CH-7-8 Fraud Risk Assessment – Auditing: An International Approach : Book Guide

This Document Contains Chapters 7 to 8 CHAPTER 7 Fraud Risk Assessment SOLUTIONS FOR REVIEW CHECKPOINTS 17-1 White collar crime is fraud perpetrated by people who work in offices and steal with a pencil or a computer terminal. The contrast is violent street crime. Employee fraud is the use of fraudulent means to take money or other property from an employer. It consists of three phases: (1) the fraudulent act, (2) the conversion of the money or property to the fraudster's use, and (3) the coverup. Embezzlement is a type of fraud involving employees' or nonemployees' wrongfully taking money or property entrusted to their care, custody, and control, often accompanied by false accounting entries and other forms of lying and coverup. Defalcation is another name for employee fraud and embezzlement. Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements. Irregularities are intentional misstatements or omissions in financial statements, including fraudulent financial reporting (management fraud) and misappropriations of assets (defalcations). Direct-effect illegal acts are violations of laws or government regulations by the company or its management or employees that produce direct and material effects on dollar amounts in financial statements. "Illegal acts" (far- removed) are violations of laws and regulations that are far removed from financial statement effects (for example, violations relating to insider securities trading, occupational health and safety, food and drug administration, environmental protection, and equal employment opportunity). 17-2 Fraud perpetrators look like other people, hence the difficulty in spotting them easily. However, the sometimes exhibit behavioral red flags of odd habits. 17-3 Canadian auditing standards require: (a) understanding and awareness of signs of errors, fraud , and illegal acts (b) design the audit to provide reasonable assurance of detecting material errors and fraud, but the expectation is lower for illegal acts, where audit procedures require inquiry and familiarity, auditors should make inquiries about management's policies and procedures for compliance with laws and regulations and obtain written management representations concerning the absence of violations of laws and regulations. but further procedures would be performed only when specific information indicates that possible illegal acts may have a material effect on financial statements. (c) auditors should have the proper degree of professional skepticism, not assuming honesty of management; (d) for reporting, the materiality concept is different: (1) for errors, the usual idea of materiality prevails, (2) for fraud matters that are considered ‘trivial’ can be reported to levels of management below the board of directors and audit committee. More important matters go to the director level, and management involvement in fraud or illegal acts is never considered inconsequential. 17-4 Egocentric Motivations My father was wealthy, and I need to be wealthy too. My friends admire cars, and I need to have an expensive one. Ideological motivations: The company sells tobacco and alcohol, and doesn't deserve to make a profit. I can award the government housing grants to best use without the red tape. (Justifying diversion of funds in government housing programs Economic Motivations Pay college tuition Pay hospital bills for a parent with cancer Pay gambling debts Pay for drugs Pay alimony and child support Pay for high life style (homes, cars, boats) Finance business or stock speculation losses Report good financial results 17-5 Related directly to employee fraud: Nobody counts the inventory, so losses are not known The petty cash box is often left unattended Supervisors set a bad example by taking supplies home Upper management considered a written statement of ethics but decided not to publish one Another employee was caught and fired, but not prosecuted The finance vice-president has investment authority without any review Frequent emergency jobs leave a lot of excess material just laying around Related to financial reporting fraud: This is a temporary cash shortage The loan agreement is too tight anyway The shareholders will suffer if we declare bankruptcy I'll lose my executive job if the company fails 17-6 Rationalizations: I need it more than the other person (Robin Hood theory) I'm borrowing the money and will pay it back Nobody will get hurt The company is big enough to afford it A successful image is the name of the game Everybody is doing it The second part of the question is intended to stimulate class discussion. 17-7 The person could create fictitious medical claims to fictitious doctors and hospitals, cause the company to issue payments, intercept the payments (have them sent to P.O. boxes or accomplices' addresses), and convert the money to personal use. 17-8 The inventory warehouse manager responsible for taking physical inventory and reconciling to perpetual inventory records could cover up his own mistakes (including theft) and "fix the records" permanently. He could report "adjustments," and thus effectively make a one-sided entry in the accounts to cause the difference pop out as "shrinkage" or "damage" loss. 17.9 The former petty cash custodian apparently had more expenditures than the new one. Maybe the former one was running false expense claims. 17-10 No separation of these duties and responsibilities: (1) transaction authorization, (2) recordkeeping, (3) custody of, or access to, assets, and (4) reconciliation of actual assets to the accounting records. A supervisor may not take approval responsibilities seriously and fail to perform them (like the supervisor of the petty cash custodian in the text case). Tight control may be too expensive and simply not performed. The payroll employee who has responsibility for preparing personnel files for new hires, approval of wages, verification of time cards, and distribution of payroll checks can "hire" fictitious employees, fake their records, and order checks through the payroll system. Managers can override controls and order people to ship bricks (as in the text case) or manipulate records to create false numbers from a position of accounting authority (inventory falsification text case). 17-11 There would be a cash debit that never got deposited in the bank. Audit of the bank reconciliation should reveal the discrepancy. 17-12 The three general descriptions are: (1) overstating revenues and assets, (2) understating expenses and liabilities, and (3) giving disclosures that are misleading or omit important information. For some further examples, Merchant gives this typology of fraudulent financial reporting ploys (Merchant, K.A., Fraudulent and Questionable Financial Reporting: A Corporate Perspective (Morristown: Financial Executives Research Foundation, 1987), p. 5) Type of Fraud Examples Manipulating, falsifying or altering records or documents Changing dates on supplier invoices to delay expense recording Changing dates on shipping documents to record sales early Changing invoice amounts to understate recorded expenses Creating false inventory count sheets Suppressing or omitting transactions Failing to record supplier invoices at year end Recording transactions without substance Creating fictitious customer orders Misapplying accounting principles Capitalizing costs that should be expenses according to GAAP Recognizing revenue on sales for which a significant risk of return exists Purposely recording inadequate reserves estimates to show a predetermined (target) income Recording prepayments as current expenses to understate income Failing to disclose significant information Concealing an impairment in the value of certain assets Concealing pending litigation Not reporting a change in accounting policy 17-13 Compare the amount written on the cheque with the bank's magnetic imprint of the amount paid by the bank. 17-14 The company has no control to test for invalid social insurance numbers. Consider the following example showing the check digit feature of SINs: What's wrong with 585-671-234: The first three digits, 585, may not be fictitious, but this number was issued in New Brunswick, not Alberta where Byron Middleton is said to have been born (Number could have been issued later in New Brunswick.); but the middle two digits are false because (1) no odd numbers above 67 have been issued for New Brunswick, and (2) since this number ought to have been issued before 1965 (when "Middleton" was 15 years old), middle digits greater than 100 should have been even numbers, not odd (71). 17-15 Two endorsements may indicate that the payee of the cheque is not the party that received the benefit of the cheque payment. The payee may be fictitious. 17-16 Medical and life insurance: fictitious employees will not have elected these insurance coverages, though most real employees would. Social insurance numbers: fictitious employees often have false or unlikely numbers made up by the fraudster. Addresses: fictitious employees may have the same address as a real employee or the same address as other fictitious employees, multiple employees at the same address is the tipoff. 