The entry to correct is: Supplies 42,000 Accounts Payable 42,000 f. An adjustment is required. The telephone bill applies to December 2018 and the $32,450 should be an accrued expense. The entry to correct is: Telephone expense 32,450 Accrued Expenses 32,450 Solution to Discussion Case 11-31 a. The accounts payable audit procedures should be directed toward searching for proper inclusion of all accounts payable and ascertaining that recorded amounts are reasonably stated because the primary audit purpose is to reveal any possible material understatements. The principal objectives of the accounts payable examination are: 1. To determine adequacy of internal control for processing and payment of invoices. 2. To prove that amounts shown on the balance sheet are in agreement with supporting accounting records. 3. To determine that liabilities existing at the balance sheet date have been reconciled. b. Mincin is not required to use accounts payable confirmation procedures. The auditor, with three exceptions, is required to obtain direct confirmation of accounts receivable, since the primary audit test is for possible material overstatements and generally the entity has available only internal documents such as sales invoices. For accounts payable, however, the auditor can examine external evidence such as vendor invoices and vendor statements that substantiate the accounts payable balance. Although not required, the accounts payable confirmation is often used. The auditor might consider such use when: 1. Internal controls are weak. 2. The company is in a "tight" cash position and bill paying is slow. 3. Physical inventories exceed general ledger inventory balances by significant amounts. 4. Certain vendors do not send statements. 5. Vendor accounts are pledged by assets. 6. Vendor accounts include unusual transactions. 7. Change in personnel or management behavior related to payables. c. A selection technique using the large dollar balances of accounts is generally used when the primary audit objective is to test for overstatements (e.g., accounts receivable audit work). Accounts with zero balances or relatively small balances would not be subjected to selection under such an approach. When auditing accounts payable, the auditor is primarily concerned with the possibility of unrecorded payables or understatement of recorded payables. Selection of accounts with relatively small or no balances for confirmation is the more efficient direction of testing, since understatements are more likely to be detected when examining such accounts. When selecting accounts payable for confirmation, the following procedures could be followed: 1. Analyze the accounts payable population and stratify it into accounts with large balances, accounts with small balances, accounts with zero balances, etc. 2. Use a sampling technique that selects items based on criteria other than the dollar amount of the items (e.g., select based on terminal digits, select every nth item based on predetermined interval, etc.). 3. Design a statistical sampling plan that will place more emphasis on selecting accounts with zero balances or relatively small balances, particularly when the entity has had substantial transactions with such vendors during the year. 4. Select prior-year vendors who are no longer used. 5. Select new vendors used in the subsequent period. 6. Select vendors that do not provide periodic statements. 7. Select accounts reflecting unusual transactions during the year. 8. Select accounts secured by pledged assets. Solution to Internet Assignments 11-32 It may be difficult to get information directly on some of EarthWear’s competitors. Lands’ End and Timberland are publicly traded companies. Eddie Bauer, L.L. Bean and Patagonia are privately held companies and there are no publicly available financial statements. 11-33 A search of the SEC’s website should identify a recent company that has been cited by the SEC for issues related to the recognition of expenses. Solution Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312