Chapter 11 To 29

CHAPTER 11
A RISK-BASED AUDIT APPROACH – PART II
I. Review Questions
1. Use the model AR = IR x CR x DR to solve for different values of Audit Risk

(AR) when internal control risk (CR) is given different values. In all cases IR =
0.90 and DR = 0.10, therefore, AR = 0.90 x CR x 0.10
When CR is AR is
0.10 0.009 or 0.9 percent
0.50 0.045 or 4.5 percent
0.70 0.063 or 6.3 percent
0.90 0.081 or 8.1 percent
1.00 0.090 or 9.0 percent
2. a. Risk of Assessing Control Risk Too Low or Overreliance is a matter of

judgment about the importance (“key”) characteristic of a particular client
control procedure. An auditor can take more risk of assessing control risk
too low on unimportant controls than on important (“key”) ones.
Alternatively, the risk of assessing control risk too low can be considered a
constant (say, 0.05) and the importance of a control can be measured in
terms of a smaller or larger tolerable rate. (The authors prefer the latter
approach.)
b. Risk of Assessing Control Risk Too High or Underreliance is a matter of
judgment about the efficiency of an audit engagement. The risk can be
quite high when the audit team is willing to do extensive substantive work
anyway. If the work budget is tight, auditors need to find objective ways
(e.g., larger test of controls audit samples) to mitigate the risk.
c. Tolerable Deviation Rate is a judgment about how many control deviations
can exist in the population, yet the control can still be considered effective.
Auditors need to be careful about brushing aside findings of deviations.
d. Expected Deviation Rate in the Population is an estimate, usually based on
assumptions or sketchy information, of the imbedded incidence of control
deviations. The only use of this estimate in classical attribute sampling is to
figure a sample size in advance. The statistical evaluation (CUL
calculation) does not use it.
e. Population Definition might be called a judgment about identification of the
population of control performances that correspond to an audit objective.
For example, an auditor would want to be sure he is sampling from a file of
14-2 Solutions Manual - Principles of Auditing and Other Assurance
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recorded documents if his objective is to audit the controls over transaction
validity.
3. Assessing the control risk too low causes auditors to assign less control risk
(CR) in planning procedures than proper evaluation would cause them to assign.
The result could be (1) inadvertently conducting less audit work than properly
necessary and taking more audit risk (AR) than originally contemplated, perhaps
to the unpleasant results of failing to detect material misstatements (damaging
the effectiveness of the audit) or (2) discovering in the course of the audit work
that control is not as good as first believed, causing an increase in the audit
work, perhaps at a time when doing so is very costly (damaging the efficiency of
the audit).
4. The important consideration involved in judging an acceptable risk of assessing

control risk too high is the efficiency of the audit. Assessing control risk too
high causes auditors to think they need to perform a level of substantive work
which is greater than a proper evaluation of control would suggest. Assessing
control risk too high leads to overauditing.
Some auditors may be willing to accept high risks of assessing the control risk
too high because they intend to overaudit anyway, and the audit budget can
support the work.
Other auditors want to minimize their work (within acceptable professional

bounds of audit risk) and thus want to minimize the risk (probability) of
overauditing by mistake.
Technically, the risk of assessing control risk too high in relation to an attribute
sample is the probability of finding in the sample (n) one deviation more than
the “acceptable number” for the sampling plan. For example, if the plan called
for a sample of 100 units and a tolerable rate of 3 percent at a 0.10 risk of
assessing control risk too low, the “acceptable number” is zero deviations.
The probability of finding 1 or more deviations when the population rate is

actually 2 percent is:
Probability (x > 0 : n = 100, r = 0.02) = 1 – (1 – r) n
= 1 – (1 – 0.02) 100
= 0.867 or 86.7 percent
5. All the elements of the risk model are products of auditors’ professional
judgments. Auditors must judge:
Inherent risk – the probability that material errors or irregularities have entered
the accounting system used to develop financial statements.
Audit Working Papers 14-3
Internal control risk – the probability that client’s system of internal control
policies and procedures will fail to detect material errors and irregularities,
provided any enter the data accounting system in the first place.
Analytical procedures risk – the probability that auditors’ analytical procedures
will fail to produce evidence of material errors and irregularities, provided
any have entered the accounting system in the first place and have not been
detected and corrected by the client’s internal control procedures.
Audit risk – the probability that auditors will not discover by any means errors
and irregularities that cause an account balance to be materially misstated.
Test of detail risk appears at first glance to be the product of a formula and not a
professional judgment. However, everything in the risk model is a judgment, so
the test of detail derived from the model is no less a judgment.
6. An incorrect acceptance decision directly impairs the effectiveness of an audit.

Auditors wrap up the work and the material misstatement appears in the
financial statements.
An incorrect rejection decision impairs the efficiency of an audit. Further

investigation of the cause and amount of misstatement provides a chance to
reverse the initial decision error.
7. Detection risk is the component of audit risk that is controllable by the auditor.
It may be raised or lowered by reducing or increasing the amount of substantive
audit testing. It is determined by the auditor’s assessment of inherent risk and
control risk.
8. The auditor deals with both inherent risk and control risk during the planning
phase of the audit. Inquiry of client personnel, study of the business and
industry, application of analytical procedures, and documentation of the
auditor’s initial understanding of internal control are all performed during the
planning phase of the audit. Further study of internal control procedures may
occur after the planning phase if the auditor wishes to further reduce the
assessed level of control risk, and considers it economically feasible to do so.
9. An auditor would assess control risk to be at maximum when (1) effective

controls for the assertion have either not been designed or not put in place, or (2)
when the auditor believes performing substantive tests of the assertion is more
cost effective. When an auditor assesses control risk to be below the maximum,
the auditor should believe that effective controls are present to prevent or detect
misstatements in the financial statement assertions.
10. When the auditor assesses control risk at a level lower than maximum, the
auditor may generally perform fewer substantive tests.
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11. The audit risk model is useful in managing audit risk for assertions. By
determining planned audit risk for an assertion, assessing inherent and control
risks, an auditor can determine the allowable detection risk (the amount of
detection risk an auditor can allow) for an assertion. Allowable detection risk is
used to determine the nature, timing, and extent of audit procedures for the
assertion.
12. Detection risk exists because auditors (1) may use an inappropriate audit
procedure, (2) may misapply an audit procedure, (3) may misinterpret the
findings, or (4) do not examine 100 percent of an account balance or transaction
class.
13. The amount of audit evidence an auditor must gather varies inversely with
allowable detection risk. As allowable detection risk decreases, the amount of
evidence required increases, and vice versa. Chapter 12 introduces audit
procedures and discusses how auditors modify audit procedures to obtain
sufficient competent evidential matter by changing (1) the nature, (2) the timing,
or (3) the extent of procedures.
14. The audit risk model is
Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)
15. Risks identified at the financial statement level may have a substantial impact on
the assessment of inherent risk for specific assertions. For example, concern
about management integrity, identified as a risk at the financial statement level,
would cause an auditor to assess a higher level of inherent risk for existence of
sales.
II. Multiple Choice Questions
1. d 12. d 23. c 34. c

2. d 13. a 24. c 35. d
3. c 14. d 25. d 36. b
4. d 15. d 26. d 37. d
5. a 16. c 27. c 38. d
6. b 17. b 28. b 39. c
7. a 18. a 29. d 40. a
8. a 19. a 30. a 41. c
9. b 20. b 31. a 42. d
10. b 21. d 32. b
11. a 22. a 33. a
III. Comprehensive Cases
Case 1. Factors that will affect your evaluation of audit risk include
 integrity of management – Jimenez’s reputation and lawsuit.
 trend toward domination of operating and financial decisions by
Jimenez.
 increased management compensation based on performance.
 aggressive attitude toward financial reporting by new personnel.
 profitability inconsistent with the industry.
Case 2. The factors that will affect Josefina’s audit risk and business risk are (a) this is a
special audit, (b) the audit will be used to set the value of certain assets, (c) the
auditor is to evaluate any disputed amount (although this is a common provision
in purchase agreements, one might question whether auditors should agree to
such terms), and (d) the materiality level is set at P50,000, even though that is
considerably below an amount that might be determined using a percentage of
assets and/or income. These factors will increase the risk at the financial
statement level and potentially increase business risk.
Case 3. a. The audit risk model gives the following results:

AR = IR x CR x DR (or) DR x AR / (IR x CR)
(1) 2.5% (4) 3.33%

(2) 0.67% (5) 2.5%
(3) 1
In the third situation, the auditor does not have to accumulate any evidence
because inherent risk and control risk give the appropriate level of planned
audit risk.
b. (1) 3 (tied) (4) 2

(2) 5 (5) 3 (tied)
(3) 1
Case 4. a. (1) Medium (4) Low

(2) Low (5) Low
(3) Low
b. (1) Least (4) 2 (tied)

(2) 2 (tied) (5) 2 (tied)
(3) 2 (tied)
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Case 5. 1. a. This will have an impact on audit risk for valuation of accounts
receivable.
b. Accumulation of additional evidence regarding collectability of
receivables will be necessary.
2. a. This situation may or may not affect overall audit risk, depending on
the impact of the financing needed and whether the company will
become so heavily leveraged that profitability becomes inadequate.
This situation might create increased business risk because of the
potential change in ownership. It would have an impact on audit risk
for valuation of stockholders’ equity.
b. Additional evidence will have to be accumulated relating to
stockholders’ equity, as well as any additional debt incurred.
3. a. The client’s changing of its accounting system will affect control risk in
each cycle, primarily for existence, completeness, and valuation.
b. Additional information will have to be accumulated about the system in
each cycle.
4. a. This will affect risk at the financial statement level, which may also
have an impact on risk for assertions relating to earnings and valuation
of assets. For example, the volatility in the industry may indicate the
potential for inadequate industry earnings or for a client’s earnings
being inconsistent with the industry.
b. Additional evidence will have to be accumulated about the financial
viability of the client and to provide evidence that management fraud
does not exist.
5. a. The increase in inventory will affect existence and valuation of
inventory.
b. Additional evidence will have to be accumulated about the existence
and valuation assertions.
Case 6. 1. a. Sales and collection

b. Primarily affects existence, completeness, and valuation assertions
c. Increase
2. a. Acquisitions and payments
b. Potential impact on all assertions
c. Increase
3. a. Sales and collections
b. Valuation, cutoff, and existence
c. No effect
4. a. Production and warehousing
b. Valuation
c. Increase
CHAPTER 12
AUDIT PROCEDURES
I. Review Questions
1. “Procedures” relate to acts to be performed. “Standards” deal with measures of

the quality of performance of those acts and the objectives to be attained by the
use of procedures. The standards are less subject to change. The standards
provide the criteria for rejecting, accepting, or modifying a procedure in a given
circumstance. An example of the relative stability of standards and procedures
is found in the change from non-EDP to EDP systems. New procedures were
required to audit EDP systems, but auditing standards remained unchanged and
were the criteria for determining the adequacy of the new procedures.
2. A “substantive audit procedure” is any action (resembling a specific variation of

one of the seven general audit procedures) undertaken for the purpose of
producing evidence about a peso amount of a disclosure that appears in the
financial statements under audit.
The nature of a procedure is its description – usually associated with one of the
seven general audit procedures. For example, the nature of a procedure may be
confirmation, document, vouching, etc.
The timing of a procedure is the period during which it is performed – usually

distinguished as interim (before the balance sheet date), year-end (on or close to
the balance sheet date), and subsequent (after the balance sheet date).
The extent of a procedure is the number of details audited with it, or another
measure of intensity or frequency. Oftentimes, extent is measured by the sample
size.
3. Inspection techniques include physical examination of assets, examination of

documents and records, performance of mechanical accuracy tests, and
analytical procedures.
4. Vouching and tracing are two types of commonly performed documentation.

Vouching involves the examination of documents that served as a basis for
recording the transaction. Vouching usually starts with a recorded transaction
and works back to the documents and addresses existence. Tracing involves
determining whether source documents have been recorded properly in the
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accounting records. By tracing, an auditor can obtain evidence that the
recording of the transaction is complete.
5. An inquiry involves requesting information from client personnel and receiving

their response. The request and response may be either written or oral. A
confirmation is a response a third party makes directly to the auditor on the
request of a client. The response includes information about certain
transactions, relationships, and/or balances that have an impact on a specific
financial statement assertion.
6. Confirmations are usually considered more reliable because they are from
outside parties, while inquiries are made of client personnel.
7. When equivalent procedures are available to satisfy the need for evidence, an
auditor may consider cost in selecting among the alternatives.
8. Vouching is relevant to testing the existence of sales; tracing is not. Tracing is

relevant to testing the completeness of sales, but vouching is not.
1. c 3. c 5. c 7. a 9. d
2. d 4. a 6. c 8. d
Case 1. The objectives for the audit of Wesson’s securities investments at December 31
are to obtain evidence about the assertions implicit in the financial presentation,
specifically:
1. Existence. Obtain evidence that the securities are bona fide and held by
Wesson or by a responsible custodian.
2. Occurrence. Obtain evidence that the loan transaction and securities
purchase transactions actually took place during the year under audit.
3. Completeness. Obtain evidence that all the securities purchase transactions
were recorded.
4. Rights. Obtain evidence that the securities are owned by Wesson.
Obligation. Obtain evidence that P500,000 is the amount actually owed on
the loan.
5. 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.
6. Measurement.
7. 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 is
disclosed fully and agrees with the loan documents.
Case 2. Types of procedures used by auditors in general, with examples:

1. Recalculation by the auditor
* recomputing the client’s calculation of depreciation expense
2. Observation by the auditor
* observation, test-counting of client’s physical inventory-taking
3. Confirmation by letter
* obtaining accounts receivable confirmations
* obtaining client’s lawyer’s letter
4. Inquiry and written representations
* ask client personnel about accounting events
* complete an internal control questionnaire
* obtain written client representation letter
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
Case 3. a. An audit confirmation is a written statement to the CPA from someone

outside the enterprise on a fact that a person is qualified to affirm.
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
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2. The auditor must obtain the information directly from the informed
party.
Case 4. 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 write-down
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 cost-flow calculations
Case 5. a. A material decline in sales may indicate unrecorded sales; a decrease in cost
of goods sold may be due to unrecorded purchases; and an increase in cost
of good sold may be the result of omissions from the ending inventory. An
increase or decrease in gross profit will result from any one or a
combination of the above omissions.
b. A decline in the miscellaneous revenue account balance, or the absence of a

previously existing source of miscellaneous revenue, could be attributable
to a failure to record miscellaneous revenue.
c. Unrecorded accounts payable at year-end would cause an increase in

calculated accounts payable turnover.
d. An apparent increase in accounts receivable turnover may, in fact, be the

result of failure to record credit sales transactions.
e. A higher than average operating return may be indicative of unrecorded
purchases or operating expenses; a lower than average return could result
from unrecorded sales.
Case 6. a. This is an inappropriate application of cost/benefit to auditing. The second

standard of audit field work states that the auditor is to gather sufficient
competent evidential matter to support the audit opinion. If two or more
sets of audit procedures are available for satisfactorily achieving a set of
specific audit objectives, the cost/benefit concept suggests selection of the
least costly set of procedures. In the present instance, the cost savings from
not observing the branch inventories is achieved only at the sacrifice of
obtaining sufficient evidence to support the audit objective concerning
existence of the inventories.
b. This is an appropriate application of the cost/benefit concept. Confirmation

with the trustee, who is an independent third party, achieves the audit objectives
concerning existence and ownership just as satisfactorily as examination of the
securities – and it is a less costly procedure.
Case 7.
1. f 8. n
2. l 9. k
3. h 10. c
4. e 11. a
5. p 12. g
6. m 13. b
7. d 14. j
Case 8.
1. observation
2. inspection (analytical procedures)
3. inspection (examination of documents)
5. inquiry
6. inspection (mechanical accuracy tests)
8. confirmation
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CHAPTER 13
audit evidence
I. Review Questions
1. Refer to page 494, 2nd and 4th paragraphs of the textbook.
2. Refer to page 494, 3rd paragraph of the textbook.
4. Refer to page 497, 1st paragraph of the textbook.
5. Refer to page 497, 2nd paragraph of the textbook.
6. Refer to page 498, 4th paragraph of the textbook.
7. 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 client.
External-internal documentary evidence is documentary material that originates

outside the bounds of the client’s data processing system but which has been
received and processed by the client.
Internal documentary evidence consists of documentary material that is