17-17 (1) If the employees cannot be found, maybe they do not exist. The names are odd. All the first and last names begin with the same letter. (2) If Eloise Garfunkle is a company employee, somehow she cashed a check payable to a supplier. Maybe she is related to the supplier, or maybe she intercepted the check before it reached the supplier. (3) Somebody is working on holidays! These dates are normal workdays off for most businesses: New Year's Day, Victoria day, Canada Day, Labour Day, Thanksgiving Day, Christmas Day. 17-18 To audit for fictitious sales, audit the account(s) that could hold the "dangling debit" -- cash and accounts receivable. SOLUTIONS FOR EXERCISES AND PROBLEMS EP7-1 Give Examples of Errors and Frauds Students can probably think of many examples for each of the cases. This solution does not purport to be exhaustive. a. Overstate an asset, understate another asset Hold cash receipts journal open past the year end (cutoff date) and record too much cash, reducing accounts receivable. b. Overstate an asset, overstate stockholder equity Record appraised value of property, plant, and equipment, with a corresponding credit to a capital account. c. Overstate an asset, overstate revenue ⸀ Hold the sales journal open past the year end (cutoff date) and record too much sales revenue and cash or accounts receivable. ⸀ Record fictitious sales and accounts receivable. d. Overstate an asset, understate an expense ⸀ Capitalize maintenance expense, making the asset amount higher than warranted and the expense amount lower. Subsequent depreciation would reverse this misstatement, but the first effect would be to overstate the asset and understate the expense. ⸀ Record an expenditure as a prepaid expense instead of a current expense. e. Overstate a liability, overstate an expense Accrue too much liability for expenses not yet paid, such as wages, rent, interest, product warranties, etc. f. Understate an asset, overstate an expense ⸀ Calculate too much depreciation expense on assets. ⸀ Classify expenditures as current expenses when they should be classified as prepaid expenses. g. Understate a liability, understate an expense Fail to accrue liabilities for expenses not yet paid, such as wages, rent, interest, product warranties, etc. EP7-2 Overall Analysis of Accounting Estimates The company has fudged the writeoffs toward being as small as possible, hoping to satisfy the auditors. Taken one at a time, only the uncertainty about the deferred subscription costs is large enough to break the materiality threshold. But the set of problems cannot be taken one at a time. Here is a suggested low-high audit estimate: Low Estimate High Estimate Write-off deferred subscription costs (1) $ 6,000,000 $12,000,000 Provide allowance for bad debts (2) $ 4,000,000 $ 4,000,000 Provide for expected warranty expense (3) $ 2,000,000 $ 6,000,000 Lower of cost or market inventory writedown (4) $ 5,600,000 $ 5,600,000 Loss on government contract refund (5) $ 1,000,000 $ 2,000,000 Total write-offs and losses $18,600,000 $29,600,000 (1) The low estimate gives benefit of doubt to survival of the business, writing off half the deferred costs as if one-half might be written off over the next two years. The company seems to have taken the 50% probability ($6 million) and allocated half to each of the two years. (2) The company seems ready to provide allowance for all the doubtful accounts receivable. (3) Not much information for an auditor (such as a probability distribution). (4) It looks like the company plans to rebuild the inventory and recover as much as it can, namely the $4,400,000 that can be realized from selling the rebuilt parts, but the lower of cost or market was figured incorrectly. The company seems to have subtracted the selling price ($8 million) from the inventory cost ($10 million) to get the $2 million writedown. The correct calculation is: Net Realizable Value: Selling price proceeds $ 8,000,000 Cost to rebuild (2,000,000) Cost to market and ship (20% x $8 million) (1,600,000) Ceiling (net realizable value) $ 4,400,000 Floor, Subtract "normal profit" (5% x $8 million) ( 400,000) Floor $ 4,000,000 The "market" for lower of cost or market is NRV = $4,400,000, and the inventory writedown is $10 million - $4,400,000 = $5,600,000. Sale of the rebuilt parts will produce zero profit in subsequent period(s): Selling price $ 8,000,000 Inventory sold (written-down cost) $4,400,000 Rebuilding cost 2,000,000 Total cost of goods sold (6,400,000) Cost to market and ship (1,600,000) Profit -0- (5) For a contingency such as this government contract dispute, GAAP(ASPE) suggests recognizing loss at the lower end of a range for loss, so a $1 million loss provision would satisfy GAAP. IAS 37 would require establishing a provision for this amount since it is acknowledged the amount will be owing to the government and a reasonable estimate is available. Recommended Adjustment: Management's suggestion of $11,000,000 cost/loss recognition is not sufficient. It "leaves" $7,600,000 income overstatement, even using the auditors' low estimate of $18,600,000. Even booking the low estimate "leaves" $10,000,000 unrecognized (including the government contract contingency at $1 million instead of $2 million). The minimum adjustment, given the limited information available in this problem, is below. Adequate disclosures should be made about the $6 million deferred subscription costs remaining and the prospects for the business, and about the warranty expense estimate, since these are the items that leave uncertain assets and liabilities in the financial statements. Debit Credit Subscription expense $ 6,000,000 Bad debt expense $ 4,000,000 Warranty expense $ 2,000,000 Cost of goods sold $ 5,600,000 Government contract loss $ 1,000,000 Deferred subscription costs $ 6,000,000 Allowance for doubtful accounts $ 4,000,000 Estimated warranty liability $ 2,000,000 Inventory $ 5,600,000 Estimated liability on contract $ 1,000,000 EP7-3 Select Effective Extended Procedures These procedures are offered without explanation of the information that might be discovered. For each one, a confirmation of the suspicion might arise. One definite instance is enough to justify proceeding with an investigation (real fraud examination), but failure to find confirming evidence can mean (1) nothing wrong is going on, or (2) the crook is too clever for the auditor. All of these procedures should be conducted with care not to falsely impugn the integrity of the people under investigation. a. Count the petty cash fund on Friday morning in the presence of the supervisor and custodian of the fund. Then, perform a second surprise count Friday afternoon before the custodian leaves work for the day. b. Ask the local Better Business Bureau for reports on the eight new vendors. Ask the local Chamber of Commerce if they are members. Look them up in the telephone book. Telephone them, asking about business hours, product availability, and other matters. but not in a way to arouse suspicion of investigation. Visit the business location (telephone book address) to browse. Go to the local tax assessor-collector office files to look up the owner of the property where the businesses are located. If any of the new vendors are professional people, look them up in government licensing agency directories (e.g. PAs, lawyers, doctors). Go to the Ministry of Industry and Trade and look up the corporate charter to see if the purchasing agent is shown as an incorporator, officer, or director (if a large company, you can use the Standard & Poor's Register of Corporations, Directors, and Executives). Look them up in the provincial, regional or county "assumed name" files for real names. Write a cheque to each business, and use the canceled cheque to identify the businesses' banks; then get one of the purchasing agent's canceled payroll cheque to see whether they all bank at the same place. (This is circumstantial evidence that needs more work, but it would be an unlikely coincidence in most cases if all of them had accounts at the same bank.) Avoid approaching the chief purchasing agent with inquiries about the new vendor approval process because you might alert the person to the investigation. c. Select the people who have quit and determine their termination dates. In the payroll records, find the identification of their last paycheques (cheque number), then find the canceled cheques and examine the endorsement, looking for two endorsements, one of which might be the payroll supervisor. Contact the terminated employees on the pretext of an exit conversation, and inquire whether they received all their paycheques, being sure to identify the last period or severance pay provision for them. d. Add the customers' subsidiary accounts and compare to the general ledger control account. If clerks are giving customers proper credit in their subsidiary accounts but not depositing the money and enabling the accounting system to credit the control account, they may be out of balance. If you can identify suspicious accounts, ask the customers to give you originals or copies of their canceled cheques so you can examine the endorsements to see whether they appear to have been negotiated by a company employee. e. Use the cash receipts journal date and the deposit date at the bank to see whether there is a pattern of delay that could indicate the cashier is holding the deposits. Last resort is a surprise cash count at the cashier's desk to see whether cash on hand is actually on hand. EP7-4 Horizontal and Vertical Analysis Horizontal analysis refers to changes of financial statement numbers and ratios across several years. Vertical analysis refers to financial statement amounts expressed each year as proportions of a base such as sales for the income statement accounts and total assets for the balance sheet accounts. Auditors look for relationships that do not make sense as indicators of potential large misstatement and fraud. MEMO TO: Current Working Paper File FROM: Auditor DATE: dd/mm/yy SUBJECT: Retail Company audit--preliminary analytical review Revenue and Current Ratio Sales decreased 10%, and the company may be tempted to misstate accounts in order to avoid reporting an income decrease. The requirement to maintain a 2:1 current ratio presents temptation to overstate current asset accounts and understate current liability accounts. Sales, Sales Returns, and Accounts Receivable Both sales and accounts receivable are down. The days' sales in receivables and receivables turnover ratios confirm