produced, circulates, and is finally stored within the client’s information system.
Such evidence is not touched by outside parties at all or is several steps removed
from third-party attention.
8. Auditors can help the effectiveness of confirmation requests by:

a. Having the confirmation letters printed on the client’s letterhead and signed by a
client 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 client’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 client cannot
tamper with them.
e. Receiving the reply directly, so the client cannot intercept and alter them.
9. Factual evidence is direct evidence, in that conclusions may be drawn from the
evidence without further corroboration. An example of factual audit evidence is
physical observation of inventory for existence. Inferential evidence is indirect,
in that direct conclusions cannot be drawn from the evidence. The auditor
typically examines other evidence to further corroborate the inferences drawn.
An oral statement by a product manager that one or more products are fully
saleable and not obsolete is an example of inferential evidence. The auditor may
perform inventory turnover tests and/or determine the date of last sale of the
product to further corroborate the product manager’s statement.
10. Sufficiency of audit evidence is a matter of audit judgment. Materiality and the
quality of internal control are important ingredients in determining sufficiency.
If internal control produces over sales processing and cash receipts, for example,
are effective, the auditor may elect to confirm fewer customers’ accounts
receivables than under conditions of weak internal control.
11. Physical evidence tests the existence assertion. Examples of physical evidence
are inventory observation, examination of securities, inspection of plant asset
additions, and count of cash on hand.
12. The quality of existing internal control is the major factor supporting the
strength of documentary evidence. A voucher produced under conditions of
strong internal control over the processing of vendors’ invoices, for example,
possesses greater validity and is therefore stronger evidence than vouchers
produced under weak control conditions.
13. Auditing standards define an accounting estimate as “an approximation of a

financial statement element, item or amount.” Estimates are used because (1) an
amount is uncertain pending specific future events or (2) relevant data cannot be
accumulated on a timely, cost-effective basis. Examples of accounting estimates
include allowance for uncollectible accounts, obsolete inventory, useful lives
and residual values of fixed assets, natural resources and intangibles, accruals
for taxes on real and personal property, accruals based on actual assumptions in
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pension plans, contract revenue using percentage of completion method,
litigation losses, fair values in nonmonetary exchanges, and current values in
personal financial statements.
14. In evaluating the reasonableness of accounting estimates, an auditor should

consider the internal controls related to the estimates in order to reduce the
likelihood of material misstatements in the estimates, whether the accounting
estimates are reasonable given the situation, and whether the accounting
estimates are presented in accordance with appropriate accounting principles.
15. Evidence is persuasive if the auditor considers the evidence to be sufficient and
competent enough to afford a reasonable basis for an opinion.
1. d 4. c 7. d 10. d 13. b
2. d 5. a 8. b 11. a
3. c 6. d 9. d 12. b
Case 1. 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.
Case 2. 1. Types of evidence
Evidential items/sources in reliability rank

d. Letter from creditor 1. External
a. Monthly statements 2. External-internal
b. Voucher register 3. Internal
c. Audit computation of discounts 4. Mathematical (based on
unaudited data)
2.
c. Audit computation of expense 1. Mathematical (based on
amounts unaudited data)
a. Letter from bond trustee 2. External
d. Cancelled checks 3. External-internal
b. Minutes of directors’ meetings 4. Internal
CHAPTER 14
audit working papers
I. Review Questions
2. The major function of audit workpapers is to provide evidence of conformance

with generally accepted auditing standards. As a body, the workpapers are
the principal record of the evidence which the auditor has gathered and
evaluated in support of the audit opinion.
3. Refer to pages 524 to 525 of the textbook.
4. Refer to page 524, 2nd paragraph of the textbook.
5. With electronic spreadsheets, audit adjustments need only be entered once – in

the supporting schedule. The adjustments are then automatically reflected
in lead schedules and in the working trial balance through equations entered
in appropriate cells. The cell equations “link” the workpapers such that an
adjustment need be entered only once in order for all affected workpapers to
be automatically updated.
6. Permanent files contain information that is of a continuing interest to the auditor.

A permanent file typically contains (1) copies or abstracts of significant
company documents and (2) auditor- or client-prepared information on accounts.
Current-year files contain working papers prepared to support the assertions
embodied in the financial statements.
7. Client personnel may prepare working papers to reduce the time spent by the
auditor on the engagement. When client personnel prepare working papers, the
auditor should give the client personnel detailed instructions. Working papers
prepared by the client should be identified as PBC (prepared by client) and
should involve no decision making. The auditor should test completed working
papers against underlying documentation.
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8. The lead schedule, especially on larger engagements, is designed to bridge the

gap between the working trial balance and the general ledger by listing all
general ledger accounts that are reported as one account in the financial
statements. Supporting schedules is a term for working papers that support the
amounts presented in the financial statements by providing support for a detailed
account on a lead schedule. Supporting schedules represent the bulk of working
papers.
9. In general, a properly prepared working paper should meet firm policy, have a
proper heading, clearly indicate the work performed, clearly meet the audit
objective for which it was designed, and clearly state the auditors’ conclusion.
10. The prior year’s audit working papers are a useful guide to staff assistants
because the audit procedures performed in the prior year usually are similar to
those of the current year. By referring to last year’s working papers, the
assistant can see how the procedures were documented and is given a possible
format for organizing the current year’s working paper. In addition, exceptions
noted in last year’s working papers may alert the assistant to possible problems
in the current year. Finally, the prior year’s working papers contain information
substantiating the beginning balances for the current year.
11. The more common types of audit working papers and their principal purposes
may be summarized as follows:
(1) Audit administrative working papers – aid the auditors in planning and
administration of the audit, and include such items as the audit programs,
questionnaires and flowcharts, decision aids, time budgets, and
engagement letters.
(2) Working trial balance – represents the backbone of the auditors’ working
papers, for it contains the balances of the ledger accounts, the adjustments
and reclassifications deemed necessary by the auditors, and the adjusted
amounts that appear in the financial statements. It also contains references
to all supporting schedules and analyses, thus serving to control the other
types of working papers.
(3) Lead schedules – working papers that serve to combine similar general
ledger accounts, the total of which appears on the working trial balance.
(4) Adjusting journal entries – material misstatements in the accounts disclosed by
the auditors’ investigation are corrected by means of adjusting journal entries.
These appear on the auditors’ working trial balance, and in addition, a list of
such entries is turned over to the client at the conclusion of the audit with the
request that they be approved and entered in the accounting records.
(5) Reclassification entries – entries necessary to properly reflect financial
results but not representing misstatements in the financial records of the
client.
(6) Supporting schedules – although the term schedule is at times applied to
various types of working papers, the preferred usage is to designate a
listing of the details or elements comprising the balance in an account at a
specified date. Preparation of such a listing is often an essential step in
determining the nature of an account.
(7) Analyses – consist of working papers showing the changes which occurred in an
account during a given period. By analyzing an account, the auditors determine
its nature and contents.
(8) Reconciliations – working papers that prove the relationship between two
amounts obtained from different sources.
(9) Computational working papers – used to verify such data as interest
expense, income taxes, and earnings per share.
(10) Corroborating documents – working papers that provide support for specific
representations made in the financial statements, such as letters of
representations from clients, lawyers’ letters, audit confirmations, and copies of
the contracts.
12. Audit working papers are the property of the auditor; however, they must not
violate the confidential relationship between client and auditors by making the
papers available to outsiders or even to the client’s employees without specific
permission from the client.
13. Refer to page 535, 1st and 2nd paragraphs of the textbook.
1. d 9. b 17. d 25. b
2. d 10. b 18. c 26. d
3. c 11. a 19. c 27. d
4. a 12. d 20. d 28. c
5. d 13. d 21. b 29. d
6. c 14. b 22. d 30. c
7. c 15. d 23. a 31. d
8. d 16. d 24. b 32. d

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Case 1. a. (1) The functions of audit working papers are to aid the CPA in the conduct
of his work and to provide support for his opinion and his compliance
with auditing standards.
(2) Working papers are the CPA’s records of the procedures performed, and
conclusions reached in the audit.
b. The factors that affect the CPA’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 client’s business.
3. The nature of the financial statements, schedules or other information
upon which the CPA is reporting and the materiality of the items
included therein.
4. The nature and condition of the client’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

CPA’s compliance with generally accepted auditing standard includes:
1. Evidence that the financial statements or other information upon which
the auditor is reporting were in agreement or reconciled with the
client’s records.
2. Evidence that the client’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 CPA 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 a client’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.
Case 2. In general, the working paper is not set up in a logical manner to show what the
auditor wants to accomplish. The primary objective of the working paper is to
verify the ending balance in notes receivable and interest receivable. A
secondary objective is to account for all interest income, cash received and cash
disbursed for new notes, collateral as security, and other information about the
notes for disclosure purposes.
Specific deficiencies of the working paper presented in the question are:
a. b.
DEFICIENCY IMPROVEMENT
1. Tick mark explanation “tested” Should have separate tick marks
does not indicate specifically meaning:
what was done.  Agreed to confirmation
 Footed
 Traced to cash receipts journal
 Recomputed, etc.
2. Explanation of some tick marks is Explain all tick marks on the same
not given. page of the working paper.
3. Classification of long-term Recompute portions of notes which are
portion indicates no verification. long-term.
4. Paid-to-date row is confusing. Column should say “date paid to” and
this should be confirmed.
5. Due dates are missing for C.C. Include due dates on working paper
Co., P. Pablo and Tetra Co. for these notes.
c. SPREADSHEET SOLUTION
The purpose of using an Excel spreadsheet in this problem is to give the
student some experience in preparing a simple working paper using an
Excel spreadsheet. It should be explained to students that this type of
working paper may or may not be prepared in actual practice, and that often
templates are used to prepare more time-consuming working papers. Also,
whether or not tick marks are computerized is a matter to be decided. The
advantage is that the completed audit work can then be stored and reviewed
electronically, a direction many firms are going. On the other hand, it may
be more efficient to indicate audit work manually as it is performed, and a
contrast in the color of the tick marks through use of a colored pencil may
be desirable.
The formulas used are self-evident, so no listing is provided. Two items

deserve comment:
Services
1. An advantage of using a spreadsheet program for these types of
analyses is that footing and crossfooting are done automatically.
2. When auditor tick marks are done by computer, a problem arises as
to how to place them on the worksheet. One could use narrow
columns inserted between the scheduled client data, or, as done
here, the tick marks are placed in blank rows beneath the related
data.
14-21 Solutions Manual - Principles of Auditing and Other Assurance Services
FOURTH PACIFIC COMPANY Schedule N-1 Date

A/C # 110 – NOTE RECEIVABLE Prepared by JD 1/21/04
12/31/03 Approved by PP 2/15/04
Account # 110 – Notes Receivable Interest

Date Interest
Made / Rate / Face Value of Balance Balance Receivable Receivable
Maker Due Date Paid to Amount Security 12/31/02 Additions Payments 12/31/03 12/31/02 Earned Received 12/31/03
Alba Co. c* 6/15/02 / 5% / 5000 None 4000 0 1000 3000 104 175 0 279
6/15/04 None pd. tp r tp <
Barrios, Inc. c* 11/21/02 / 5% / 3591 None 3591 0 3591 0 0 102 102 0
Demand 12/31/03 tp r tp < r
C.C. Co. c* 11/1/02 / 5% / 13180 24000 12780 0 2400 10380 24 577 601 0
4/1/08 12/31/03 tp r tp < r
(P200/Mo.)
P. Pablo c* 7/26/03 / 5% / 25000 50000 0 25000 5000 20000 0 468 200 268
8/1/05 9/30/03 r r < r
(P1000/Mo.
)
Martin Cruz c* 5/12/02 / 5% / 2100 None 2100 0 2100 0 0 105 105 0
Demand 12/31/03 tp r tp < r
Tetra Co. c* 9/3/03 / 6% / 12000 10000 0 12000 1600 10400 0 162 108 54
2/1/06 11/30/03 r r < r
(P400/Mo.)
22471 37000 15691 43780 128 1589 1116 601
f f f f, cf f f f f, cf
tp wtb tb op wtb
Legend of Auditor’s Tick Marks

f Footed
cf Crossfooted
tp Traced to prior year working papers
wtb Traced total to working trial balance
op Traced total to operations working paper – OP6
* Examined note for payee, made and due dates, interest rate, face amount, and value of
security. No exceptions noted.
c Received confirmation, including date interest paid to, interest rate, interest paid during 2003,
note balance, and security. No exceptions noted.
r Traced to cash receipts journal
< Recomputed for the year
MANAGEMENT ACCOUNTING (VOLUME II) - Solutions Manual
CHAPTER 15
BASIC CONCEPTS AND ELEMENTS

OF INTERNAL CONTROL
I. Review Questions
1. Refer to page 548, 3rd paragraph and page 549, 1st paragraph of the textbook.
2. Internal control systems are defined as “. . . the process by which an entity’s

board of directors, management and/or other personnel obtain reasonable
assurance as to the achievement of specified objectives.”
3. The basic elements of internal control are:

a. Control environment, and
b. Control procedures.
4. All internal control systems, due to the human factor, contain certain inherent
limitations. Because of these inherent limitations, internal control provides
reasonable, but not absolute, assurance as to the achievement of control
objectives.
5. Management support of internal control is prerequisite to its effectiveness. That

is, no matter how sound the other components, the system will not be effective if
management does not support it and communicate that support throughout the
organization. An organizational awareness that management takes internal
control seriously, helps to maximize the effectiveness of the control activities.
A management operating style that supports proper ethical behavior also

enhances the effectiveness of the entity’s internal control. If employees perceive
that management conducts itself in accordance with proper ethical behavior,
such conduct will tend to reflect itself throughout the organization. Proper
ethical behavior, in turn, minimizes the probability that financial statements will
be intentionally misstated.
6. A centralized, efficient human resources function, an integral part of the control

environment, enhances competence by placing the right people in the right jobs
and training them properly to perform their assigned tasks.
7. An effective set of internal controls requires a careful analysis of decision

alternatives, and the assumption of high risk only where warranted. A
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Application of Quantitative Techniques in Planning, Control and Decision Making
– II Chapter 18
management attitude geared toward excessive risk-taking hampers goal
attainment and thereby compromises control.
8. Monitoring affects all of the other controls by assuring their effectiveness over
time. “Ongoing” monitoring is recurring and somewhat automatic. An example
is the periodic analysis of cost variances and follow-up control where the
variance is material and controllable. “Separate evaluation” applies to those
controls not conducive to ongoing monitoring. Integrity, ethical values, and
competence, for example, cannot be monitored on a “real-time” basis, but
require periodic review for effectiveness.
9. Fixing of responsibility enhances control by providing accountability for assets.