the relative decrease. The allowance for doubtful accounts ratio is approximately in line with last year. Even though the sales decline might tempt people to record invalid sales, there is not much room to hide them in accounts receivable. If the allowance for doubtful accounts should be 8%, as last year, the allowance should be $32,000, indicating a $2,000 understatement in the allowance and $2,000 overstatement of net realizable value of accounts receivable. Inventory and Cost of Goods Sold Cost of goods sold as a percent of sales is down from 70 percent to about 65 percent. If 70 percent is more accurate, cost of goods sold might be understated by $405,000, or almost 76 percent of the $530,000 operating income (before taxes, interest expense, and other revenue and expense). The related inventory accounts may therefore be overstated, perhaps as much as $405,000. The trial balance shows inventory increased $440,000 (29 percent). The days' sales in inventory and inventory turnover ratios confirm the relative increase of inventory dollars. We should audit the physical inventory and inventory pricing carefully. Accruals and Expenses The depreciation expense is the same as last year, but $1,000,000 new assets are in the Equipment account. We need to recalculate depreciation expense. Either the company forgot to record depreciation on new assets, the assets are fictitious and have not been put on the depreciation schedule, or the assets were acquired so late in the year that fractional depreciation is immaterial. Interest expense on the new bank loan appears not to have been paid or accrued. The interest expense in the trial balance seems to be interest on the long term debt at 10 percent. According to the problem information, interest since July 1 at 11% on $750,000 (expense = $41,250) should have been recorded. Other accruals are smaller than last year, and general expenses are only slightly lower. Maybe some accrued expenses did not get recorded. We need to be sure to conduct the search for unrecorded liabilities and expenses. If the ratio of accruals to expense for last year (0.03) is relevant for this year, the accruals should be about $60,000 instead of $10,000. Liabilities It looks like there was an error in the prior year audited financial statements. $100,000 of the long-term debt should have been classified as "current portion of long-term debt." None is classified as a current liability in the current year unaudited financial statements. Retained Earnings We were told that no dividends have been declared or paid, but the ending retained earnings is not equal to the beginning retained earnings plus net income. There is a $100,000 discrepancy that could be dividends, a prior period adjustment, or a loss improperly debited to retained earnings. Maybe the books just do not balance! A constructed cash flow statement (attached) shows an unexplained $100,000 cash "shortage." Maybe a loss or expense was debited directly to retained earnings. Going Concern Consideration The company appears to have used operating cash flow and new bank loans ($750,000) to finance asset purchases ($1,000,000) and long term debt repayment ($100,000). Current liabilities increased much more than current assets (inventory increase), and the current ratio declined from 4.57 to 2.00. Likewise the total debt to equity ratio increased from .35 to .56. Overstatement of the inventory, omission of accrued expenses, and misclassification of the current portion of long term debt would cause the current ratio to be 2:1, exactly as required by the loan agreement, instead of less than 2:1. The existence of the loan agreement requirement make the risk of misstatement higher under these conditions. While the company does not seem to be in dire financial straits, we ought to review the cash flow budget for next year. EP7-4 (attachments) Retail Company Cash Flow Statement Operations: Net income $ 294,000 Depreciation 300,000 Decrease net accounts receivable 90,000 Increase inventory (440,000) Increase accounts payable 150,000 Decrease accruals ( 60,000) Cash Flow from Operations $ 334,000 Investing Activities: Additions to fixed assets (1,000,000) Financing Activities: New loan acquisition $ 750,000 Debt repayment (100,000) Financing Cash Flow 650,000 Net Cash Increase $ ( 16,000) Beginning Cash Balance 600,000 Ending Cash Balance $ 584,000 Reported Cash Balance 484,000 Unexplained Cash Difference $ 100,000 Retail Company Summary of Potential Problems Current Current Income Assets Liabilities Reported (unaudited) $ 294,000 $ 2,794,000 $ 1,400,000 Added bad debt allowance ( 2,000) ( 2,000) Overstated inventory (405,000) ( 405,000) Interest accrual ( 41,250) 41,250 Expense accrual ( 50,000) 50,000 Depreciation expense (100,000) Unidentified RE debit (100,000) Reclassify long term debt 100,000 Income tax reduction* 279,300 279,300 Adjusted $(124,950) $ 2,666,300 $ 1,591,250 Adjusted current ratio 1.6851 * Refund of taxes paid plus refund from tax loss carryback. SOLUTIONS FOR DISCUSSION CASES DC7-1 Famous Fraud Cases Analysis Discussion Cases These cases are best done as group projects. Good starting points are Google search engine at www.google.ca and The Wikipedia at http://en.wikipedia.org using the company name in the search. Here we outline a solution for the most notorious case, Enron, which was successfully prosecuted in June 2006. a. The fraud was detected via an SEC investigation which led to U.S. federal prosecution and trial that ended in June 2006. Evidence presented at trial indicates there were suspicions of questionable reporting at Enron well before it failed. A surprisingly rich source for first hand information on Enron can be found in the thousands of pages of trial transcripts at http://www.kenlayinfo.com/public/pag149.aspx. b. According to the jury conclusion the fraud was perpetrated by management misleading the auditors and issuing fraudulent public statements and fraudulent financial reports. But perhaps what is most interesting about this case was that management was able to find 2 prominent, high profile expert accounting witnesses to testify under oath that Enron’s accounting was in conformity with GAAP. For extensive testimony on this read the May 2,3,and 4, 2006 testimony by Jerry Arnold and Walter Rush (about 900 pages of transcript)at the above website. It appears that the jury was more swayed by the prosecution attack on the credibility of the expert witnesses than by the accuracy of accounting technical details of the testimony itself. As expert accountants and auditors your students may wish to focus on the accounting technical merits of the expert witness arguments, possibly by taking opposing viewpoints debated in class. Since no standard setter has commented on the narrow technical accounting issues, this is a topic still open to debate. c. In theory, there was no weakness in corporate governance. In fact on paper Enron was a model of corporate governance, including one of the first corporations to use a corporate code of conduct to be applied to all employees, including management and the board of directors. In practice, however, the independence of the board and corporate governance were compromised through lucrative consulting engagements and related party transactions. On a broader level, conformity with GAAP may not deter Enron type frauds which relied on sophisticated accounting misestimates which may be hard to detect using current GAAP. If controls are designed to adhere to GAAP then the controls may not be sufficient to deter Enron type frauds which exploit weaknesses in GAAP itself—management and expert witnesses may claim there is nothing wrong with the company’s GAAP. d. It all depends what “present fairly” means. If it means a material deviation from GAAP, then the audit may not be capable of detecting such frauds that don’t violate GAAP. If “present fairly” incorporates accounting risk, as we have advocated in this text it should, then the discussion case at the end of the chapter provides an overview of how to go about detecting these types of misleading reporting. e. Not if internal control effectiveness is defined relative to current GAAP, as discussed above. This case shows that fraud auditing may not be separable from the criteria, such as GAAP, used to evaluate the financial reporting. WorldCom: Again, The extent of detail depends on instructor preferences. This question makes an excellent basis for 15 minute class presentations by student groups. Roughly 15 minutes for each company. Below is an outline for WorldCom. a. All frauds were investigated by the SEC. The WorldCom investigation followed after its bankruptcy which is the largest in corporate history. b. In the case of WorldCom extensive capitalization of repairs and maintenance costs thereby inflating its profits in the financial statement fraud. c. CEO Bernie Ebbers, a Canadian, was allowed to dominate the Board of Directors, audit committee, and internal auditors thereby eliminating key segregation of duties at the top levels of corporate governance. d. Yes, the capitalization of repairs and maintenance violates GAAP. e. Yes, GAAP violations fall within the traditional responsibilities of internal auditors. DC7-2 Gildan’s independence is threatened by being offered a business partnership by officer of auditee. This can create conflict of interest because of his self-interest in getting the business opportunity. Also Gildan may be inclined to support President in covering up the cash problems in PGI. These cash discrepancies are problems which may suggest a fraud, collusion, etc. In a public company scenario, this can have dire consequences for the auditor since the company is highly regulated, fraud is always ‘material’ regardless of its monetary magnitude. The President’s representation not sufficient evidence for the auditors to conclude this is not a material misstatement. Gildan should be advised to decline the President’s offer. He should also be advised to go to a senior person in his audit firm for advice on how to follow up on the cash discrepancies that are raising a suspicion of fraud. To comply with the CAS this suspicion must be followed up till it is either dispelled or confirmed. Gildan’s firm may decide to get legal advice if a fraud is strongly suspected or actually uncovered. The situation could also be interpreted as showing possible intent on the part of the President to ‘bribe’ the audit staff member - this reflects on the trustworthiness of top management and call into question whether the preconditions of an audit continue to exist in this engagement. Again, the audit firm would need to seek legal advice on how to proceed in this situation. DC7-3 J. J. Barnicke Ltd.: Missing Millions and a Widow with a Lavish Lifestyle. a) One glaring control weakness in this case is lack of segregation of duties. The case illustrates the importance of this control in reducing fraud risk. Segregation of incompatible responsibilities permeates a number of key control activities such as independent reconciliations (e.g. salary expense to T4 summaries, bank reconciliations) and cheque or bank transfer approvals. Corporate governance by Board of Directors’ oversight is another control that appears to be lacking. Various assumptions can be made about how the audited financial statements corresponded to the actual financial condition of the business, but it appears there was no-one in a position to notice the alleged discrepancies. This situation creates the opportunity for fraud to occur. It also appears the company was extremely profitable, so that the CFO may have believed he was entitled to a large part of those profits, hence providing a rationalization for fraud. Additionally, if no-one else in the company missed the millions of dollars, this itself might provide the CFO with a rationale for believing he was responsible for earning these funds and hence entitled to them. If the company’s board or president never formerly approved the CFOs compensation, or were not clear about the approval, this could provide a further rationalization for the CFO awarding himself a large pay. The motive to take the money is quite easily seen through the kind of expensive lifestyle the Lakes led. With these three ‘fraud triangle’ factors in place, the risk of fraud was very high. Other valid points can be discussed. b) This part requires one to develop arguments for both sides of the dispute, a key skill for analysis, evaluation and applying judgment. The strengths and weaknesses of both sides can be discussed objectively. A case can be made for either side as the situation contains several dilemmas. The main evidence to be provided in this case would have been from documentation that either supported the CFO pay as being legitimate, or indicated it was not approved and obtained through fraudulent means. This illustrates the important role of good systems of internal control including authorizations and record-keeping. c) One audit procedure would be verification of authorization of bank transfers between the accounts of related entities. If the auditor is not appointed to audit all the entities however, this procedure is limited to transfers between audited entities. In this case, transfers from the trust accounts to the payroll account may have stood out as unusual, but if the CFO was able to conceal the descriptions of the transfers, and kept the amounts to relatively small amounts by transferring more frequently, it may have been hard to uncover. Other valid procedures can be described. CHAPTER 8 AUDIT EVIDENCE AND ASSURANCE SOLUTIONS FOR REVIEW CHECKPOINTS 8-1 Six basic types of evidence and six general techniques to gather it: (1) computation, (2) observation, (3) confirmation, (4) enquiry, (5) inspection, and (6) analysis. 8-2 Strengths of computation are its reliability and objectivity. Limitation is the that its results are only as good as the underlying components the auditor uses in the computations, as these still need to be audited to ensure they are reliable. 8-3 Strengths of observation are objectivity, but a limitation is that it only provides evidence at the time of the auditor’s observation not other times. If people know the auditor is watching they may perform differently than they usually do. Another weakness that the evidence is a function of the observer’s judgment and ability to properly assess what is being observed, which could be biased or ill-informed. 8-4 Auditors need to control the entire confirmation process so there is no opportunity for the auditee to alter the confirmation requests or responses. 8-5 Auditors can help the effectiveness of confirmation requests by: a. Having the confirmation letters printed on the auditee's letterhead and signed by an auditee officer. b. Being careful to be assured of reliable addresses for recipients; that is, being assured that the confirmations are not misdirected (for example, to a auditee's accomplices in fraud). c. Asking confirmation of information that recipient can supply, like the amount of a balance or the amounts of specified invoices or notes (not the balances of homeowners' mortgages or financial amounts, like certificates of deposit with accrued interest, for which people usually do not keep their own accounting records). d. Controlling the mailing and return of confirmations so the auditee cannot tamper with them. e. Receiving the reply directly, so the auditee cannot intercept and alter them. f. Following up on any confirmations that have no response to determine the reason. This may indicate a customer that does not exist. 8-6 External authoritative documents are prepared or validated by other parties and sent to the auditee. Even though these are internal sources of audit evidence, they will contain original signatures, seals, engravings and other distinctive stylistic formal attributes that make them less susceptible to alteration by the auditee, and thus more reliable and convincing as audit evidence. Ordinary documents prepared by outsiders that could easily be forged or altered in ways that the auditor could not easily detect are less reliable source of documentary audit evidence. 8-7 "Vouching" means the examination of documents. Generally, an item of financial information is selected from an account, and the auditor then goes backward through the bookkeeping-filing system to find the source documentation which supports the item selected. "Tracing" essentially is the opposite direction compared to "vouching." In the process of tracing, the auditor selects sample items of basic source documents and proceeds forward through the bookkeeping process to find the final recording of the accounting transactions. "Scanning" refers to the auditor's scrutinizing documentation or bookkeeping records (account details or entries in journals) for unusual items and events. 8-8 Analysis consists of identifying the components of a financial statement item or account to on the basis of particular characteristics that are relevant to designing analytical or other audit procedures; studying meaningful relationships among components of financial and non-financial information to form expectations about what amounts recorded in the accounts should be; comparing such expectations with the recorded amounts to identify inconsistencies ; and using the results of this comparison to help determine what, if any, other audit procedures are needed to obtain sufficient appropriate audit evidence that the recorded amounts are not materially misstated. [CAS 520] 8-9 Analysis is used at: 1. the planning stage to identify risks and guide the design of audit work 2. the field work stage as substantive procedures for generating evidence 3. the end of the audit as an overall review and evaluation when forming a conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the business as the basis of the audit opinion. 8-10 Information sources for analysis include: - Financial account information for comparable prior period(s). - Company budgets and forecasts. - Financial relationships among accounts in the current period. - Industry statistics. - Nonfinancial information from the company’s information systems. 8-11 When analysis is used to provide substantive evidence, auditors need to use independent, reliable information to perform the analytical procedures. Thus, the sources of information need to be assessed for independence and objectivity. Quantitative information must be verified by the auditor if a high level of reliance is placed on the evidence provided by analysis. 8-12 Analysis can be very effective because it integrates evidence from a variety of information sources and often provides an independent way of providing evidence about whether the financial statement assertions hold true. Analysis also allows the auditor to assess or detect unusual or unexpected patterns in account relationships, making it an effective risk assessment procedure as well as a revealing risk response procedure. 8-13 Judging from the Wright-Ashton data from KPMG Peat Marwick audits: the overstatements/understatements look mixed in the current assets; understatements are in the majority in the noncurrent assets; understatements appear to be in the majority in the liabilities, and; understatements appear to be in the majority in the expense accounts. 8-14 Initial Event/Audit Procedures, generally in order of their likely effectiveness for detecting financial statement misstatements 1. Tests of details: examination of transaction amounts and descriptions, account balance details, workups to support account balances, data on various reconciliations. 2. Expectations from the prior year. 3. Analytical procedures: comparison of current unaudited balances with balances of prior years, predictions of current balances based on exogenous data, analyses of interrelationships. 