The person responsible for prelisting incoming cash receipts, for example, will
be initially accountable for any discrepancy between such prelisting and the
receipted deposit ticket obtained from the bank. Knowledge of such
accountability, in turn, will encourage care in preparing the prelisting and in
transferring the cash receipts to the person designated as responsible for
preparing and making bank deposits.
10. Any internal control system, regardless of how sound it is, has certain inherent
limitations. The system can be circumvented by collusion among two or more
employees; management can override the structure; and the procedures can
break down temporarily causing a lag in the adaptation of the controls. For
these reasons, an effective system of internal control provides reasonable, but
not absolute assurance as to the prevention and detection of material errors or
irregularities. Auditors, therefore, must not rely totally on a sound control
system as support for their audit opinion. Rather, they must recognize the
inherent limitations and, at the very least, perform a minimum amount of
substantive audit testing.
11. Small entities, typically, cannot afford the degree of separation of functional
responsibilities existing in larger firms. Also, small firms, typically, cannot
support a separate internal audit staff. For these reasons, compensating controls
are necessary in smaller organizations. Such compensating controls ordinarily
require that the owner/manager assume an active role in reviewing transactions,
examining documents, reconciling bank accounts, and otherwise performing
many of the tasks normally done by internal auditors in larger organizations.
12. Separating recordkeeping from custody of the related assets provides an

independently maintained record which may periodically be reconciled with
assets on hand. This independent record holds the personnel of a custodial
department accountable for assets entrusted to their care. If the accounting
records were maintained by the custodial department, opportunity would exist
for that department to conceal its errors or shortages by manipulating the
records.
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Chapter 18 Application of Quantitative Techniques in Planning, Control and
Decision Making - II
13. Most controls can be classified as either prevention controls or detection
controls. A control environment, for example, that reflects strong
management support of effective control activities and proper ethical
behavior, will encourage organizational personnel to be conscientious in
performing their assigned tasks, and thereby assist in preventing errors or
irregularities. Periodic inventories and comparisons, on the other hand, will
assist in detecting errors or irregularities which have already occurred.
Both types of controls are vital to an effective system of internal control.
14. A company control procedure is an action taken for the purpose of preventing,
detecting, or correcting errors and irregularities in transactions.
15. Examples of periodic comparisons:

Count of cash on hand.
Reconciliation of bank accounts.
Count of securities.
Confirmation of accounts receivable.
Confirmation of accounts payable.
Physical count of inventory.
16. Four kinds or functional responsibilities that should be segregated:

1. Authorization to execute transactions.
2. Recording of transactions (bookkeeping).
3. Custody of assets.
4. Periodic reconciliation (comparison) of existing (real) assets to
recorded amounts.
17. Key factors in protecting against losses through embezzlement include an

adequate internal control structure, fidelity bonds, and regular audits by
independent public accountants.
18. Assuming that the general category of transaction has already been authorized
by top management, at least three employees or departments should usually
participate in each transaction to achieve strong internal control. One employee
approves the transaction after determining that the details conform to company
policies, another employee records the transaction in the accounting records, and
the third employee executes the transaction by releasing and/or taking custody
of the related assets. (Note: the approval function may be omitted in an
extremely simple transaction such as a cash sale not involving a check).
19. Refer to page 557 of the textbook.
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– II Chapter 18
1. d 4. d 7. b 10. a
2. d 5. d 8. a 11. c
3. b 6. b 9. d 12. c
Case 1.
RELEVANT TO ASSERTION HOW
AUDIT? AFFECTED AFFECTED?
a. Yes Completeness Year-end adjustments for accruals
Valuation and/or allocations may be
overlooked.
b. Yes Existence Customers may be billed for goods
Valuation not shipped. If so, customer
accounts may not be valid.
c. No N/A N/A
d. Yes Valuation Debits and credits to incorrect
Presentation accounts are likely to cause
materiality errors.
e. Yes No assertions are adversely affected, given the
compensating control of conducting an annual physical
inventory
f. Yes Completeness Some cash receipts may not be
deposited.
Valuation Cash in bank and/or accounts
receivable may be overstated,
depending on whether or not
undeposited cash was recorded.
g. Yes Presentation Trade accounts receivable should
be kept separate from nontrade
receivables. Credit balances in
customer accounts should be
reported as current liabilities.
h. Yes Existence Invoices may be submitted a
Valuation second time for payment and the
signed disbursement checks
misappropriated. The result may
be debits to inventory or other
accounts for nonexistent goods or
services.
i. No N/A N/A
18-25
Case 2.
INHERENT OR CONTROL TYPE OF INHERENT OR
WEAKNESS CONTROL REMEDY
a. Inherent Temporary breakdown: environmental
changes not accompanied by revised
controls.
b. Control Chart of accounts and accounting
manuals; training of personnel who
determine debits to various expenditure
accounts; review of account distribution
by second person; internal auditor
review of transactions on a test basis.
c. Inherent Management override.
d. Control Bills of lading evidencing shipment of
goods should be prenumbered and
signed by the carrier. A copy should be
forwarded to accounts receivable and
should trigger the mailing of an invoice
to the customer. The numeric sequence
of used bills of lading should be
accounted for periodically and bills of
lading should be matched with customer
invoices on a test basis.
e. Control Billing clerks should not handle cash
receipts. Incoming cash receipts should
be prelisted and compared with daily
deposits. Credits to customer accounts
should be made from remittance advices.
Checks should be forwarded directly to
the treasurer (cashier) for deposit.
Writeoffs of customer accounts should
require approval by the credit manager
or some other responsible officer.
f. Inherent Collusion
Case 3. a. The planned assessed level of control risk is the level the auditors intend to
use in performing the audit for a particular financial statement assertion.
For example, after obtaining the understanding of internal control necessary
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– II Chapter 18
to plan the audit, the auditors will project a planned assessed level of
control risk based on their understanding of the internal control structure.
The assessed level of control risk is the level of risk based on the tests of
controls performed to evaluate control risk for an assertion. Control risk is
the actual, but unknown, level of risk pertaining to an assertion.
b. While obtaining an understanding of the internal control structure, the
auditors may determine a planned assessed level of control risk for the
existence of accounts receivable which requires them to test a sample of
sales transactions. Based on the results of the tests of controls for sales, the
auditors may arrive at an assessed level of control risk that is either higher
or lower than the level planned. The actual level of control risk for
existence of receivables is, as always, at an unknown level.
Case 4. a. After obtaining an understanding of the internal control structure, the

auditors assess control risk. At this point they may or may not have
performed some tests of controls. When they believe that a lower level of
assessed control risk may be possible, and that the related reduction of
substantive tests may be cost justified, the auditors will perform additional
tests of controls. Finally, when the additional tests of controls have been
performed, the auditors will reassess control risk and design substantive
tests.
b. Obtain an understanding Prepare flowchart

Prepare checklists
Prepare questionnaires
Perform walk-through of transactions
Perform some tests of controls
Determine the planned assessed
level of control risk Analyze results obtained
Perform additional tests
of controls Perform inquiry procedures
Inspect documents for performance
Observe application of procedures
Reperform application of procedures
Reassess control risk and
design substantive tests Analyze results obtained
Case 5. Since Vasquez’s consideration of the internal control structure shows that
controls are very weak, he may omit performing tests of controls. He must,
however, have an adequate understanding of internal control to plan the
remainder of the audit. At a minimum, Vasquez should obtain a basic
understanding of the control environment, accounting system, and important
18-27
control procedures. He should document this understanding, and also document
that control risk is assessed at the maximum level.
Case 6. a. (1) The primary advantage of the internal control questionnaire is that
control weaknesses, including the absence of control procedures, are
prominently identified by the “no” answers. Another advantage of the
questionnaire is its simplicity. If the questions have been
predetermined, as is usual, the auditors’ responsibility includes the
completion of the questionnaire with yes-or-no answers, and written
explanations are required only for the “no” or unfavorable answers.
Also, the comprehensive list of questions provides assurance of
complete coverage of significant control areas.
(2) An advantage of the written narrative approach in reviewing internal
control is that the description is designed to explain the precise controls
applicable to each examination. In this sense, the working paper
description is tailor-made for each engagement and thus offers
flexibility in its design and application. A second advantage is that its
preparation normally requires a penetrating analysis of the client’s
system. In requiring a written description of the flow of transactions,
records maintained, and the division of responsibilities, the
memorandum method minimizes the tendency to perform a perfunctory
review.
(3) The use of a flowchart in documenting internal control offers the
advantage of a graphic presentation of a system or a series of sequential
processes. It shows the steps required and the flow of forms or other
documents from person to person in carrying out the function depicted.
Thus, the tendency to overlook the controls existing between functions
or departments is minimized. Another advantage is that the flowchart
method avoids the detailed study of written descriptions of procedures
without sacrificing the CPA’s ability to appraise the effectiveness of
internal controls under review. An experienced auditor can gain a
working understanding of the system much more readily by reviewing
a flowchart than by reading questionnaires or lengthy narratives.
Information about specific procedures, documents, and accounting
records can also be located more quickly in a flowchart. Because of
these advantages, flowcharting has become the most widely used
method of describing internal control in audit working papers.
b. Even though internal control appears to be strong, the auditors are required
to conduct tests of controls. Just because policies and procedures are prescribed
does not mean that the client’s personnel are adhering to those requirements.
Employees may not understand their assigned duties, or may perform those
duties in a careless manner, or other factors may cause the internal controls
actually in place to differ from those prescribed.
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– II Chapter 18
Through tests of controls the CPAs obtain reasonable assurance that the
internal control policies and procedures are in use and are operating as
planned, and they may detect material errors of types not susceptible to
effective internal control. In addition, such testing enables the CPAs to
comply with the third standard of field work which calls for obtaining
sufficient competent evidential matter to provide a reasonable basis for an
opinion.
Note to instructor – Auditors may forego tests of controls if they conclude
that internal controls are so weak as to provide no basis for assessing
control risk at a level lower than the maximum.
Case 7.
PURPLE CORP.
Raw Materials Recording and Transferring System Flowchart
December 31, 2003
ACCOUNTING
Start INVENTORY CLERK MANUFACTURING
STORES
Clerk
Prepares
Goods
Stock-in Requisition
from
Report
Supplier
Requisition
Storeskeeper Posts Inventory 1
Prepares Perpetual Records at 2
Stock-in Inventory Standard
Report Records Cost
Supervisor
Approves
Stock-in Filed
Requisition
Report 1 by
2
2 date
Approved Approved
Filed Requisition 1
by Requisition
1 2
date
Reviews
for
Completeness Filed
by Job
3 Order
18-29
Posts Transfer to Inventory
Perpetual Records at
Inventory Standard
Records Cost
Filed
by
4
date
Case 8. a. The quantity of serially numbered tickets issued during the shift of each
cashier is multiplied by the price per ticket to determine the amount of cash
which the cashier should have on hand at the end of the shift.
Two employees participate in each transaction. The withholding cash

receipts would require collusion between the cashier and the door attendant
because the door attendant does not have access to cash and the cashier
cannot cause a patron to be admitted without issuing to him a serially
numbered ticket.
b. The following steps should be taken by the manager to make these controls
work effectively:
(1) Maintain careful control over unused rolls of tickets.
(2) Make a record of the serial number of the first and last ticket issued on
each cashier’s shift.
(3) Count the cash in possession of cashier at beginning and end of shift.
In addition to these regular routines, the manager should take the following
steps at unannounced intervals:
(4) Observe that the cashier never has loose tickets in his or her possession
and does not sell tickets in any manner other than ejecting them from the
ticket machine.
(5) Verify by inspection of tickets being presented by patrons to the door
attendant that only recently issued tickets (current serial numbers) are
being used.
c. Collusion by the cashier and door attendant to abstract cash receipts often
consists of the door attendant pocketing whole tickets presented by patrons
rather than tearing the ticket in half. He or she may then give these unused
tickets to the cashier; the cashier may then resell the tickets to customers at the
box office rather than punching out new tickets on the machines. The cashier
withholds the cash received from sales of these “used tickets” and divides it with
the door attendant.
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– II Chapter 18
d. Observation on a surprise basis by the manager of the serial numbers of
tickets being presented at the door by customers may reveal that these
tickets are not freshly issued ones. Observation of the cashier’s work may
reveal that this employee is handling loose tickets.
CHAPTER 16
CONSIDERATION OF INTERNAL CONTROL

IN A FINANCIAL STATEMENTS AUDIT
I. Review Questions
1. An auditor obtains an understanding of a client’s internal control structure as a

part of the control risk assessment process in order (1) to plan the nature, timing,
and extent of subsequent substantive audit procedures, and (2) to obtain
information about reportable conditions (control deficiencies) to report to the
client.
2. The primary reason for conducting an evaluation of a client’s existing internal

control system is to give the auditors a basis for finalizing the details of the
account balance audit program – to determine the nature, timing and extent of
subsequent substantive audit procedures.
A secondary purpose for conducting an evaluation of internal control is to be

able to make constructive suggestions for improvements. Officially, the
profession considers these suggestions a part of the audit function and does not
define the work as a MAS consultation.
Another purpose of the evaluation is to report to management and the board of

directors or its audit committee any discovery of “any reportable conditions” of
internal control deficiencies.
3. Refer to page 590, 1st paragraph of the textbook.
4. 1. Advantages of control questionnaire:

Easy to complete.
Checklist of questions.
Less chance of overlooking something important.
Disadvantages:
18-31
May contain numerous irrelevant questions.
Tendency to treat it like another form to fill out.
2. Advantages of memorandum documentation:

Can explain the precise controls applicable to the particular client.
(precise tailoring)
Requires penetrating analysis.
Minimizes tendency toward perfunctory review.
Disadvantages:
Hard to write. Often lengthy.
Hard to revise in subsequent years.
3. Advantages of flowchart:
Graphic presentation of systems.
Shows the steps required and the flow of forms and documents.
Easy to read and analyze.
Easy to update in subsequent years.
Disadvantages:
Takes some time to draw neatly.
5. “Observation,” in a test of control procedure, refers to auditors looking to see

whether client personnel stamped, initialed, or left other signs that their assigned
control procedures had been performed.
“Reperformance,” in a test of control procedure, refers to auditors doing again

the control that was supposed to have been performed by the client personnel
(recalculating, looking up the right price, comparing quantities, and so forth).
6. Written reports on internal accounting control (IAC) for external use.
Type of Engagement Character of Report

Special IAC study Report on IAC with opinion on IAC
system taken as a whole.
Service auditor engaged to report for A special-purpose report on IAC can
benefit of user auditor and their take special forms, the main feature of
mutual client. which includes an opinion relating to
the controls applied by the service
organization to the client
organization’s transactions.
7. The auditor must obtain a sufficient understanding of the client’s system of

internal financial controls to identify the types of potential material
misstatements of financial statement components, and the risks associated with
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– II Chapter 18
each. Such understanding is obtained by gathering evidence relating to the basic
elements of the client’s internal financial controls.
8. The auditor obtains an initial understanding of the client’s financial controls by

studying the organizational structure, inquiring of management, and studying
last year’s working papers if a recurring audit.
9. The documentation of the auditor’s understanding must provide clear evidence

of support for the auditor’s conclusions regarding the assessed level of control
risk. This is especially necessary if control risk is assessed below the maximum
level. The documentation at this point typically consists of some combination of
narrative memoranda, questionnaires or checklists, and internal control
flowcharts, as well as documentation of the auditor’s conclusions, and the
reason(s) for assessing control risk below maximum, if applicable.
10. Testing of internal financial controls may permit the auditor to further reduce the
assessed level of control risk. This, in turn, should lead to a decrease in the
nature, timing, and/or extent of substantive audit testing in the circumstances.
11. The following factors may cause the auditor to decide not to test the client’s
internal financial controls beyond obtaining an initial understanding:
a. Controls may already have been evaluated as ineffective;
b. Further testing is not cost effective (i.e., the cost of further testing is
greater than the cost savings resulting from reduced substantive testing)
12. Some combination of the following means is typically utilized by the auditor in
testing a client’s internal financial controls:
a. Reprocessing transactions through the client’s system;
b. Observation of controls; and
c. Document examination and testing.
13. Misrepresentation is a form of financial statement misstatement caused by

intentional efforts by management to distort reported financial position and/or
results of operations. Misappropriation is a form of fraud whereby one or more
employees effect a transfer of assets from employer to employee, accompanied
by concealment in the form of account or substance alteration.
14. The following are some examples of internal control weaknesses and suggested
expanded substantive testing, given the weaknesses:
a. Perpetual inventory records not maintained: Expand test counts during
inventory observation
b. Bank accounts not reconciled: Expand year-end audit of cash accounts
18-33
c. Customer exceptions to monthly statements not investigated and
cleared: Expand accounts receivable confirmation at year-end.
15. Reportable conditions are matters coming to the auditor’s attention, as a result of
his/her study and evaluation of the client’s internal financial controls, relating to
significant deficiencies in the design or operation or of the internal controls that
could adversely affect the organization’s ability to record, process, summarize,
and report financial data consistent with the assertions of management in the
financial statements. The purpose of the reportable conditions letter is to inform
the audit committee, or similar body within the organization, of weaknesses for
which they may not be aware. Such communication increases the likelihood
that the weaknesses will be corrected on a timely basis.
16. Use of any one of the approaches to studying and documenting a client’s internal
financial controls, by itself, is inadequate. Each approach adds a needed
dimension to the analysis. The memorandum requires depth of analysis not
found in the flowchart. The flowchart, on the other hand, promotes ease of
understanding and ready identification of strengths and weaknesses in controls.
The questionnaires and checklists add the dimension of completeness of
coverage. By using the three tools in combination, the auditor is able to gain a
deeper and clearer understanding of each of the subsets of the transaction cycles,
including major control strengths and weaknesses, thereby permitting more
accurate control risk assessments and more useful substantive audit programs
based on such assessments.
1. b 8. a 15. d 22. a
2. a 9. b 16. c 23. a
3. b 10. c 17. b 24. d
4. d 11. b 18 b 25. b
5. b 12. a 19. a 26. d
6. b 13. b 20. d 27. b
7. b 14. b 21. a 28. d
Case 1. a. Given identified financial control weaknesses, the auditor may elect to
expand the extent of substantive testing, or search for and test compensating
controls. In the present case, the following errors and irregularities may
occur, given the control weaknesses in the payroll subset of the expenditure
cycle:
1. Hours may be in error, inasmuch as the time cards are prepared by
employees and not reviewed. This could lead to overstatement or
understatement of wages expense in the income statement. This
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– II Chapter 18
could also affect the carrying value of finished goods inventories if
Quicky is a manufacturing company.
2. The payroll could be “padded” inasmuch as signed checks are
returned to the department supervisors for distribution. This could
result in overstatements of salaries and wages expense on the
income statement. It could also cause a finished goods inventory
overstatement.
b. If, based on the initial understanding, controls are thought to be adequate,

the auditor should consider the following alternatives:
1. Document the understanding, assess control risk below maximum,
as considered appropriate, and document the basis for conclusions;
or
2. Document the understanding and test controls as a means for
further reduction in the assessed level of control risk. This
alternative would be chosen if the following conditions exist:
a. Controls are thought to be effective; and
b. Cost reductions through reduced substantive testing
exceed cost of further testing of controls.
c. 1. Auditors must study and evaluate internal control each year because the
environment within which the client operates is subject to constant
change; and controls must adapt to these changes if the system is to
remain effective. The auditor must identify the environmental changes
and determine that the relevant control points remain covered after the
changes.
2. A minimum audit is necessary, even under conditions of excellent

internal control, because of the following inherent limitations in all
internal control systems:
Internal control assumes the nonexistence of collusion;
Management can override the financial controls;
Temporary breakdowns in the control system may occur and
produce material errors;
Given that these inherent limitations could produce material financial

statement misstatements, and given that the audit report provides
reasonable assurance that the financial statements do not contain
material misstatements, the auditor must perform a minimum audit,
even under conditions of excellent internal control if such assurance is
to be provided.
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Case 2.
ISLANDER DRUG STORE, INC.
Processing Cash Collections
Internal Control Questionnaire
-Question Yes No
Are customers who pay by check identified via store I.D. card or
other means?
Does company policy prohibit accepting checks for anything
except merchandise sales plus a nominal cash amount?
Is a receipt produced by the cash register given to each
customer?
Is the reading of each cash register taken periodically by an
employee who is independent of the handling of cash
receipts?
Are cash counts made on a surprise basis by an individual who is
independent of the handling of cash receipts?
Is the reading of each cash register compared regularly to the
cash received?
Is a summary listing of cash register readings prepared by an
employee who is independent of physically handling cash
receipts?
Are receipts forwarded to an independent employee who makes
the bank deposits?
Are each day’s receipts deposited intact daily?
Is the summary listing of cash register receipts reconciled to the
duplicate deposit slips authenticated by the bank?
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– II Chapter 18
Are entries to the cash receipts journal prepared from duplicate
deposit slips or the summary listing of cash register
readings?
Are the entries to the cash receipts journal compared to the
deposits per bank statement?
Are areas involving the physical handling of cash reasonably
safeguarded?
Are employees who handle receipts bonded?
Are charged back items (NSF checks, etc.) directed to an
employee who does not physically handle receipts or have
access to the books?
CHAPTER 17
BASIC AUDIT SAMPLING CONCEPTS
I. Review Questions
3. Refer to page 640 of the textbook.
4. Audit conclusions can be made only about the population from which the
sample was drawn, and a conclusion can only be valid if the sample on which it
is based actually shows the characteristics of the population. Auditors can
attempt to achieve representativeness, but they cannot guarantee it. Sampling
risk – the probability that the sample does not adequately reflect the population
– always exists.
5. Refer to page 646, 2nd paragraph; page 647, 1st paragraph of the textbook.
7. Refer to page 652, paragraphs 1 to 4 of the textbook.
8. Refer to page 652, paragraphs 3 and 4 of the textbook.
9. Refer to page 653, 4th paragraph & page 654, 1st to 3rd paragraph of the textbook.
18-37
10. Sampling risk is the probability that the auditor’s conclusions concerning the
population will be in error. In terms of conclusions regarding internal control,
sampling risk consists of two subsets:
Alpha risk, the risk that the auditor will assess control risk too high and
perform more substantive testing than is necessary under the circumstances;
and
Beta risk, the risk that the auditor will assess control risk too low and
perform less substantive testing than is necessary.
For control testing purposes, the auditor is more concerned with beta risk than
alpha risk, because beta risk poses the threat of underauditing and is therefore
the basis for the audit opinion. The auditor controls this risk by setting beta risk
sufficiently low as to maintain overall audit risk at a level less than or equal to
10%.
1. b 3. d 5. d 7. a 9. a
2. c 4. c 6. b 8. d 10. c
Case 1. a. Areas requiring the auditors to make judgment decisions when statistical
sampling techniques are employed (only four required):
(1) Defining population, characteristics to be tested, and deviations.
Unless a relationship is defined between the occurrence rate of
deviations in the population and either the validity of the client’s
financial statement or the strength of internal control, little useful
information is gained by estimating the occurrence rate.
(2) Determining the appropriate statistical selection techniques for drawing
a random sample. The auditors must recognize the advantages and
disadvantages of stratified selection, unstratified selection, and
systematic selection, and determine which technique is appropriate for
selecting an economical random sample.
(3) Establishing the required maximum tolerable deviation rate and the risk
of assessing control risk too low for the procedure. This requires
judgment decisions regarding materiality, time, cost, and the planned
assessed level of control risk.
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– II Chapter 18
(4) Interpreting sample results. This requires a decision as to whether the
results support the auditors’ planned assessed level of control risk, or
whether additional sampling is necessary to reach a conclusion.
(5) Following up on the discovery of critical errors or unacceptable
deviation rates.
(6) Determining the circumstances under which statistical sampling is
appropriate, and those in which other techniques should be used in lieu,
of or to supplement, the statistical sampling techniques.
This is an open-ended question. The student may identify numerous other

areas in which the auditors must make judgment decisions.
b. If the CPAs’ sample shows an unacceptable deviation rate, they may take
the following actions:
(1) They may enlarge their sample to increase the precision of their
estimate.
(2) They may isolate the type of deviation and expand examination as it
relates to the transactions that give rise to that type of misstatement.
(3) The auditors’ usual response to an unacceptably high deviation rate is
to increase their assessed level of control risk. Accordingly, the
auditors would increase the intensity of their substantive tests.
c. Techniques for selecting an unstratified random sample of accounts payable

vouchers include the following:
Random Sample. A random sample is a sample of a given size drawn from

a population in a manner such that every possible sample of that size is
equally likely to be drawn. Items may be selected randomly by:
(1) Table of Random Numbers. Use one of a number of published tables.
Using four columns in the table, select the first 80 numbers which fall
within the range of 1 to 3,200. The starting point in the table should be
selected randomly and the path to be followed through the table should
be set in advance and followed consistently.
(2) Random Number Generator: Using generalized audit software,
generate a list of 80 random numbers.
Systematic Sample. A systematic sample is drawn by selecting every n th

item beginning with a random start.
(1) Every nth item. Select every 40 th voucher after selecting the initial
voucher (from 1 to 40) randomly.
(2) Several random starting points. For example, use two random starting
points and select 40 of the 80 vouchers from each of the two sequences.
18-39
Select every 80th voucher (3,200/40) after each of the two random
starting points between 1 and 80 for each of the two sequences.
Case 2. a. (1) Since the results of tests of controls typically play a significant role in
determining the nature, timing, and extent of other audit procedures, the
auditors usually specify a low level of risk of assessing control risk too
low. It is usually set at 5 or 10 percent.
(2) In determining the tolerable deviation rate, an auditor should consider

the planned assessed level of control risk and the extent of assurance
desired from the evidential matter included in the sample.
(3) In determining the expected population deviation rate, an auditor

should consider the results of prior years’ tests, the overall control
environment, or utilize a preliminary sample.
b. (1) There is a decrease in sample size if the acceptable level of the risk of
assessing control risk too low is increased.
(2) There is a decrease in sample size if the tolerable deviation is increased.
(3) There is an increase in sample size if the population deviation rate is

increased.
c. Using a statistical sampling approach, Figure 18.4 reveals that 7 deviations

in a sample of size 100 results in an achieved upper deviation rate of 12.8%,
well in excess of the tolerable deviation rate (8%). The sample results
should thus be interpreted as not supporting the planned assessed level of
control risk.
Using a nonstatistical sampling approach, the 7% estimated population

deviation rate identified in the sample (7 deviations / 100 sample items)
approaches the tolerable deviation rate of 8%. Therefore, using a
nonstatistical approach, the sample result would also be interpreted as not
supporting the planned assessed level of control risk.
d. Statistical sampling allows the auditors to quantify sampling risk. As

described in part (c), only when statistical sampling is used do the auditors
know that the achieved upper deviation rate is 12.8%.
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– II Chapter 18
CHAPTER 18
APPLICATION OF QUANTITATIVE TECHNIQUES IN

PLANNING, CONTROL AND DECISION MAKING - II
I. Questions
1. PERT is superior to Gantt Charts in complex projects because:
a. PERT charts are flexible and can reflect slippage or changes in plans,
but Gantt charts simply plot a bar chart against a calendar scale.
b. PERT charts reflect interdependencies among activities; Gantt charts
do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates
for various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex
projects in sufficient detail to facilitate effective control.
A workable sequence of events that comprise the project are first
identified. Each key event should represent a task; then the
interdependent relationships between the events are structured.
After the network of events is constructed, cost and time parameters are
established for each package. Staffing plans are reviewed and analyzed.
The “critical path” computation identifies sequence of key events with
total time equal to the time allotted for the project’s completion. Jobs
which are not on the critical path can be slowed down and the slack
resources available on these activities reallocated to activities on the
critical path.
Use of PERT permits sufficient scheduling of effort by functional areas
and by geographic location. It also allows for restructuring scheduling
efforts and redeployment of workers as necessary to compensate for
18-41
delays or bottlenecks. The probability of completing this complex
project on time and within the allotted budget is increased.
3. Time slippage in noncritical activities may not warrant extensive
managerial analysis because of available slack, but activity cost usually
increases with time and should be monitored.
4. The critical path is the network path with the longest cumulative
expected activity time. It is critical because a slowdown along this path
delays the entire project.
5. Crashing the network means finding the minimum cost for completing
the project in minimum time in order to achieve an optimum tradeoff
between cost and time. The differential crash cost of an activity is the
additional cost of that activity for each period of time saved.
6. Slack is the amount of time an event can be delayed without affecting the
project’s completion date. Slack can be utilized by management as a
buffer against bottlenecks that may occur on the critical path.
7. Unit gross margin are typically computed with an allocation of fixed
costs. Total fixed costs generally will not change with a change in
volume within the relevant range. Unitizing the fixed costs results in
treating them as though they are variable costs when, in fact, they are
not. Moreover, when multiple products are manufactured, the relative
contribution becomes the criterion for selecting the optimal product mix.
Fixed costs allocations can distort the relative contributions and result in
a suboptimal decision.
8. This approach will maximize profits only if there are no constraints on
production or sales, or if both products use all scarce resources at an
equal rate. Otherwise management would want to maximize the
contribution per unit of scarce resource.
9. The opportunity cost of a constraint is the cost of not having additional
availability of the constrained resources. This is also called a shadow
price.
10. The feasible production region is the area which contains all possible
combinations of production outputs. It is bounded by the constraints
imposed on production possibilities. The production schedule which
management chooses must come from the feasible production region.
11. The accountant usually supplies the contribution margin data that is used
in formulating a profit-maximizing objective function. In addition, the
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– II Chapter 18
accountant participates in the analysis of linear programming outputs by
assessing the costs of additional capacity or of changes in product mix.
12. a. Hourly fee for inventory audit (C)
b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
i. Obsolescence costs on inventory (C)
j. Shipping costs per shipment (P)
13. Although the inventory models are developed by operations researchers,
statisticians and computer specialists, their areas of expertise do not
extend to the evaluation of the differential costs for the inventory models.
Generally, discussions of inventory models take the costs as given. It is
the role of the accountant to determine which costs are appropriate for
inclusion in an inventory model.
14. Cost of capital represents the interest expense on funds if they were
borrowed or opportunity cost if funds were provided internally or by
owners. It is included as carrying cost of inventory because funds are
tied up in inventory.
15. Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94 +
P4.85 = P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
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Stockout costs 122.00
Total P425.30
II. Problems
Problem 1 (Solution is found on the next page.)
Problem 2
Requirement (a)
The critical path through each of the three alternative paths calculated as the
longest is 0 - 1 - 6- 7- 8.
0-1-2-5-8 2 + 8 + 10 + 14 = 34
0-1-3-4-7-8 2+8+7+5+3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
________
* critical
Requirement (b)
40 - 3 - 5 = 32
Requirement (c)
If path 4 - 7 has an unfavorable time variance of 10, this means it takes a

total time of 15 to finish this activity rather than 5. This gives the path 0 - 1 -
3 - 4 - 7 - 8 a total time of 35, but since this is less than the critical path of 40,
it has no effect.
Requirement (d)
The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the
expected times.
Problem 3
18-44
– II Chapter 18
No, they didn’t make a right decision, since they included fixed costs which
do not differ in the short run. If they had used contribution margin instead of
gross margin, they would have had P5 for G1 and P6.50 for G2, therefore
they would have decided to produce G2 exclusively.
18-45
Application of Quantitative Techniques in Planning, Control and Decision Making – II Chapter 18
Problem 1
Requirement (a)
TASKS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
Hobbing Order 1 Order 3 Order 4 Order 2
Machining X X X X Order 1 X X Order 3 X X X Order 4 Order 2
___________
X Dead Time
Requirement (b)
28 days are required for the four orders.
18-46
– II Chapter 18
Problem 4
Order costs = Insurance + Other order costs
P = P860 + P18 = P878
Carrying costs = Out-of-pocket Cost of capital

+
costs on inventory
S = P65 + 20% x P222 = P119.40
a. Carrying costs:
QS 250 x P109.40
2 = 2 = P13,675.00
Order costs:
AP 1,500 x P878
= = P 5,268.00
Q 250
Total P18,943.00
b. Economic order quantity:

2 x 1,500 x P878
Q* = =  24,077 = 155 units
P109.40
Carrying costs:
QS 155 x P109.40
2 = 2 = P 8,478.50
Order costs:
AP 1,500 x P878
= = P 8,496.77
Q 155
Total P16,975.27
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Services
Problem 5
It is necessary to evaluate the annual carrying costs and expected stockout

costs at each safety-stock level. The carrying cost will be P24.40 for each
unit in safety stock. With the given order size, there are 15 orders placed a
year (i.e., 39,000/2,600 = 15). Based on these computations, we prepare the
following schedule:
Safety Carrying Costs Expected Stockout Total

Stock of Safety Stock Costs Costs
0 0 0.50 x 15a x P1,650 = P12,375 P12,375
150 150 x P24.40 = P3,660 0.20 x 15a x P1,650 = P 4,950 8,610
175 175 x P24.40 = P4,270 0.05 x 15a x P1,650 = P 1,273.5 5,507.5 (optional)
250 250 x P24.40 = P6,100b 0.01 x 15a x P1,650 = P 247.5 6,347.5
Additional computations:
a
15 is the number of orders per year.
b
It should be evident that at this level the carrying costs alone exceed
the total costs at a safety stock of 175 units. Therefore, it is not
possible for this or any safety-stock level larger than 250 to be less
costly than 175 units. Indeed, given a total cost at 175 units of
P5,507.5, stockout costs would have to occur with probability zero
for any safety stock greater than 225.72 units (i.e., P5,507.5 / P24.40
= P225.72).
III. Multiple Choice Questions
1. C 11. D 21. D 31. C

2. B 12. C 22. C 32. D
3. D 13. A 23. C 33. A
4. B 14. A 24. D 34. C
5. D 15. A 25. D 35. D
6. C 16. C 26. B 36. C
7. A 17. C 27. D 37. D
8. A 18. D 28. E 38. D
9. A 19. C 29. B
10. C 20. D 30. A
21. 31.
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A Risk-based Audit Approach – Part II 11-49
CHAPTER 19
AUDIT SAMPLING FOR SUBSTANTIVE TESTS
I. Review Questions
1. An incorrect acceptance decision directly impairs the effectiveness of an audit.