4. Auditee enquiry. 5. Test of detail: checks for mathematical accuracy. 6. Accounts receivable confirmation 7. Inventory observation 8-15 Methods and sources of information for understanding a auditee's business and industry: Inquiry, Including Prior Working Papers--prior audit working papers, personnel who worked on the audit in prior years are available to convey their understanding of the business, inquiry and interviews with the company's management, directors, and audit committee. Observation--take a tour of the company's physical facilities, keeping eyes open for activities and things that should be reflected in the accounting records. The tour is the time to see company personnel in their normal workplaces. Study. Numerous sources--CICA and AICPA industry accounting and auditing guides, specialized trade magazines and journals, registration statements and Annual Reports filed with the securities market regulators, general business magazines and newspapers (Financial Post, Report on Business, Business Week, Forbes, Fortune, Harvard Business Review, Barron's, and the Wall street Journal). 8-16 Experts are needed in audits where the auditors need understanding and evidence that can only be obtained by consulting with persons skilled in fields other than accounting and auditing, such as actuaries, appraisers, legal counsel, engineers, chemists and geologists. When using evidence from experts as audit evidence, the auditor is required to ensure the expert has appropriate professional qualifications and a good reputation. 8-17 The auditor requires evidence to judge rationally the financial statement assertions in management’s financial statements. If evidence does not relate to one of the management assertions, the evidence is not relevant to the auditor. 8-18 To be considered appropriate, evidence must be relevant and reliable. To be relevant, audit evidence must relate to at least one of the assertions. The reliability of audit evidence depends on its nature and source. The hierarchy of evidence reliability indicates the range from the strongest and most reliable (physical observation and computation) to the weakest and least reliable (management representations). 8-19 Judgment is applied to decide what is the most persuasive evidence that can be obtained in a cost-effective manner relative to a particular audit objective. Trade-off may be required if audit evidence that would be highly reliable and relevant is prohibitively costly. For example, if we wait till all the accounts receivable are collected we have 100% assurance that they existed and were correctly valued, but this evidence is impossible to obtain as it would take a very long time. In situations where no highly reliable single source of evidence is available, the auditor uses judgment to decide whether there may be two or more less reliable pieces of evidence that, when evaluated together, are adequate to support the assertion. Good professional judgment is required to make the decision on what is appropriate, sufficient evidence in a particular audit. 8-20 External documentary evidence is evidential matter obtained from the other party to an arm's-length transaction or from outside independent agencies. External evidence reaches the auditor directly and does not pass through the hands of the auditee. External-internal documentary evidence is documentary material that originates outside the bounds of the auditee's data processing system but which has been received and processed by the auditee. Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored within the auditee's information system. Such evidence is not touched by outside parties at all or is several steps removed from third-party attention. 8-21 The problem with evidence obtained from related parties is that the source is potentially biased, and the information may be self-serving and misleading. 8-22 Appropriateness refers to evidence’s relevance and reliability. Sufficiency refers to the amount of evidence, was enough evidence obtained to convince a reasonable well-informed person (or a judge) that the financial statements are not misstated? 8-23 If an auditor has not been able to obtain sufficient appropriate audit evidence about a material financial statement assertion, CAS 330 states that the auditor should express a qualified opinion or a disclaimer of opinion. 8-24 The planning memorandum documentation summarizes all the important overall planning information. This include the preliminary analytical review and the materiality and risk assessment, the work done to understand the auditee’s business and risks, information about (1) investigation or review of the prospective or continuing auditee relationship, (2) needs for special technical or industry expertise, (3) staff assignment and timing schedules, (4) the assessed level of control risk, (5) significant industry or company risks, (6) computer system control environment, (7) utilization of the company’s internal auditors, (8) identification of unusual accounting principles problems, and (9) schedules of work periods, meeting dates with auditee personnel and completion dates. The planning memo is basis for deciding on specific audit objectives and procedures to obtain sufficient appropriate audit evidence on which to base the audit opinion. 8-25 One type of audit program was called the "internal control program," and its objective is to guide the work involved in: Obtaining an understanding of the auditee's business and industry. Obtaining an understanding of management's control structure. Assessing the inherent risk and the control risk related to the financial account balances. The other type of audit program was called the "balance-audit program," and its objective is to specify the substantive procedures for gathering direct evidence on the assertions (i.e. existence, completeness, valuation, rights and obligations, presentation and disclosure) about dollar amounts in the account balances. 8-26 The nature of audit procedures refers to their identification with one of the general types of procedures-- recalculation, physical observation, confirmation, verbal inquiry, examination of documents, scanning, and analytical procedures. The timing of audit procedures refers to when they are performed, usually at (1) interim, or at (2) year-end. However, timing may have other aspects such as surprise procedures (unannounced to auditee personnel) or procedures performed after the year-end. The extent of the application of procedures usually refers to the sample sizes of data examined, such as the number of customer accounts receivable to confirm, or the number of inventory types to count. In audit sampling applications, there is also a decision related to extent of which items to select from the population of items sampled. Extent may also refer to how frequently a scanning procedure is performed, e.g.,. review all sales entries for four days in each of four months. 8-27 Working papers contain the documentation that supports the decisions regarding procedures necessary in the circumstances and all other important decisions made during the audit. They are the auditors’ proof they complied with generally accepted auditing standards and hence are support for the value of the audit to outsider users who rely on audited financial statements. The situation when Andersen was found destroying audit working papers for an auditee under SEC investigation, Enron, shows the impact of documentation on the reputation of the audit firm and the value of an audit. 8-28 In the permanent audit file: 1. Copies or excerpts of the corporate or association charter, bylaws, or partnership agreement. 2. Copies or excerpts of continuing contracts such as leases, bond indentures, and royalty agreements. 3. A history of the company, its products, markets and background. 4. Copies or excerpts of stockholders, directors, and committee minutes on matters of lasting interest. 5. Continuing schedules of accounts whose balances are carried forward for several years, such as owners' equity, retained earnings, partnership capital and the like. 6. Copies of prior years' financial statements and audit reports. Permanent audit file documents contain information of continuing interest over many years’ audits of the same auditee, such as articles of incorporation, shareholder agreements and long-term contracts. Financial or other information in the current year that is related to these agreements and contracts will be verified by comparing to these permanent records. 8-29 Audit administration papers filed in the current working paper file (usually in the first part of the file). 1. Engagement letter. 2. Staff assignments. 3. Auditee organization chart. 4. Memoranda of conferences with management. 5. Memoranda of conferences with the director's audit committee 6. Preliminary analytical review notes. 7. Initial risk assessment notes. 8- Initial materiality assessment notes. 9. Engagement planning memorandum/Overall Audit Strategy document 10. Audit engagement time budget. 11. Internal control questionnaire and control analyses. 12. Management controls questionnaire. 13. Computer control questionnaire. 14. Internal control system flow charts. 15. Audit program. 16. A working trial balance of general ledger accounts. 17. Working paper record of preliminary adjusting and reclassifying entries. 18. Memoranda of review notes and unfinished procedures (all cleared by the end of the field work.) 8-30 The most important facet of the current audit evidence papers is the requirement that they show the audit decision problems and their conclusions. These papers must record the proposition to be audited, the evidence gathered, and the final decision. The working papers should demonstrate satisfaction of the field work standards and provide support for the audit report. 