Auditors wrap up the work and the material misstatement appears in the
financial statements.
An incorrect rejection decision impairs the efficiency of an audit. Further

investigation of the cause and amount of misstatement provides a chance to
reverse the initial decision error.
2. The two methods of projecting the known misstatement to the population are the
average difference method and the ratio method. Refer to Chapter 19 for
formula expressions of each.
3. The important thing is to audit all the sample units. You cannot simply discard
one that is hard to audit in favor of adding to the sample a customer whose
balance is easy to audit. This action might bias the sample. If considering the
entire balance to be misstated will not alter your evaluation conclusion, then you
do not need to work on it any more. Your evaluation conclusion might be to
accept the book value, as long as the account counted in error is not big enough
to change the conclusion. Your evaluation conclusion might already be to reject
the book value, and considering another account to be misstated just reinforces
the decision.
If considering the entire balance to be misstated would change an acceptance

evaluation to a rejection evaluation, you need to do something about it. Since
the example seems to describe a dead end, you may need to select more
accounts (expand the sample) and perform the procedures on them (excluding
confirmation) and reevaluate the results.
4. Two main reasons for stratifying a population when sampling for variables
(peso) measurement:
a. Some units may be individually significant (e.g., large) and taking sampling risk
with respect to them is not a good idea.
b. Auditors may want to achieve audit coverage of a large proportion of pesos
in the balance by choosing the largest units (a protective sampling
objective, which is closely related to avoiding sampling risk).
18-49
Services
5. The tolerable misstatement (judged for the audit of a particular account balance)
must be less than the monetary misstatement considered material to the overall
financial statements. Also, the aggregation of multiple tolerable misstatement
amounts for several different balances under audit must be equal to or less than
the amount of monetary misstatement considered material to the overall
statements.
6. The appropriate general set of objectives is the objective(s) of obtaining

evidence about each of the client’s assertions in the financial balance. In
general, the assertions are about:
Existence (and cutoff)
Occurrence (and cutoff)
Completeness (and cutoff)
Rights and obligations (ownership, owership)
Valuation
Measurement
Presentation and disclosure
7. Influence on sample size:
Sample Size Relationships: Audit of Account Balances
Predetermined Sample Size Will Be:

High Rate or Low Rate or Sample Size
Sample Size Influence Large Amount Small Amount Relation
1. Risk of incorrect Smaller Larger Inverse
acceptance
2. Risk of incorrect Smaller Larger Inverse
rejection
3. Tolerable Smaller Larger Inverse
misstatement
4. Expected Larger Smaller Direct
misstatement
5. Population Larger Smaller Direct
variability
6. Population size Larger Smaller Direct
8. The three basic steps in quantitative evaluation are these:

1. Figure the total amount of actual misstatement found in the sample. This
amount is called the known misstatement.
2. Project the known misstatement to the population. The projected amount is
called the likely misstatement.
18-50
3. Compare the likely misstatement (also called the projected misstatement) to the
tolerable misstatement for the account, and consider the
a. Risk of incorrect acceptance that likely misstatement could be less than tolerable
misstatement even though the actual misstatement in the population is
greater, or the
b. Risk of incorrect acceptance that likely misstatement could be greater
than tolerable misstatement even though the actual misstatement in the
population is smaller.
9. Nonstatistical measurements described in Chapter 19 (page 718) leave only one

avenue for “accounting for further misstatement”: Apply experience and
professional judgment to decide if further misstatement could be large enough to
prevent an acceptance decision. If the projected likely misstatement is a great
deal less than the amount considered material, an auditor could judge that
further misstatement, if known, would not affect acceptance. If projected likely
misstatement is close to the amount considered material, maybe acceptance is
not warranted.
10. Account balances also can be audited, at least in part, at an interim date. When
account balance audit work is done before the company’s year-end date, auditors
must extend the interim-date audit conclusion to the balance-sheet date. The
process of extending the audit conclusion amounts to nothing more (and nothing
less) than performing substantive-purpose audit procedures on the transactions
in the remaining period and on the year-end balance to produce sufficient
competent evidence for a decision about the year-end balance.
Additional considerations include:

a. If the company’s internal control over transactions that produce the balance
under audit are not particularly strong, you should time the substantive
detail work at year-end instead of at interim.
b. If control risk is high, then the substantive work on the remaining period
will need to be extensive.
c. If rapidly changing business conditions might predispose managers to
misstate the accounts (try to slip one by the auditors), the work should be
timed at year-end. In most cases, careful scanning of transactions and
analytical review comparisons should be performed on transactions that
occur after the interim date.
As an example, accounts receivable confirmation can be done at an interim date.

Subsequently, efforts must be made to ascertain whether controls continue to be
strong. You must scan the transactions of the remaining period, audit any new
large balances, and update work on collectibility, especially with analysis of
cash received after the year-end.
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Services
11. Classical variables sampling estimates the value of a population by calculating
the mean and standard deviation of a sample and imputing the results to the
population. Probability proportional to size sampling uses the results of
sampling to calculate an estimated upper error limit and compares this with a
preset tolerable error limit. Although used for substantive testing purposes, PPS
sampling is actually a variation for attribute sampling.
12. Detection (or beta) risk affects sample size inversely for substantive testing
purposes. That is, the higher the acceptable detection risk, the smaller the
sample size; and the lower the acceptable detection risk, the larger the sample
size.
13. Precision is the range + – within which the true answer most likely falls. It is
set by the auditor as a function of materiality and those levels of beta and alpha
risk deemed acceptable. Reliability is the likelihood that the sample range
contains the true value. Also referred to as the confidence level, reliability is set
by the auditor on the basis of overall audit risk.
14. PPS sampling is restricted to populations for which the auditor suspects a few
errors of overstatement only.
15. Several statistical software packages are available to facilitate audit sampling
applications. In addition to calculating sample size and evaluating sample
results, these packages can also assist in the following sampling areas:
a. Stratify populations for sampling purposes;
b. Generate random numbers to facilitate sample selection;
c. Draw the sample, given computerized data bases.
1. b 5. c 9. d 13. a 17. d
2. a 6. b 10. a 14. a 18. b
3. c&d 7. b 11. a 15. c 19. c
4. b 8. d 12. c 16. d 20. d
Supporting Computations:
Audited Value 47,520 490,000 x 0.99 = 485,100
3. c. Book Value 48,000 = 0.99 ; 490,000 – 485,100 = P4,900
P480
d. 120 = P4
1,200 x P4 = P4,800
P 17,500
P500,000
18-52
7. = 3.5%
P450,000 x 3.5% = P157,500

Case 1. a. Alpha risk is the risk of rejecting a population that is essentially correct.
Beta risk is the risk of accepting a population that is materially incorrect.
Alpha risk affects audit efficiency because overauditing results from
incorrectly rejecting a population. Beta risk impacts audit effectiveness
because underauditng results from incorrectly accepting a population.
Collectively, alpha and beta risk comprise sampling risk, defined as the
probability that the auditor will draw erroneous conclusions about a
population.
b. Attention to, and quantification of, alpha and beta risk assist the auditor in
applying an audit risk approach to substantive testing. During the audit
planning stage, the auditor identifies areas of high audit risk and sets
detection (beta) risk low for these areas. The result is that more substantive
testing is devoted to the high risk areas relative to the lower risk areas. This
approach enhances both audit efficiency and audit effectiveness.
c. Because it is closely related to the basis for the auditor’s opinion, alpha risk
is usually set equal to overall audit risk. Beta risk is set on the basis of the
auditor’s evaluation of inherent risk and control risk. The greater these risk
factors, as determined by the auditor during the audit planning stages, the
lower the beta risk set by the auditor. The lower the acceptable beta risk,
the larger the sample sizes for substantive testing purposes. Alpha and beta
risk, therefore, provide the necessary link between audit risk analysis and
substantive audit testing.
Case 2. a. (1) Mean-per-unit estimates the total value of a population by (1) using the
sample mean as an estimate of the true population mean, and (2)
extending this estimated population mean by the number of items in the
population. The computations are as follows:
(1) Estimated population mean =
P582,000 / 200 lots = P2,910 per lot
(2) Estimated total value =
P2,910 per lot x 2,000 lots = P5,820,000
(2) Ratio estimation estimates total population value by (1) using the ratio
of the sample audited values to book values as an estimate of the ratio
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Services
of population audited value to book value, and (2) applying the
estimated ratio to the population book value. The computations are as
follows:
(1) Estimated ratio of audited to book value =
P582,000 / P600,000 = 97%
97% x P5,900,000 = P5,723,000
(3) Difference estimation estimates total population values by (1) using the
average difference between the audited and book values of sample
items as an estimate of the average difference for all population items,
(2) extending the estimated average difference by the number of items
in the population, and (3) using the resulting estimate of the total
difference between audited and book value to compute the estimated
total value. The computations are as follows:
(1) Estimated average difference in audit and book values:
(P582,000 - P600,000) / 200 lots = - P90 per lot
(2) Estimated total difference =
- P90 per lot x 2,000 lots = - P180,000
P5,900,000 - P180,000 = P5,720,000
b. The sample contains an element of sampling error with respect to the

average peso value of production lots. The mean book value of the
population is P2,950 (P5,900,000 / 2,000 lots), while the mean book value
in the sample is P3,000 (P600,000 / 200 lots). Mean-per-unit estimation
uses the mean value of the sample as the basis for estimating total value.
Thus, if the sample contains a disproportionate number of higher (or lower)
priced items, this sampling error will affect the estimate of the total
population value.
The estimate of total value developed in ratio estimation is based upon the
ratio of audited values to book values, rather than upon mean peso value. If
this ratio has no tendency to vary with the peso value of the lot, the estimate
of total value is not affected by the mean value of items in the sample.
However, sampling error may still be present if the sample lots are not
18-54
representative of the population with respect to the ratio of audited values
to book values.
Case 3. The auditors would project the misstatement found in the sample to the
population using either the ratio or difference approach. The ratio approach
would result in a projected misstatement of P65,500. This may be computed by
first calculating the ratio of the audited to book value as 1.0131 [P23,100 /
P22,800 (since there is a net understatement of P300, the audited value is
P23,100)] and estimating the audited value of the population as:
1.0131 x P5,000,000 = P5,065,500 (rounded)
The projected misstatement is thus P65,500 under the ratio method.
The difference approach results in an average difference of P1.50 (P300 net

difference divided by 200 items). Multiplying by the 100,000 invoices indicates
a projected misstatement of P62,400 (P1.50 x 41,600).
Case 4. The audit risk (ultimate risk) of material misstatement in the financial statements
(AR) is the product of:
(1) Inherent risk (IR), the risk of material misstatement in an assertion,
assuming there were no related internal controls.
(2) Control risks (CR), the risk of material misstatement occurring in an
assertion, and not being prevented or detected on a timely basis by the
internal control structure.
(3) Detection risk (DR), the risk that the auditors’ procedures will lead them to
conclude an assertion is not materially misstated, when in fact such
misstatement does exist.
In equation form, this relationship is expressed as follows:
AR = IR x CR x DR
This equation may be restated to solve for the allowable detection risk as
follows:
DR = AR / (CR x IR)
Using the risk levels set forth in the problem, the allowable risk of reliance upon
substantive tests is computed as illustrated below:
DR = .02 / (.2 x .5) = .20
Thus the risk of incorrect acceptance should be limited to 20 percent if the

auditors are to achieve their objective of holding audit risk to 2 percent.
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Case 5. a. (1) Required sample size is calculated as follows:
Recorded amount of population

x Reliability factor
Sample size = Tolerable misstatement –
(Expected misstatement x Expansion factor)
P500,000 x 3
Sample size = P25,000 – (P2,000 x 1.6) = 69
Note: The reliability factor is from the zero misstatements row of the
PPS sampling table given in the case.
(2) The sampling interval is calculated simply by dividing the book value
of receivables by the sample size, as follows:
Sampling interval = Recorded receivables / Sample size

= P500,000 / 69 = P7,246
b. The results may be evaluated as follows:
(1) Projected misstatement =
Book Audite Tainting Samplin Projected

Value d Value Misstatemen % g Misstatemen
t Interval t
P 50 P 47 P 3 6% P7,246 P 435
800 760 40 5% 7,246 362
8,500 8,100 400 NA NA 400
P1,197
(2) Basic precision = Reliability factor x Sampling interval
= 3.0 x P7,246 = P21,738
(3) Incremental allowance =
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Reliability Projected Incremental
Factor Incremen (Increment – 1) Misstatement Allowance
3.00
4.75 1.75 .75 P435 P326
6.30 1.55 .55 362 199
P525
(4) Upper limit on misstatement = P1,197 + P21,738 + P525
= P23,460
NOTES:
Projected misstatement
(a) Tainting percentages are calculated as the difference between book
and audited value divided by book value (e.g., (P50 – P47) / P50 =
6%).
(b) No tainting percentage is calculated for items in excess of the
sample interval and the actual misstatement is extended to
projected misstatement (as for the third error).
Basic precision is always the reliability factor for zero misstatements

multiplied times the sampling interval.
Incremental allowance
(a) Reliability factors are read from the PPS sampling table given in
the case, starting at zero misstatements.
(b) “Increment – 1” is the difference in the two adjacent reliability
factors minus 1 (e.g., 4.75 – 3.00 – 1.00 = .75).
(c) Misstatements in excess of the sampling interval are not
considered in the incremental allowance. This is because the
nature of the process requires that all items in excess of the
sampling interval be included in the sample – therefore no
allowance for items not in the sample is necessary.
c. The results obtained in part b would indicate that the auditors may accept
the population as not containing a tolerable misstatement at the 5 percent
level of risk of incorrect acceptance. The auditors would also consider the
results obtained in conjunction with other audit tests.
Case 6. a. The advantages of probability-proportional-to-size (PPS) sampling over

classical variables sampling are as follows:
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 PPS sampling is generally easier to use than classical variables
sampling.
 The size of a PPS sample is not based on the estimated variation of
audited amounts.
 PPS sampling automatically results in a stratified sample.
 Individually significant items are automatically identified.
 If no misstatements are expected, PPS sampling will usually result
in a smaller sample size than classical variables sampling.
 A PPS sample can be easily designed and sample selection can
begin before the complete population is available.
b. Sampling interval = Recorded receivables / Sample size
= P300,000 / 60 = P5,000
c. Projected misstatement =
Book Audite Tainting Samplin Projected

Value d Value Misstatemen % g Misstatemen
t Interval t
P 400 P 320 P 80 20% P1,000 P 200
500 0 500 100% 1,000 1,000
3,000 2,500 NA NA NA 500
P1,700
CHAPTER 20
THE COMPUTER ENVIRONMENT
I. Review Questions
1. In a batch processing system, documents evidencing transactions and events are

gathered and processed by groups. The day’s sales invoices, for example, may
be converted to machine-readable form and processed the next morning. In a
real time system, transactions are input into the system and processed as they
occur. A branch sale, for example, may be input into the system via a terminal at
a remote location. The computer checks for product availability, customer
authenticity, customer credit approval, and shipping terms; and if all conditions
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are met, the sale is processed immediately and the sales invoice and shipping
order are produced.
2. In a real-time system, much of the data are stored internally and

documentation is often not as extensive as in a batch system. Retrieval
and audit of transaction data, therefore, are often more difficult in a real-
time system. Also, controls are more likely to be programmed in real-
time systems, and for this reason, are more difficult to test.
3. Inasmuch as computer processing requires increased dependence on the

computer systems and software for the accuracy and completeness of
processing, documentation assumes major significance relative to effective
control. Documentation facilitates reviewing and updating systems and
programs as the environment changes; and it also minimizes the probability of
unauthorized system and program changes which could result in loss of control
and decreased reliability of financial data.
4. In a batch system, files are stored off-line for the most part, and access control
assumes the form of safeguarding the programs, transaction files, and
master files by assigning responsibility for the files to a librarian and
instituting a formal checkout system. Only those persons authorized to
process transactions (computer operators) are permitted access to
transaction and master files; and programmers are permitted access to
programs only for testing and “debugging” purposes. In an on-line, real-
time system, transactions and master files are stored internally, often in a
system of integrated data bases. Access control in this type of data
environment assumes the form of controlling access to data bases and fixing
of responsibility for the data base components. Assigning a password to an
individual who is responsible for the data base component accessible by that
password, canceling passwords of former employees, and frequent changing
of existing employees’ passwords are examples of access controls in a real-
time system.
5. Recording forms and transaction logs assure consistency and completeness of
data inputs. The form or log should include codes describing such transaction
components as employee number, customer number, vendor number, department
number, stock number, purchased part number, or job number. The form should
also provide for quantities, prices, dates, and usually a short narrative
description of products, parts, materials, or services for purchase and sales
transactions.
6. A transaction file is the batch of entered data that has been converted into
machine-readable form. A transaction file may contain payroll information for a
specific period of time. It is similar to a journal in a manually prepared system.
A master file contains updated information through a particular time period. It is
similar to a ledger in a manual system.
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7. Small businesses have found that microcomputers or personal computer systems

are cost effective for processing accounting data. In small businesses, one
would expect to find microcomputers (or personal computers) using
commercially available software.
8. In the computerized system, documents to support a transaction may not be

maintained in readable form, requiring associated performance of controls.
However, the computerized system will enable processing of transactions to be
done more consistently, duties to be consolidated, and reports to be generated
more easily.
1. d 5. c 9. c 13. c 17. c
2. c 6. c 10. c 14. d 18. a
3. a 7. c 11. d 15. a 19. b
4. a 8. b 12. c 16. a 20. a
An auditor should have the following concerns about the Box system:
 Does the system have any flaws or incompatibilities? (No one appears to
have tested the software or found out about others’ satisfaction with it.)
 The computer sits out in the open. (Anyone could have access to and
damage the hardware.)
 Anyone could come up with the password by guessing.
 The backup disks are not stored in a safe place.
 Was the conversion appropriately executed, with no data lost or added?
CHAPTER 21
INTERNAL CONTROL IN THE

COMPUTER INFORMATION SYSTEM
I. Review Questions
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1. The proper installation of IT can lead to internal control enhancements by
replacing manually-performed controls with computer-performed controls. IT-
based accounting systems have the ability to handle tremendous volumes of
complex business transactions cost effectively. Computer-performed controls
can reduce the potential for human error by replacing manual controls with
programmed controls that apply checks and balances to each transaction
processed. The systematic nature of IT offers greater potential to reduce the risk
of material misstatements resulting from random, human errors in processing.
The use of IT based accounting systems also offers the potential for improved
management decisions by providing more and higher quality information on a
more timely basis than traditional manual systems. IT-based systems are usually
administered effectively because the complexity requires effective organization,
procedures, and documentation. That in turn enhances internal control.
2. When entities rely heavily on IT systems to process financial information, there

are new risks specific to IT environments that must be considered. Key risks
include the following:
 Reliance on the functioning capabilities of hardware and software. The risk

of system crashes due to hardware or software failures must be evaluated
when entities rely on IT to produce financial statement information.
 Visibility of audit trail. The use of IT often converts the traditional paper
trail to an electronic audit trail, eliminating source documents and paper-
based journal and records.
 Reduced human involvement. The replacement of traditional manual
processes with computer-performed processes reduces opportunities for
employees to recognize misstatements resulting from transactions that
might have appeared unusual to experienced employees.
 Systematic versus random errors. Due to the uniformity of processing
performed by IT based systems, errors in computer software can result in
incorrect processing for all transactions processed. This increases the risk
of many significant misstatements.
 Unauthorized access. The centralized storage of key records and files in
electronic form increases the potential for unauthorized on-line access from
remote locations.
 Loss of data. The centralized storage of data in electronic form increases
the risk of data loss in the event the data file is altered or destroyed.
 Reduced segregation of duties. The installation of IT-based accounting
systems centralizes many of the traditionally segregated manual tasks into
one IT function.
 Lack of traditional authorization. IT-based systems can be programmed to
initiate certain types of transactions automatically without obtaining
traditional manual approvals.
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 Need for IT experience. As companies rely to a greater extent on IT-based
systems, the need for personnel trained in IT systems increases in order to
install, maintain, and use systems.
3. General controls relate to all aspects of the IT function. They have a global
impact on all software applications. Examples of general controls include
controls related to the administration of the IT function; software acquisition and
maintenance; physical and on-line security over access to hardware, software,
and related backup; back-up planning in the event of unexpected emergencies;
and hardware controls. Application controls apply to the processing of
individual transactions. An example of an application control is a programmed
control that verifies that all time cards submitted are for valid employee ID
numbers included in the employee master file.
4. The most significant separation of duties unique to computer systems are those
performed by the systems analyst, programmer, computer operator, and data
base administrator. The idea is that anyone who designs a processing system
should not also do the technical work, and anyone who performs either of these
tasks should not also be the computer operator when real data is processed.
5. Typical duties of personnel:

a. Systems analysis: Personnel will design and direct the development of new
applications.
b. Programming: Other personnel will actually do the programming dictated by
the system design.
c. Operating: Other people will operate the computer during processing runs, so
that programmers and analysts cannot interfere with the programs designed
and executed, even if they produce errors.
d. Converting data: Since this is the place where misstatements and errors can be
made – the interface between the hardcopy data and the machine-readable
transformation, people unconnected with the computer system itself do the
data conversion.
e. Library-keeping: Persons need to control others’ access to system and program
software so it will be used by authorized personnel for authorized purposes.
f. Controlling: Errors always occur, and people not otherwise connected with the
computer system should be the ones to compare input control information
with output information, provide for correction of errors not involving
system failures, and distribute output to the people authorized to receive it.
6. Documentation differs significantly as to inclusion of program flowcharts,

program listings, and technical operating instructions. File security and
retention differs because of the relatively delicate form of the magnetic media
requiring fireproof vault storage, insulation from other magnetic fields,
safeguards from accidental writing on data files, and so forth.
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7. Auditors review documentation to gain an understanding of the system and to

determine whether the documentation itself is adequate for helping manage and
control the computer processing.
8. Responsibilities of the database administrator (DBA) function are:

 Design the content and organization of the database, including logical
data relationships, physical storage strategy and access strategy.
 Protect the database and its software, including control over access to
and use of the data and DBMS and provisions for backup and recovery
in the case of errors or destruction of the database.
 Monitor the performance of the DBMS and improve efficiency.
 Communicate with the database users, arbitrate disputes over data
ownership and usage, educate users about the DBMS and consult users
when problems arise.
 Provide standards for data definition and usage and documentation of
the database and its software.
9. Five things a person must have access to in order to facilitate computer fraud
are:
a. The computer itself.
b. Data files.
c. Computer programs.
d. System information (documentation).
e. Time and opportunity to convert assets to personal use.
10. Because many companies that operate in a network environment decentralize

their network servers across the organization, there is an increased risk for a lack
of security and lack of overall management of the network operations. The
decentralization may lead to a lack of standardized equipment and procedures.
In many instances responsibility for purchasing equipment and software,
maintenance, administration, and physical security, often resides with key user
groups rather than with features, including segregation of duties, typically
available in traditionally centralized environments because of the ready access to
software and data by multiple users.
1. c 7. b 13. c 19. c 25. b

2. a 8. b 14. c 20. c 26. c
3. d 9. c 15. c 21. a 27. c
4. b 10. a 16. a 22 c 28. d
5. d 11. b 17. b 23. b 29. b
6. d 12. a 18. a 24. c 30. d
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Case 1. Does access to on-line files require specific passwords to be entered to identify
and validate the terminal user?
POSSIBLE ERRORS OR IRREGULARITIES – unauthorized access may be obtained to
processing programs or accounting data resulting in the loss of assets or other
company resources.
Are control totals established by the user prior to submitting data for
processing?
POSSIBLE ERRORS OR IRREGULARITIES – sales transactions may be lost in data
conversion or processing, or errors made in data conversion or processing.
Are input totals reconciled to output control totals?

POSSIBLE ERRORS AND IRREGULARITIES – (same as above). Control totals are
useless unless reconciled to equivalent controls created during processing.
Case 2. a. 1. Input control objectives

Transactions have been recorded properly (neither double-counted
nor omitted – that is, control over validity and completeness)
Transactions are transmitted from recording point to processing
point
Transactions are in acceptable form
2. Processing control objectives
Loss or nonprocessing of data is detected
Arithmetic functions are performed accurately
Transactions are posted properly
Errors detected in the processing of data are controlled until
corrected and processed
3. Output control objectives

Processed data are reported correctly and without unauthorized
alteration
Output is required by the user
Output is distributed only to persons authorized to receive it
b. 1. Control procedures – input source data

Registration at point of entry
Sequential numbering
Grouping (batching) with control totals
Key verification
Programmed edits
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Edits for completeness and reasonableness
Checklists to ensure input arrived and on time
2. Control procedures – processing controls
Prevention of loss or nonprocessing of data (e.g., control totals)
Performance of arithmetic functions
Assurance of proper posting (sample test of postings)
Correction of errors
Exclusion of unauthorized persons from operating areas (e.g.,
programmers)
3. Control procedures – output controls
Review performed by originating area of the reports and other
output data
Sampling and testing of individual transactions
Use of control totals obtained independently from prior processing
or original source data
Distribution lists used to route output only to authorized persons
Making inquiries as to whether the output is desired by the
recipient
Case 3. a. The primary internal control objectives in separating the programming and
operating functions are achieved by preventing operator access to the
computer or to input or to output documents, and by preventing operator
access to operating programs and operating program documentation, or by
preventing operators from writing or changing programs.
Programmers should not be allowed in the computer room during

production processing. They should submit their tests to be scheduled and
run by the operators as any other job.
Operators should not be allowed to interfere with the running of any

program. If an application fails, the operators should not be allowed to
attempt to fix the programs. The failed application should be returned to the
programmers for correction.
b. Compensating controls usually refer to controls in user departments
(departments other than computer data processing). In a small computer
installation where there are few employees, segregation of the programming
and operating functions may not be possible (as in a microcomputer or
minicomputer environment). An auditor may find compensating controls in
the user department such as: (1) manual control totals compared to
computer output totals and (2) careful inspection of all output. Such
compensating controls in a simple processing system could provide
reasonable assurance that all transactions were processed, processing was
proper and no unauthorized transactions were processed.
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An auditor may find the following compensating controls that are
particularly important when the programming and operating functions are
not separate:
1. Joint operation by two or more operators.
2. Rotation of computer duties.
3. Comparison of computer times to an average or norm.
4. Investigation of all excess computer time (errors).
5. Adequate supervision of all computer operations.
6. Periodic comparison of a program code value to a control value.
7. Required vacations for all employees.
Case 4. a. Input editing is the process of including, in EDP systems, programmed

routines for computer checking as to validity and accuracy of input. Types
of input editing controls are: tests for valid codes; tests for reasonableness;
completeness tests; check digits; and tests for consistency of data entered in
numeric and alphabetic fields.
b. Examples of payroll input editing controls are:

Test for validity of employee number;
Test for proper pay rate;
Test for reasonableness of hours worked.
Examples of sales input editing controls are:

Test for validity of customer number;
Test for credit approval;
Credit limit test;
Sales price list.
c. As EDP system complexity increases, documentation, as well as manual

checking decreases. To provide reasonable assurance as to completeness,
existence, and accuracy of processed transactions under these
circumstances, input editing becomes increasingly necessary.
Case 5. a. Most commonly associated with supervisory programs contained in on-line

real-time systems, design phase auditing involves the auditor in system
design. The goal is to ensure inclusion of controls that will detect
exceptions or unusual conditions and record and log information about the
initiating transactions. Once the necessary controls have been designed and
incorporated into the system, frequent visits by the auditor to the client’s
premises are necessary to determine that the controls are functioning
properly.
b. Some individuals and groups have suggested that independence may be

impaired, given auditor monitoring and reviewing a system which he/she
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has helped to design. The AICPA has taken the position that making control
recommendations during system design is no different from auditor
recommendations for control improvements after the fact and documented
in the management letter.
c. In some complex EDP systems, a computer audit specialist may be needed

to assist in designing the necessary controls, as well as monitoring and
reviewing the control functions. A computer audit specialist is an employee
of the CPA firm who, typically, will have served on the audit staff for a
period of time, followed by specialized training in computer system design
and control, and EDP auditing.
d. The auditor may rely on the computer audit specialist to whatever degree
considered necessary to assure proper control installation and
implementation. The in-charge field auditor must keep in mind, however,
that use of a computer audit specialist does not compensate for the field
auditor’s lack of understanding of the internal control, including the EDP
applications.
CHAPTER 22
AUDITING IN A COMPUTER INFORMATION SYSTEMS

(CIS) ENVIRONMENT
I. Review Questions
1. Additional planning items that should be considered when computer processing

is involved are:
 The extent to which the computer is used in each significant accounting
application.
 The complexity of the computer operations used by the entity,
including the use of an outside service center.
 The organizational structure of the computer processing activities.
 The availability of data.
 The computer-assisted audit techniques to increase the efficiency of
audit procedures.
 The need for specialized skills.
2. Understanding the control environment is a part of the preliminary phase of

control risk assessment. Computer use in data processing affects this
understanding in each of the parts of the control environment as follows:
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The organizational structure – should include an understanding of the
organization of the computer function. Auditors should obtain and evaluate: (a)
a description of the computer resources and (b) a description of the
organizational structure of computer operations.
Methods used to communicate responsibility and authority – should include the

methods related to computer processing. Auditors should obtain information
about the existence of: (a) accounting and other policy manuals including
computer operations and user manual and (b) formal job descriptions for
computer department personnel. Further, auditors should gain an understanding
of: (a) how the client’s computer resources are managed, (b) how priorities for
resources are determined and (c) if user departments have a clear understanding
of how they are to comply with computer related standards and procedures.
Methods used by management to supervise the system – should include

procedures management uses to supervise the computer operations. Items that
are of interest to the auditors include: (a) the existence of systems design and
documentation standards and the extent to which they are used, (b) the existence
and quality of procedures for systems and program modification, systems
acceptance approval and output modification, (c) the procedures limiting access
to authorized information, (d) the availability of financial and other reports and
(e) the existence of an internal audit function.
3. The “audit trail” is the source documents, journal postings and ledger account
postings maintained by a client in order to keep books. These are a “trail” of the
bookkeeping (transaction data processing) that the auditor can follow forward
with a tracing procedure or back ward with a vouching procedure.
In a manual system this “trail” is usually visible to the eye with posting
references in the journal and ledger and hard-copy documents in files. But in a
computer system, the posting references may not exist, and the “records must be
read using the computer rather than the naked eye.” Most systems still have
hard-copy papers for basic documentation, but in some advanced systems even
these might be absent.
4. The audit trail (sometimes called “management trail” as it is used more in daily
operations than by auditors) is composed of all manual and computer records
that allow one to follow the sequence of processing on (or because of) a
transaction.
The audit trail in advanced systems may not be in a human-readable form and
may exist for only a fraction of a second.
The first control implication is that concern for an audit trail needs to be
recognized at the time a system is designed. Techniques such as integrated test
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facility, audit files and extended records must be specified to the systems
designer. The second control implication is that if the audit trail exists only
momentarily in the form of transaction logs or master records before destructive
update, the external auditor must review and evaluate the transaction flow at
various times throughout the processing period. Alternatively, the external
auditor can rely more extensively on the internal auditor to monitor the audit
trail.
5. Major characteristics:
1. Staff and location of the computer – operated by small staff located within the
user department and without physical security.
2. Programs – supplied by computer manufacturers or software houses.
3. Processing mode – interactive data entry by users with most of the master file
accessible for inquiry and direct update.
Control Problems:
1. Lack of segregation of duties.
2. Lack of controls on the operating system and application programs.
3. Unlimited access to data files and programs.
4. No record of usage.
5. No backup of essential files.
6. No audit trail of processing.
7. No authorization or record of program changes.
6. Auditing through the computer refers to making use of the computer itself to test
the operative effectiveness of application controls in the program actually used
to process accounting data. Thus the term refers only to the proper study and
evaluation of internal control. Auditing with the computer refers both to the
study of internal control (the same as “auditing through”) and to the use of the
computer to perform audit tasks.
7. Both are audit procedures that use the computer to test controls that are included
in a computer program. The basic difference is that the test data procedure
utilizes the client’s program with auditor-created transactions, while parallel
simulation utilizes an auditor-created program with actual client transactions. In
the test data procedure the results from the client program are compared to the
auditor’s predetermined results to determine whether the controls work as
described. In the parallel simulation procedures the results from the auditor
program are compared to the results from the client program to determine
whether the controls work as described.
8. The test data technique utilizes simulated transactions created by the auditor,
processed by actual programs but at a time completely separate from the
processing of actual, live transactions. The integrated test facility technique is
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an extension of the test data technique, but the simulated transactions are
intermingled with the real transactions and run on the actual programs
processing actual data.
9. User identification numbers and passwords prevent unauthorized access to

accounting records and application programs. The transaction log does not
prevent unauthorized access but may be reviewed to detect unauthorized access.
Even then, responsibility could not be traced to a particular individual without
user identification numbers and passwords. The transaction log is more
important to establish the audit trail than to detect unauthorized access.
10. Generalized audit software is a set of preprogrammed editing, operating, and