8-31 Indexing allows for each section to be given to different audit team members and for easy expansion within a given section without affecting other sections. Cross-indexing documents the connections between different accounts and transaction streams that are audited in different sections of the file so the links can be followed by other audit team members or by the audit supervisor or manager who is reviewing the working papers. 8-32 Working papers should be clear, concise, complete, neat, well indexed and informative. Each separate working paper (or multiple pages that go together) should be complete in the sense that it can be removed from the working paper file and considered on its own, with proper cross-reference available to show how the paper co- ordinates with other working papers. The papers must record the management assertions that were audited (book values or qualitative disclosures), the evidence gathered about them and the final decisions. Auditing standards (CAS/ISA 300 and 230 (5145)) recommend that the working papers show (1) evidence that the work was adequately planned and supervised; (2) a description of audit evidence obtained include memoranda, check lists, questionnaires, flowcharts, audit programs, schedules, correspondence and extracts of legal documents; (3) evidence of the evaluation and disposition of misstatements; and (4) copies of letters or notes concerning audit matters reported to the auditee. The working papers also should explain how exceptions and unusual accounting questions were resolved or treated. 8-33 Audit software allows the use of electronic working papers and can automate many documentation tasks such as automatically carrying over adjustments to related working paper documents and the financial statements, integrating the audit information and facilitating access, review and changes to the format, content or order of the files. Because most auditee data are already in electronic form, they can be imported into the audit software. Software allows for electronic communication and sharing of information among staff and supervisors. The entire audit process can be more efficient through use of standard templates and electronic questionnaires. Audit working paper software can also facilitate analysis. Links can be established to other databases, or even websites so that data or information from these sources can be cross referenced or transferred to the working papers. Thus, audit staff work and various other sources of information can be integrated to support the auditor’s opinion. SOLUTIONS FOR EXERCISES AND PROBLEMS EP8-1 Audit procedures Types of procedures used by auditors in general, with examples: 1. Recalculation by the auditor * recomputing the auditee's calculation of depreciation expense 2. Observation by the auditor * observation, test-counting of auditee's physical inventory-taking 3. Confirmation by letter * obtaining accounts receivable confirmations * obtaining auditee's lawyer's letter 4. Inquiry and written representations * ask auditee personnel about accounting events * complete an internal control questionnaire * obtain written representation letter from auditee management 5. Vouching * find brokers' invoices and cancelled checks showing agreement with record amounts for securities investments. 6. Tracing * select a sample of shipping documents and trace them to sales invoices, sales journal recording and posting to general ledger 7. Scanning * scan expense accounts for credit entries * scan payroll check lists for unusually large checks 8. Analytical procedures--any example that fits one of these: * compare financial information with prior periods * compare financial information with budgets and forecasts * study predictable financial information patterns (e.g., ratio analysis) * compare financial information to industry statistics * study financial information in relation to nonfinancial information EP8-2 Potential Audit Procedure Failures This is a very open-ended discussion topic. Students' responses could be quite varied depending upon their experience and imagination. The best classroom strategy is to start with one of the procedures, then list the students' suggestions on the chalkboard. The discussion can become very lively! EP8-3 Confirmation procedure a) An audit confirmation is a written statement to the PA from someone outside the enterprise on a fact which that person is qualified to affirm. b) The two main characteristics a confirmation should possess are: 1. The party supplying the information requested must be knowledgeable and independent, i.e., he must have knowledge of information of interest to the auditor and he must be outside the scope of influence of the organization being audited, and 2. The auditor must obtain the information directly from the informed party. EP8-4 Audit Procedure Terminology 1. Scanning for debit balances in accounts payable Recalculation of amounts on supporting documents Vouching of account entries to supporting documents 2. Vouching of policies from expense and prepayment entries Recalculation of expiration of insurance premium Analysis of interrelationships--compare insurance coverage to assets owned and leased 3. Scanning inventory records for "old" last-issue dates Verbal inquiry--question inventory control personnel about slow-moving inventory Vouching--examine journal entries for evidence of actual book writedown of the specific inventory items 4. Tracing--trace remittance amounts to appropriate customer's account Recalculation--recalculate amount of discounts and allowances Vouching--examine authoritative documents supporting unusual discounts and/or allowances 5. Observation and examination by the auditor--of the inventory and the inventory-taking procedures Confirmation by letter--of inventory held in outside warehouses Recalculation--of the accuracy of cost-flow calculations EP8-5 General Audit Procedures and Financial Statement Assertions The related assertions are taken from the textbook explanation of the procedures. General Audit Procedures Related Management Assertions 1. Recalculation Existence, Valuation 2. Physical observation Existence, Valuation 3. Confirmation Existence, Rights (Ownerships) Valuation (sometimes) Cutoff (sometimes) 4. Verbal inquiry All assertions: however, responses typically yield more assertions, in turn subject to audit with corroborating evidence 5. Examination of documents Existence (vouching direction) Completeness (tracing direction) Valuation or allocation Rights and obligations Presentation and disclosure 6. Scanning Raises questions that may be relevant to all objectives, but may not produce actual "evidence." Since it is performed on recorded amounts, it works best for Existence, Valuation, Rights, and Presentation/Disclosure. When applied to source documents, it might work for the completeness assertion. 7. Analytical Procedures Existence or occurrence Valuation Completeness EP8-6 Relative Appropriateness of Evidence a) Evidential matter obtained from independent sources outside an enterprise provides greater assurance of reliability (competency) than that which is secured solely within the enterprise. b) Accounting data and financial statements developed under satisfactory conditions of internal control are more reliable (competent) than those which are developed under unsatisfactory conditions of internal control. c) Direct personal knowledge obtained by the independent auditor through physical examination, observation, computation, and inspection is more persuasive than information obtained indirectly. EP8-7 Relative Appropriateness of Evidence 1. Types of evidence in reliability rank Evidential items/sources 1. External d. Letter from creditor 2. External-internal a. Monthly statements 3. Internal b. Voucher register 4. Mathematical (based on c. Audit computation of unaudited data) discounts 2. 1. Mathematical (based on c. Audit computation of expense audited data) amounts 2. External a. Letter from bond trustee 3. External-internal d. Cancelled checks 4. Internal b. Minutes of directors' meetings EP8-8 Audit Working Papers a) 1. The functions of audit working papers are to aid the PA in the conduct of his or her work and to provide support for the opinion and the compliance with auditing standards. 2. Working papers are the PA's records of the procedures performed, and conclusions reached in the audit. b) The factors that affect the PA's judgment of the type and content of the working papers for a particular engagement include: 1. The nature of the auditor's report. 2. The nature of the auditee's business. 3. The nature of the financial statements, schedules or other information upon which the PA is reporting and the materiality of the items included therein. 4. The nature and condition of the auditee's records and internal controls. 5. The needs for supervision and review of work performed by assistants. c) Evidence which should be included in audit working papers to support a PA's compliance with generally accepted auditing standards includes: 1. Evidence that the financial statements or other information upon which the auditor is reporting were in agreement or reconciled with the auditee's records. 2. Evidence that the auditee's system of internal control was reviewed and evaluated to determine the nature, timing, and extent of audit procedures. 3. Evidence of the auditing procedures performed in obtaining evidential matter for evaluation. 4. Evidence of how exceptions and unusual matters disclosed by auditing procedures were resolved or treated. 