output routines that can be called into use with a simple, limited set of
programming instructions by an auditor who has one or two weeks intensive
training.
11.
Phases Noncomputer auditor involvement
1. Define the audit objectively 1. Primary responsibility
2. Feasibility 2. Evaluate alternatives
3. Planning 3. Review with computer auditor
4. Application design 4. none
5. Coding 5. none
6. Testing 6. Review final test results, compare to plan
7. Processing 7. Actual computer processing – none
Use of results – depends on application
8. Evaluation 8. Full responsibility
12. Automated microcomputer work paper software generally consists of trial

balance and adjustment worksheets, working paper (lead schedule) forms, easy
facilities for adjusting journal entries, and electronic spreadsheets for various
analyses.
13. A microcomputerized electronic spreadsheet can be used instead of paper and

pencil to create the form of a bank reconciliation, with space provided for text
lists of outstanding items (using the label input capability), and math formulas
inserted for accurate arithmetic in the reconciliation. Printing such a
reconciliation is easy (and much prettier than most accountants’ handwriting!).
14. With either data base or spreadsheet software packages, macros (sets of
instructions) can be developed for retrieving data from the working trial balance
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and converting this data into classified financial statements. If one or more
subsidiaries are to be included, the consolidated process can also be automated
by the inclusion of special modules designed for that purpose. The standard
audit report, as well as recurring footnotes, can be included in the data base, and
modified to fit the circumstances of the current year’s audit results.
15. Relational data base packages have all the advantages of spreadsheets, and, in
addition, have the capacity to store and handle larger quantities of data. They
are especially useful in manipulating large data bases, such as customer accounts
receivable, plant assets, and inventories.
1. a 5. d 9. b 13. c 17. b
2. c 6. d 10. d 14. a 18. c
3. c 7. c 11. b 15. d 19. d
4. d 8. b 12. b 16. b
Case 1. a. Auditing “around” the computer generally refers to examinations of

transactions in which a representative sample of transactions is traced from
the original source documents, perhaps through existing intermediate
records in hard copy, to output reports or records, or from reports back to
source documents. Little or no attempt is made to audit the computer
program or procedures employed by the computer to process the data. This
audit approach is based on the premise that the method of processing data is
irrelevant as long as the results can be traced back to the input of data and
the input can be validated. If the sample of transactions has been handled
correctly, then the system outputs can be considered to be correct within a
satisfactory degree of confidence.
b. The CPA would decide to audit “through” the computer instead of “around”
the computer (1) when the computer applications become complex or (2)
when audit trails become partly obscured and external evidence is not
available.
Auditing “around” the computer would be inappropriate and inefficient in

the examination of transactions when the major portion of the internal
control system is embodied in the computer system and when accounting
information is intermixed with operation information in a computer
program that is too complex to permit the ready identification of data inputs
and outputs. Auditing “around” the computer will also be ineffective if the
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sample of transactions selected for auditing does not cover unusual
transactions that require special treatment.
c. (1) “Test data” is usually a set of data in the form of punched cards or
magnetic tape representing a full range of simulated transactions, some of
which may be erroneous, to test the effectiveness of the programmed
controls and to ascertain how transactions would be handled (accepted or
rejected) and if accepted, the effect they would have on the accumulated
accounting data.
(2) The auditor may use test data to gain a better understanding of what the
data processing system does, and to check its conformity to desired
objectives. Test data may be used to test the accuracy of programming
by comparing computer results with results predetermined manually.
Test data may also be used to determine whether errors can occur
without observation and thus test the system’s ability to detect
noncompliance with prescribed procedures and methods.
Assurance is provided by the fact that if one transaction of a given type

passes a test, then all transactions containing the identical test
characteristics will – if the appropriate control features are functioning
– pass the same test. Accordingly, the volume of test transactions of a
given type is not important.
d. In addition to actually observing the processing of data by the client, the

CPA can satisfy himself that the computer program tapes presented to him
are actually being used by the client to process its accounting data by
requesting the program of a surprise basis from a computer librarian and
using it to process test data.
The CPA may also request, on a surprise basis, that the program be left in
the computer at the completion of processing data so that he can use the
program to process his test data. This procedure may reveal computer
operation intervention. If, so, ensures that a current version of the program
is being audited, an important procedure in computer installations newly
installed and undergoing many program changes. To gain further assurance
about this matter, the CPA should inquire into the client’s procedures and
controls for making program changes and erasing superseded program
tapes, and should examine log tapes where available.
Case 2. a. Document retention

IMPACT ON THE INTERNAL CONTROL SYSTEM: In on-line real time
systems and EDI systems, the audit trail is frequently modified in the form
of reduced documentation. To compensate, internal controls should provide
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for adequate input editing, as well as some form of transaction log as
documentation at the input stage.
IMPACT ON THE INDEPENDENT AUDIT: In examining internal
control, under these circumstances, the auditor must rely more on
observation, inquiry, and reprocessing of transactions for control testing
purposes, and less on document testing. If documents are retained for only
a short period, the auditor should also consider the feasibility of frequent
visits for both substantive and control testing purposes.
b. Uniformity of processing
IMPACT ON THE INTERNAL CONTROL SYSTEM: The impact of this
internal control characteristic is to generally strengthen control by
increasing the consistency of processing. Once the proper controls are
installed and tested, processing consistency increases the accuracy of
transaction processing over that which exists in manual systems.
IMPACT ON THE INDEPENDENT AUDIT: The auditor must emphasize
control study and testing at the point of transaction input and processing to
determine that the necessary controls exist and are functioning. Upon
determining that the necessary input and processing controls are in place
and functioning properly, the auditor may elect to perform little or no
document testing.
c. Concentration of functions
IMPACT ON THE INTERNAL CONTROL SYSTEM: In manual systems,
separation of functional responsibilities provides a double-check for the
purpose of enhancing processing accuracy. In EDP accounting systems,
consistency of processing removes the need for double-check.
IMPACT ON THE INDEPENDENT AUDIT: The auditor must determine
that the necessary input editing controls are in place and functioning to
ensure that transactions are accurately introduced into the processing
stream. Moreover, to ensure checks and balances within the electronic data
processing function, the auditor should study the organizational structure of
the EDP group to ascertain proper separation among the following
functions:
Systems analysis and design
Program design, development, and testing
Computer operations involving data processing
Distribution of EDP output and reprocessing of errors
d. Access to data bases
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IMPACT ON THE INTERNAL CONTROL SYSTEM: The greater the
number of input terminals providing access to data bases, and the more
integrated the data base, the greater the danger of unauthorized access. To
protect the data bases under these circumstances, the internal control
policies and procedures should provide for effective control over
identification codes and passwords permitting access to data bases; and the
control policies should also fix responsibility in designated individuals for
specified elements of data bases.
In batch systems, access to magnetic tape and disk files and programs
should be secured by assigning responsibility over these files to one or more
individuals designated as “librarians,” and instituting a formal “checkout”
system for releasing and reacquiring files and programs.
IMPACT ON THE INDEPENDENT AUDIT: The auditor should determine
that proper control over I.D. codes and passwords exists, that codes and
passwords are changed frequently and voided upon termination of
employment, and that responsibility for elements of data bases has been
appropriately fixed.
In batch systems, the auditors should determine that tape and disk files and
programs stored off-line are properly secured.
Case 3. a. Test data approach: The auditor prepares simulated input data (both valid
and invalid transactions) that are processed, under the auditor’s control, by
the client’s processing system.
Advantage: A good way of testing existing controls for proper functioning.

Disadvantage: Difficulty in designing comprehensive test data; Difficulty
in ascertaining whether the programs tested are the same programs used by
the client in processing actual transactions and events during the year.
ITF approach: The auditor creates a fictitious entity within the client’s
actual data files, and processes simulated data during live processing by
client. The auditor then compares the results of processing with anticipated
results.
Advantage: Greater assurance that programs tested are programs used by

the client (the approach can be applied at different points in time during the
year).
Disadvantage: Difficult to remove test data from the system without
harming client’s files.
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Tagging and tracing: This is a technique whereby an identifier or “tag” is
affixed to a transaction record; and the tag triggers “snapshots” during the
processing of transactions. Following the tagged transactions through the
system permits the auditor to evaluate the logic of the processing steps and
the adequacy of programmed controls.
Advantage: The use of actual data eliminates the need for removing data
from the client’s processing system.
Disadvantage: The auditor analyzes the transactions only after processing
is completed.
SCARF: A systems control audit review file is an audit log used to collect
information for subsequent analysis and review. An imbedded audit module
monitors selected transactions as they pass by specific processing points.
The module then captures the input data so that relevant information,
accessible only by the auditor, is displayed at key points in the processing
system.
Advantage: Utilizes real- rather than simulated-transaction data, and does

not require reversing the entries.
Disadvantage: Does not necessarily capture erroneous data.
Surprise audit: The auditor, on an unannounced basis, requests copies of

client’s programs, and compares them with auditor’s copy of authorized
versions.
Advantage: Assists the auditor in determining whether client personnel are

using authorized versions of programs in processing data.
Disadvantage: Auditor may not always be notified by the client when
program changes are made, thus making the comparison irrelevant.
b. Inasmuch as each of the above alternatives have distinct advantages and

disadvantages, a combination approach overcomes the disadvantages
resulting from using a single approach. Using ITF, for example on a few
simulated transactions, while applying the tagging and tracing or SCARF
approach for numerous actual transactions, provides effective testing of
control procedures for error prevention and detection, without requiring the
reversal of a large number of simulated transactions from the client’s
system.
c. In auditing around the computer, the auditor predetermines the processing

results (output) of selected input data, and compares the predetermined
results with actual computer output. The advantage of this approach is its
ease of application; a significant disadvantage is that the auditor gains no
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understanding of how the computer processes data, nor of the controls
which have been incorporated into the computer programs.
In auditing through the computer, the auditor actually tests the programmed
controls used in processing specific applications. Such techniques as design
phase auditing, ITF, tagging and tracing, SCARF, test data, and surprise
audit are examples of auditing through the computer.
d. Parallel simulation is an automated version of auditing around the computer

in that the auditor creates a set of application programs that simulate the
processing system, and compares output from the real and simulated
systems. Comparison of input with output ignores the essential
characteristics of the processing system and assumes that if the outputs are
identical, the system is processing transactions accurately.
The auditor might elect to use parallel simulation in combination with

design phase auditing. Design phase auditing ensures that the necessary
controls are installed during system design. By permitting the auditor to
test large volumes of transactions, parallel simulation helps to confirm
whether these controls are working.
Case 4. (a) Test decks, also called “test data,” are sets of computer input data which
reflect a variety of auditor-identified transactions for verification through
actual computer processing to detect invalid processing of results (i.e.,
existing programs run test data). Ideal test data should present the
application under examination with every possible combination of
transactions, master file situations, and processing logic which could be
encountered during actual comprehensive processing. Test data are usually
processed separately from actual data using copies of master files. Test
decks are most feasible when the variety of transactions processing and
controls is relatively limited (i.e., fairly simple files).
Uses include checking and verifying: (1) input transaction validation

routines, error detection, and application system controls, (2) processing
logic, and controls associated with creation and maintenance of master files,
(3) computational routines such as interest and asset depreciation, and (4)
incorporation of program changes.
(b) Parallel simulation consists of the preparation of a separate computer

application that performs the same functions as those used by the actual
application programs. The simulation programs read the same input data as
the application programs, use the same files, and attempt to produce the
same results (e.g., real data run through test programs). These simulated
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results are matched with those from the live programs, providing a means
for testing through comparison.
Uses include all those cited for test decks.
(c) The integrated test facility approach permits the introduction of auditor-
selected test data into a computer system with actual or “live” data and then
traces the flow of transactions through the various system processing
functions for comparison to predetermined actual results. An ITF involves
the creation or establishment of a “dummy” entity (e.g., a branch or
division) to receive the results of the test processing. Therefore,
transactions are processed against the test entity together with actual
transactions. Test data must be removed from the entity’s records upon
completion of the test. Uses are identical to the test deck technique.
(d) Tagging and tracing and SCARF are forms of transaction tracking provided
only for auditor selected computer inputs carrying a special code. If the
capability is provided in the application system in advance, the attachment
of a code to any input transaction can be made to generate a printed
transaction trail for that item following each step of the application
processing.
Uses include: (1) determining the impact of specific transactions on master

records or calculations in high volume systems, (2) “flagging” unusual or
abnormal transactions, and (3) “debugging” application programs.
Case 5. In an audit of a computer-based system, adequate training and experience must

be directly related to EDP. In particular, the auditor should be knowledgeable of
what computer systems do, how to test the operations of an EDP system, and
how to use EDP-unique documentation.
The training and proficiency standard contributes to satisfaction of the

independence standard by enabling the auditor to make his own decisions and
judgments. Otherwise, he might tend to subordinate his judgment to other
persons, possibly to client personnel. When the auditor lacks training and
proficiency, it is virtually impossible to maintain an operational independence
over audit decisions. An independence of mental attitude is futile if actual
decisions are subordinated to others.
The exercise of due audit care requires a critical review at every level of audit
supervision of the work done and the decisions made by auditors. Lacking the
requisite skills and lacking independent decisions, the due care expected of an
auditor at operational, supervisor, and review levels cannot be delivered.
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The Philippine Standards on Auditing require adequate planning and supervision
of assistants. Training and proficiency in computer systems auditing is
necessary in order to plan access to computerized records, programs, and to
obtain machine time for conducting audit procedures. The planning should
provide for an early examination of the computer system so that further
procedures involving non-computer control and accounting features may be
planned should they depend upon computer control procedures.
Training and proficiency are very important for being able to obtain an
understanding of the internal control structure in a computer system. Client
personnel will expect audit personnel to be capable of working with a computer
system.
The Philippine Standards on Auditing also require the auditor to obtain sufficient
competent evidential matter to provide a basis for an opinion on financial
statements. Documentary evidence relating to a computer system includes
program flow charts, logic diagrams, and decision tables that are not normally
used in non-computer systems. Since these types of documentation are a part of
the evidence, they must be understood by the auditor, and understanding of them
comes through training and proficiency in their use.
CHAPTER 23
TESTS OF CONTROLS
I. Review Questions
1. Directly. Higher levels of control risk induce auditors to audit larger samples of
receivables, with confirmation date closer to the fiscal year end date. As for
nature of the procedures: higher levels of control risk induce auditors to use
positive confirmations instead of negative confirmations, and to consider
vouching subsequent payments by the customers.
2. A “walk through” is the process of following a transaction from its initiation