5. Evidence of the auditor's conclusions on significant aspects of the engagement with appropriate commentaries. d) The PA should perform an adequate examination at minimum cost and effort and the preceding year's programs will aid in doing this. The preceding year's audit programs ordinarily contain information useful in the current examination (such as descriptions of the unique features of an auditee's operations or records, a formalized sequence of audit steps in logical order, and approximate time requirements to perform various phases of the work.) The auditor should decide whether to use the old program or prepare a new one. EP8-9 Audit procedure for error detection. a) Sales are understated, A/R are understated. b) It is a cut off error. It affects the completeness assertion because a sale that occurred in the current year was left out of this year’s sales total, making it understated/incomplete. The sale was put in the following year. Unless the error is corrected, the following year will be overstated by a sale that did not occur/exist in that period. c) Cut off test procedures would detect this error, e.g. Inspect internal sales documentation, and trace documentation of last completed jobs before the year end to the sales records to ensure they are all recorded in correct period. d) Accounts receivable turnover with error = 32000000/ (495000-45000)= 3200000/450000 = 7.1 times Accounts receivable turnover after correcting error = (3,200,000 + 145,000) / (495000-45000+145,000) = 3345000/595000= 5.6 times Correcting the error makes the turnover lower, indicating poorer performance to a user, such as the bank e) In size the error amounts to 5% of total revenue so it could be considered material based on its size (quantitative factor). The error has the effect of shifting revenues to following year. CEO has already received her maximum bonus this year - note: (3,200,000- 1,000,000) * 1% = $22,000 and maximum is $20,000 so maximum is already exceeded and she only gets $20,000. So the error may affect bonus plan, by shifting profit to next year she will be more likely to make the bonus next year. This qualitative factor also suggests the error is material as it affect important users and decisions whether manager should receive a bonus. This qualitative factor could make the error more significant for the Board as it may affect decisions they make, and it may indicate to them management has attempted to manipulate the financial statements. SOLUTIONS FOR DISCUSSION CASES DC8-1 Financial Assertions and Audit Procedures The objectives for the audit of Kingston's securities investments at December 31 are to obtain evidence about the assertions implicit in the financial presentation, specifically: 1. Existence. Obtain evidence that the securities are bona fide and held by Kingston or by a responsible custodian. Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually took place during the year under audit. 2. Completeness. Obtain evidence that all the securities purchase transactions were recorded. 3. Ownership Rights. Obtain evidence that the securities are owned by Kingston. Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan. 4. Valuation. Obtain evidence of the cost and market value of the securities held at December 31. Decide whether any writedowns to market are required by GAAP. 5. Presentation and Disclosure. Obtain evidence of the committed nature of the assets, which should mean they should be in a non-current classification like the loan. Obtain evidence that restrictions on the use of the assets are disclosed fully and agree with the loan documents. DC8-2 Financial Assertions and Audit Objectives The objectives for the audit of Karachi’s product warranty liability at December 31 are to obtain evidence about the assertions implicit in the financial presentation, specifically: 1. Existence. Obtain evidence that the warranty liability is not overstated and that all appropriate warranty related costs have been recorded as a reduction of the liability balance. Occurrence. Obtain evidence that the sales giving rise to increases in warranty liability actually took place during the year under audit. 2. Completeness. Obtain evidence that all the sales transactions giving rise to warranty liability were considered in determining the liability amount. 3. Ownership/ Obligation. Obtain evidence that the warranty liability is an actual legal obligation of Karachi by considering trade practice, terms of sale. 4. Valuation. Obtain evidence to verify the warranty amount has been calculated correctly as of December 31 based on accurate inputs from sales and warranty costs incurred, as well as considering warranties that have expired. 5. Presentation and Disclosure. Assess whether the presentation of the liability in the balance sheet, and disclosure of the liability and the underlying accounting policy in the footnotes are appropriate and in accordance with GAAP. DC8-3 Appropriateness of Evidence and Related Parties a) Do you perceive any problems with related party involvement in the evidence used by M. Johnson? Explain. Yes, there are problems. Verbal assurance of collectibility from Bumpus, the S&L officer with an investment in the Smith Street property, is the weakest type of self-serving information. Bumpus is a related party and information from him ought to be regarded as biased. Another problem lies in the appraisal company. With the name of Guaranteed Appraisal Partners, Inc., the appraisers may be related, even owned by, the auditee--Guaranteed Savings & Loan Company. An auditor's general knowledge of financial institution difficulties in real estate lending and the widespread problems with appraisers should alert Johnson to the possible relation of the appraisers to the auditee. Further investigation should be carried out to identify the appraisers. b) Do you perceive any problems with M. Johnson's reasoning or the competence of evidence used in that reasoning? Yes, there are problems. In addition to the dubious related party sources of information just mentioned, Johnson's "assumption" about the collectibility of the Baker Street loan is unwarranted. Auditors are not entitled to "assume" collectibility on any grounds with supporting evidence. The fact that a loan is new or construction is still in progress is no reason to "assume" collectibility. DC8-4 Audit Plan with Weaknesses in Revenue Controls, Not-for-Profit Auditee. a) The main business risk factors affecting the nursing home’s continuing operations are the uncertainty about being able to renew the bank loan, and the change in the industry towards more new government funded nursing homes. These risks affect KH’s future viability as its revenues may be reduced if the new homes draw away patients, and if the loan cannot be renewed it may lack the working capital to keep its operations going. These factors increase the risk of financial failure, and this high level of business risk would likely lead the auditor to lower the level of audit risk that is acceptable on this engagement. b) The risk of material misstatement appears to be high because there is a history of errors in invoicing patients and accounts receivable recording. The accounts receivable balance is likely to be highly material since it is the main revenue source. A further concern is the nature of the revenues in this organization - these come from patients who are not very able to provide confirmation evidence, and this lowers the reliability of evidence available to support the revenue existence and valuation. Also, control risk is high in some areas as accounting staff appears to be unable to apply effective independent verification in the invoicing and receivables recording processes. The effectiveness of management supervisory controls over cash transactions, and the lack of indicators of fraud risk, lower the concern about the control weaknesses having significant impact on the financial statements. c) The main stages of the audit and the procedures used in this case are outlined below. Understanding the auditee and its risks The case indicates the auditor has obtained an understanding of KH’s internal control and performed a preliminary assessment. Enquiries of auditee personnel, and study of prior-year audit working paper information would be the procedures used. Enquiries of management, external parties and industry research sources would have provided information about the plans to build new government funded homes that will possibly compete with KH. Assessing the risk of material misstatement (inherent and control risks combined) Based on enquiry of auditee personnel and observation of accounting information system and internal control there appear to be weaknesses in controls over invoicing and accounts receivable recording. While it would not be effective to test these controls, the auditor would need to consider these control weaknesses by assessing whether the organization’s procedures are adequate to prevent fraud. The auditor has assessed that controls over cash receipts are effective, so testing the controls over cash receipts would be planned for. Dual purpose tests would be most efficient to provide both control and substantive assurance. These tests would involve enquiry and observation of the control procedures, and examination of the documents and records recording the cash receipts. Substantive tests of details of transactions and account balances The overall audit approach planned would emphasize substantive tests of transactions for revenues. For a sample of patient invoices from the sales journal, the auditor will obtain evidence about existence and valuation by examining supporting documents such as the invoice and the supporting patient records showing the services KH provided, by verifying the service fee agrees to the approved fee schedule, and by recalculating the service revenues to ensure accuracy. Verifying there are no recording misstatements would be tested by tracing invoice details (patient, amounts and dates) to the accounts receivable subledger, and tracing posting totals from the sales journal to the general ledger. As the confirmation responses are unreliable, alternative procedures such as verification of subsequent cash receipts to banking records would be used to verify the existence and ownership of receivables (this was outlined above as a component of the dual purpose testing on cash receipts transactions). Other substantive tests of transactions for revenues would also address completeness by searching for unrecorded revenues (direction of this completeness testing is tracing from a sample of patient records to revenue billings). If there are any large, long overdue, or unusual invoices, these would be confirmed. Given the nature of the patients, bad debts are likely and so a careful examination of overdue accounts and consideration of the adequacy of the allowance for doubtful accounts is necessary to provide evidence that accounts receivable are valued at net realizable value. Analytical procedures Analysis would be used extensively to provide substantive evidence. In addition to analysis of financial relations and trends in revenues, receivables, and bad debts, comparisons with non-financial information such as number of beds, occupancy statistics, and service capability of the nursing staff could provide very powerful evidence of any material misstatements in revenues. DC8-5 Working paper review a) The following information is missing: * The date of purchase of S security * The date of purchase and sale of R security * Data concerning the accrual and/or receipt of interest due on R to date of sale * Data concerning the accrual and/or payment of interest due on S to the date of purchase * Justification for accrual of dividends * Accounting treatment of bond discounts * Data concerning the December 31, 2002 revenue accruals * Data required to evaluate the classification of securities b) The following procedures were not noted as having been performed: * The securities were not physically inspected or confirmed. * The broker's advice (or other independent corroborating evidence) verifying the sale of R was not examined. * Dividend rates were not verified by reference to public records (Standard & Poor's) of dividend declarations. * The stated interest rates, maturity dates, and market values were not verified. * Computations of year-end accruals were not made. * Not all amounts (for example, loss on sale of R) were traced to the general ledger. DC8-6 Comprehensive Audit Planning Case a) Factors that support accepting/continuing ECR , based on facts given in case, include: Obtaining and reviewing financial information about prospective client - are there unusual accounts or business practices that audit firm is not familiar with? Need to understand business risks. --ECR imports processes and sells fair trade coffee beans to retail-level businesses in Ontario - we need to understand factors such any regulations affecting this business, nature of sales and purchasing agreements, - we may have valuation or ownership challenges in doing audit based on foreign purchases and long shipping times, also letter of credit arrangements , risks do not appear unusually high Is the financial condition good? --ECR profits are around $2 million, have Assets-Liabilities around $2.2 million - strong balance sheet & earnings, high certainty it will continue as a going concern Evaluation of audit firm's independence -- no facts given in case, no indication of conflicts in this regards, firm should re-examine if there are any changes from previous year, or any concern audit team members becoming too familiar over time indicating they should be rotated off the engagement. Does audit firm have competency and resources to do an effective audit? --Consider ECR size, location, nature of operations, and business seems simple enough that can assume audit firm has competence to audit this business, stated in case this is a continuing audit so can assume have competence Determine management’s willingness to accept responsibility for financial statements that are fairly presented in accordance with GAAP/acceptable framework and accept responsibility for adequate internal control -- management seems willing to provide auditors with information, last year audit found an error (<~1% of inventory) but not corrected - paid bonus before audit finding were in may suggest lack of regard for audit value, or confidence in accuracy of accounting..no facts given about control, fair presentation etc. Communicate with predecessor auditor, if new engagement (assumption required in this case) to learn any reasons not to accept audit engagement, key risks and carryforward information from past audits. b) Calculate net income from trial balance data = $2493k* (or 2993 before bonus if bonus considered arbitrary, not ‘normal’) Take 5-10% to provide a preliminary range of $125 to 250K Note relevant qualitative considerations to determine the Overall Materiality level from the preliminary range - A significant error was found last year - we should consider the possibility that similar errors exist this year; this indicates we should go to a lower level in the range. It also has implications for the performance materiality decisions, as discussed below. Main users are pension funds. These are sophisticated investors who will have other information sources. This supports going to the higher end of range Relative size of other financial items, AR, Inventory, have large balances, suggests using the higher end of range This suggests a reasonable materiality judgment, consistent with our supporting reasons is to set the Overall Materiality level at $200k. Following the guideline provided in the case, the Overall Performance Materiality is calculated by simply taking 70% or other amount, this is $140,000. Using this lower level of materiality for deciding on extents of testing and performance of other auditing procedures will increase our chances of finding all material misstatements. However we should also consider whether any other reasons indicate a different approach is more valid (In this case an alternate approach is to use last years error discovered, so $200-65 = $135k) c) Auditor’s decision on acceptable audit risk (AR) level is based on nature of engagement, consequences of audit failure. Three factors with appropriate impact on audit level acceptance, such as: • Public vs. private company It is not stated in the case if ECR is public, but it has fairly sophisticated investors such as pension funds - this would lower AR willing to accept. If there ar public investors who are making risky financial decisions based on the audited financial statements, this also leads to wanting a lower AR • Auditee financial health/risk of business failure - The company appears sound. This may raise AR that could be accepted. However, business risk factors suggest economic conditions may affect future financial health (premium product, fluctuating market prices), so keeping a lower AR may still be prudent. • Management's reputation/integrity, willingness to accept responsibilities for preparing GAAP financial statements, for designing and implementing adequate internal control, and to provide written representations. There may be some questions here since there are errors in a major account, inventory, so this may tend to decrease acceptable AR level d) In order to design an effective audit, auditors must understand the business and the economic environment of the business including factors such as: economic conditions - growth in sales in past years, but the recession may affect future expected growth in luxury coffee geographic locations - purchasing coffee beans around the world , with long time with risk of loss/damages developments in taxation and regulation - import duties, sales taxes changes to consider specific industry characteristics & risks - reputation based on quality and ‘fair trade’ buying policy, extends reporting interests of investors to a compliance assertion - are their claims true? business objectives- grow sales, maintain premium pricing position key strategies employed to meet those objectives - quality control, research/improve production processes, etc. risks that threaten achievement of those objectives - obtaining quality beans - price changes risk, product quality & reputation to defend e) Inventory in a coffee business will be made up of raw and roasted beans, beans on hand, and beans shipped and in transit but already owned. Assertions- Consider the following risk assessments with supporting reasons Existence: high - Inventory on ships can be lost or damaged by moisture/insects, ECR may not be able to establish legal ownership due to complex payment arrangements with foreign suppliers, uncertainty Completeness: medium - Depends on good controls over recording all purchases that ECR has legal ownership of, possible to miss recording unless controls are good Valuation: high - are the raw beans of suitable quality once they arrive? Long shipping times impose risk of damage and loss - are all shipping, insurance, duty, etc. costs captured? There will be a valuation impact if prices drop or recover. This may increase complexity of valuation and increase risk of misstatement. Error in pricing /valuation in prior year suggests higher risk Ownership: High - Similar factors as existence risks (but if ECR has good controls, that could lower this risk) Presentation: medium - classification is fairly straightforward, but disclosure of policies regarding valuation, ownership need to be examined for accuracy f) One example of an evidence procedure and the assertion the evidence is relevant is: Examination of Inventory ‘in transit’ involving verification of inventory in terms of ownership, existence, valuation (damage?) by confirmation of quantities & types of beans with suppliers, and with the shipping company Verify that terms of sale that allow ECR to take title have been met. Solution Manual for Auditing: An International Approach Wally J. Smieliauskas, Kathryn Kate Bewley 9780071051415