(customer order in the Revenue Cycle) through all the various processing steps
until it is recorded in the formal accounting records (accounts receivable and
sales). Usually samples of all documents are collected (sales order, sales
invoices, sales return slip, credit memo, shipping document, remittance advice
and daily remittance report) and notes are made of procedures each person
performs.
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The purpose of the “walk through” is to obtain an understanding of the
transaction flow, the control procedures and populations of documents that may
be utilized in test of controls auditing.
3. The review (obtaining an understanding) of the control structure is primarily a

process of identifying control procedures (strengths) and lack of controls
(weaknesses) which will affect subsequent substantive procedures.
4. The internal auditors should, through periodic checks, ensure that the control
account is periodically reconciled to the customer subsidiary accounts, bank
statements are reconciled and that all prenumbered documents, especially
invoices, have all numbers accounted for. Some internal auditors also confirm
accounts receivable. Internal auditors also might review and evaluate customer
complaints for signs of weaknesses in the procedures leading to errors in
accounts receivable.
5. The features of a cash receipts internal control system which would be expected
to prevent an employee from absconding with company funds and covering with
funds from the employee pension fund is the prohibition against one employee
having custody of company funds and noncompany funds. The auditor can
detect such transfers by controlling and counting both funds simultaneously.
To prevent the cash receipts journal and recorded cash sales from reflecting
more than the amount shown on the daily deposit slip, the internal control
system should provide that receipts be recorded daily and intact. A careful bank
reconciliation by an independent person could detect such errors.
6. The evaluation after the review phase was to determine which controls appeared
adequate as a basis for justifying a low control risk assessment. The final
assessment after test of controls auditing is to determine if the controls are
actually operating as well as they appeared to be.
7. The objectives of internal control relate to transactions, and by

category are: validity, completeness, authorization, accuracy,
classification, accounting and proper period. The objectives
expensed in general terms and specific terms applied to cash
receipts are as follows:
Example of Cash Receipts
General Objective Specific Objective
1. Recorded transactions are valid 1. Recorded cash receipts are
and documented. supported by remittance advices.
2. All valid transactions are recorded 2. All cash receipts are entered in the
and none omitted. daily remittance list, deposited
intact and recorded in the accounts
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receivable control account.
3. Transactions are authorized by 3. Cash receipts for transactions other
company policy. than merchandise sales (scrap
sales, sales of fixed assets) are
properly authorized.
4. Transaction peso amounts are 4. Cash receipts are compared to
properly calculated. invoice terms to determine proper
cash discounts.
5. Transactions are properly 5. Cash receipts for nonmerchandise
classified in the accounts. sales are posted to proper accounts.
6. Transaction accounting is 6. All cash receipts for credit sales are
complete. posted to customer individual
accounts.
7. Transactions are accounted in the 7. Cash receipts are deposited daily
proper period. intact and recorded as of date
received.
8. If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
9. The functions which should be separated to maintain internal control in a

purchasing system include (1) custody of the goods (receiving and stores
departments), (2) authority to initiate a transaction (purchasing department) and
(3) bookkeeping (accounts payable department, inventory record-keeping
department).
10. The “walk through” of a purchase transaction would begin with the preparation
of the requisition by the Stores department, through the bidding process and
preparation of the purchase order by the purchasing agent, to receipt of vendor’s
invoices and receiving report by the purchasing agent and finally to accounts
payable voucher preparation. Procedures would be observed and notations
made on document samples of procedures followed.
Documents are collected to note where documentary evidence exists or control

procedures being followed. The following documents would be collected:
requisition, purchase order, receiving report and voucher. The “walk through”
and sample documents would assist the auditor in understanding the flow of
transactions.
11. a. Blank vouchers kept in secure location available only to authorized

personnel.
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b. Blank supporting documents (invoices, receiving reports, requisitions,
purchase orders) kept in secure locations available only to authorized
personnel.
c. Supporting documents canceled by Cash Disbursement function when
checks are prepared.
d. Separation of duties of preparers of supporting documents, preparation of
vouchers, check preparation, and check signing.
e. Vouchers and other supporting documents reviewed by check signers.
f. Checks mailed directly by signer and not returned to accounts payable.
12. Authorization for vouchers payable recording mainly consist of an approved

purchase order, a receiving report, and an accurate vendor invoice. Auditors
should look for purchase approval signatures, receiving approval signatures, and
approval of the vendor invoice – checks by client for proper quantity, price, and
discount.
13. The point of this quotation is to generate discussion on the source of errors and
therefore the controls necessary when an accounting process is computerized.
Discussion items might include the following:
1. People have bad days and make mistakes; computers do not have bad days.
2. Murphy’s Law – If it is possible to make an error, someone will find a way
to do it.
3. People initiate the transactions and will make errors.
4. All controls should be considered together (manual and computer).
Excellent computer controls cannot be relied upon if the related manual
controls are weak.
5. In computer systems, it is extremely important to establish extensive input
validation controls to prevent people errors from getting into the processing
(GIGO – garbage in, garbage out).
6. People can prevent a good computer system from working well if they are
not convinced it is in their best interests.
7. People will rarely question computer printed output, even though it may not
be correct.
8. Most computer controls are to prevent, detect, or correct errors made by
people.
14. The purpose of the auditor’s search for unrecorded liabilities is to gather
evidence as to whether the liability assertion is true. The same concern exists in
the internal control objective “all valid transactions are recorded and none are
omitted.” From an evidence gathering perspective, it is much more difficult to
gather evidence on unrecorded transactions than to gather evidence that recorded
transactions (and account balances) are proper.
The search for unrecorded liabilities includes procedures in other audit areas
such as questions on bank and insurance confirmations and vouching the source
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of funds for asset additions. Specific audit procedures in the search for
unrecorded liabilities include:
1. Obtain vendor’s invoices (or accounts payable vouchers) recorded for
several days after the balance sheet date to determine if the liability relates
to the balance sheet period under audit.
2. Scan cash disbursements for several days subsequent to year-end and vouch
to support to determine if cutoff was proper. Scan all cash disbursements
until the end of field work for unusual amounts and payees to determine if
amounts paid represent liabilities of the balance sheet period.
3. Examine BIR tax reports and correspondence and the audit reports of tax
authorities and trace additional tax assessments to the accounts.
4. Confirmation of accounts payable.
5. Use analytical procedures such as trend comparisons of accounts payable to
sales, sales taxes to sales, payroll taxes to gross payroll and interest expense
to average notes payable.
15. A “walk through” involves following a transaction from initiation

through the various steps until the transaction is recorded in the
formal accounting records. In the conversion cycle, the following
would constitute a complete “walk through:”
Step Documents Collected Controls Noted
Prepare production Production Order (P.O.) Support for P.O.
orders
Prepare bill of materials Bill of materials (B.M.) Separation planning
and manpower needs Manpower needs (M.N.) from production.
Assign job order and Note separation
foreman production supervisor
from foreman duties.
Job tickets and material Job tickets (JT) Production foreman
requisitions prepared Material requisition (MR) duties separated from
authorization.
Raw material records Issue slip (IS) Materials not issued
updated, issue slips without MR. IS
prepared prepared for all materials
released.
Observe time entered Approval by foreman of
and foreman approval on hours.
JT
Direct labor report Labor report (LR) Job tickets support L.R.
prepared
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Observe timekeeping, Reconciliation hours per
compare job tickets to clock cards to hours per
clock cards J.T.
Material used report Material used report Issue slips and
prepared (MUR) requisitions support
MUR.
Observe matching issue Records from sources
slips and material used reconciled.
report
Observe matching job Records from separate
time tickets (or labor sources reconciled.
distribution) to labor
report
Enter costs in job cost Job cost sheets (JCS) Support for all entries in
sheets JCS.
Summary entry Summary entry form Job cost sheets support
prepared. summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
Preparation of Report of units Independent report of
completion report completed (RUC) production completed.
Observe units compared Independent check of
to RUC, post finished RUC.
records
Products received report Products received report Independent records of
prepared (PRR) units put into finished
goods inventory.
Observe comparison Records from separate
RUC and PRR sources reconciled.
Job sheets closed out, Summary entry form Closed job sheets, RUC
summary entry prepared and PRR support
summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
16. Weaknesses (lack of control where auditors believe one is necessary) are not
audited because auditors do not rely upon weaknesses to prevent, detect or
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correct material errors. Auditors must consider the financial impact of
weaknesses on financial statements and plan substantive tests accordingly.
A control strength may be identified in interviews during the review phase (or in
preparing the flowcharts or questionnaires), but during test of controls auditing,
found to be nonexistent or operating ineffectively. For example, in the
conversion cycle the production management may state that foremen approve
workers’ job time tickets. However, when a sample of job time tickets are
examined by auditors for evidence of approval, none is found. Thus, a weakness
is not found until the control is tested. Therefore, control risk should not be
assessed low until evidence is gathered that the control is operating effectively.
17. The purpose of this review question is to foster discussion toward what
information an independent auditor needs to know. Items relevant to the
quotation might include:
1. Reference to the standard regarding “adequate technical training and proficiency
as an auditor.”
2. Reference to the standard regarding “due professional care.”
3. Obviously, the auditor must be knowledgeable about cost accounting to
audit a manufacturing company.
4. In a manufacturing company, the inventories most likely will be a major
asset which will require substantial audit work.
5. A proficient auditor must be knowledgeable in all phases of the business,
including production, marketing, finance as well as accounting data
processing.
18. The surprise observation enables the auditor to see how the distribution system
really works and increases his chances of detecting fraud. Such an observation
involves taking control of paychecks, then accompanying a client representative
as the distribution takes place. The auditor checks to see that each employee is
identified and that only one check is given to each individual. Unclaimed
checks are controlled and examined to detect any fictitious persons on the
payroll.
19. A “walk through” of a personnel and payroll transaction would include

discussions with each person handling personnel and payroll records. The
following illustrates the steps and documents collected.
Steps Document(s) Collected

Hiring – personnel dept. Authorization to hire and rate assignment
Deductions – personnel Personnel forms, employee authorization for
dept. deductions
Timekeeping Clock card
Shops Job time ticket
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Cost distribution Labor distribution sheet
Accounts payable Payroll voucher
Cash disbursement Payroll checks
If the payroll is processed by computer, the clock cards and job time tickets
would be traced to batch control in the timekeeping and production departments,
to data preparation (keying to machine sensible form), to edit and validation
error reports and other computer output indicating control and finally to
computer prepared checks, labor distribution reports and summary general
ledger entries.
1. c 5. a 9. d 13. b 17. d
2. c 6. c 10. b 14. a 18. d
3. b 7. c 11. a 15. c 19. c
4. c 8. b 12. a 16. d 20. b
Case 1. 1. Controlled access to blank sales invoices.

a. Observation. Visit the storage location yourself and see if unauthorized
persons could obtain blank sales invoices. Pick some up yourself to see
what happens.
b. Someone could pick up a blank and make out a fictitious sale.
However, getting it recorded would be difficult because of the other
controls such as matching with a copy from the shipping department.
(Thus a control access deficiency may be compensated by other control
procedures.)
2. Sales invoices check for accuracy.

a. Vouching and Recalculation. Select a sample of recorded sales
invoices and vouch quantities thereon to bills of lading, vouch prices to
price lists, and recalculate the math.
b. Errors on the invoice could cause lost billings and lost revenue or
overcharges to customers which are not collectible (thus overstating
sales and accounts receivable).
3. Duties of accounts receivable bookkeeper.

a. Observation and Inquiry. Look to see who is performing bookkeeping
and cash functions. Determine who is assigned to each function by
reading organization charts. Ask other employees.
b. The bookkeeper might be able to steal cash and manipulate the
accounting records to give the customer credit and hide the theft.
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(Debit a customer’s payment to Returns and Allowances instead of to
cash, or just charge the control total improperly).
4. Customer accounts regularly balanced with the control account.

a. Recalculation. Review the client’s working paper showing the
balancing/reconciliation. Do the balancing yourself.
b. Accounting entries could be made inaccurately or incompletely and the
control account may be overstated or understated.
Case 2. The discussion could take several directions, including some or all of the
following:
1. Material Weakness. The facts seem to suggest “a condition in which
specific control features (few or none are described) or the degree of
compliance with them do not reduce to a relatively low level the risk that
errors or irregularities in amounts that could be material to the financial
statements may occur and not be detected within a timely period by
employees in the normal course of performing their assigned functions.”
Castro has authority and influence over too many interrelated activities.
Nothing he does seems to be subject to review or supervision. He even is
able to exclude the internal auditor.
An identification of the potential irregularities will illustrate the misdeeds

he can perpetrate almost single-handedly.
2. Potential irregularities include:

a. Castro can collude with customers to rig low bids and take kickbacks,
thereby depriving the company of legitimate revenue.
b. Castro can direct purchases to favored suppliers, pay unnecessarily
high prices and take kickbacks. He might even set up a controlled
dummy company to sell overpriced materials to the company. No
competitive bidding control prevents these activities.
c. Castro, through the control of physical inventory, can (i) remove
materials for himself, and (ii) manipulate the inventory accounts to
conceal shortages.
d. Castro can order truck shipping services for his own purposes and
cause the charges to be paid by the company.
e. Castro can manipulate the customer billing (similar to a above) to
deprive the company of legitimate revenue while taking an
unauthorized commission or kickback.
3. Almost every desirable characteristic of good internal control has been

circumvented:
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a. Segregation of Functional Responsibilities. Castro has authorization
and custodial responsibilities.
b. Authorization, Supervision. Castro is apparently subject to no
supervision or review. The accounting staff is probably powerless to
challenge transactions because of Samuel’s apparent approval of
Castro’s powers.
c. Controlled Access. The whole situation gives Castro access to
necessary papers, records, and assets to carry out his one-man show.
d. Periodic Comparison. No one else apparently has any access to the
materials inventory in order to conduct an actual count for comparison
to the book value (recorded accountability) of the inventory.
Case 3. The purpose of this question is to get the student to consider where the functions
that are considered incompatible in a manual system occur in a computer
system.
The functions should be separated in a manual or computer accounting system

such that different people authorize the sales transactions, record the
transactions, have custody to the assets (inventory) and reconcile the books to
the assets.
Different people should: indicate the sales order source document (authorize),
prepare the computer program (authorize and record), operate the computer
(record), have custody of inventory and correct errors (reconciliation).
Case 4. If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
Case 5. Memorandum
TO: Board of Directors, The Potter Art League

FROM: (Student’s name)
DATE:
SUBJECT: Control weaknesses related to Cash Admission Fees
You requested a report which identifies the weaknesses in the existing system of cash
admission fees and my recommendations. Below are the weaknesses that exist and my
recommendations for procedures that overcome these weaknesses. I will be pleased to
discuss these at the next board meeting and offer further explanations that may be necessary.
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Weakness: There is no segregation of duties between persons responsible for collecting
admission fees and persons responsible for authorizing admission.
Recommendation: One clerk (hereafter referred to as the collection clerk) should collect
admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the
admission clerk) should authorize admission upon receipt of the ticket or proof of
membership.
Weakness: An independent count of paying patrons is not made.

Recommendation: The admission clerk should retain a portion of the prenumbered admission
ticket (admission ticket stub).
Weakness: There is no proof of accuracy of amounts collected by the clerks.

Recommendation: Admission ticket stubs should be reconciled with cash collected by the
treasurer daily.
Weakness: Cash receipts are not promptly prepared.

Recommendation: The cash collections should be recorded by the collection clerk daily on a
permanent record that will serve as the first record of accountability.
Weakness: Cash receipts are not promptly deposited. Cash should not be left undeposited
for a week.
Recommendation: Cash should be deposited at least once each day.
Weakness: There is no proof of accuracy of amounts deposited.

Recommendation: 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.
Weakness: There is no record of the internal accountability of cash.

Recommendation: The treasurer should issue a signed receipt of all proceeds received from
the collection clerk. These receipts should be maintained and should be periodically checked
against cash collection and deposit records.
Case 6. a. The purposes of these audit procedures are:
1. To substantiate the validity of the asset “cash” in the balance sheet, as it
may substantially consist of “cash in transit” from several sales
divisions.
2. To determine proper cash “cutoff”, i.e., to detect any unintentional
errors overstating or understating cash between the current and the
following accounting period.
3. To disclose “kiting” (if any), e.g., perpetrated by the home office
cashier in collusion with one or more sales divisions employees.
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b. Audit Program for Sales Divisions – Audit Steps
1. Prepare a schedule of transfer payments made by the branch for a
period covering two weeks prior and two weeks after the end of the
fiscal period showing:
Check number
Date of entry in cash disbursements book
Amount of check
Date of perforation by paying bank
Transfer checks outstanding at the date of cutoff
Transfer checks outstanding at the date of reconciliation.
2. Compare dates of issue on canceled checks and of entries.
3. Trace and compare dates of perforation and dates of payment on the
bank statement and the “cutoff” statement.
4. Compare dates of issue of checks to date of perforation looking for:
a. unusual delays in payment
b. discrepancy in accounting periods for the two dates.
5. Scan cancelled checks and cash disbursements records during the year
for:
a. names of payees,
b. consecutive numbers of checks to determine whether any payments
other than regular transfers to main office were made from this
account.
6. Reconcile individually several transfers during the year to
corresponding collections presumed to be transferred as of each
individual date.
7. Reconcile total collections for the year to total transfers.
Case 7. 1. a. Recorded payroll transactions are valid (no fictitious employees).

b. Paychecks might be delayed and terminated workers might continue to
be “paid” (with theft of check by someone else) if payroll is not
promptly notified of new hires and terminations.
2. a. Recorded payroll deductions are valid.

b. Incorrect amounts might be deducted from pay.
3. a. Recorded payroll transactions are valid and authorized.
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b. If payroll department personnel were also responsible for time records,
they would have effective control over transaction authorization (i.e.,
hours worked approval) and could overpay themselves or friends.
4. a. Payroll and labor cost transactions are complete.

b. Cost accounting records might contain more or fewer pesos than
actually paid (per payroll data). Simple errors in cost analyses might
occur.
CHAPTER 24
SUBSTANTIVE TESTS OF
TRANSACTIONS AND BALANCES
I. Review Questions
1. The cutoff bank statement is a bank statement sent by the bank directly to the
auditor, and it is usually for a fifteen or twenty day period following the
reconciliation date. The basic use of the statement by the auditor is to determine
whether outstanding checks were actually mailed before the reconciliation date.
2. All cash funds (and negotiable investment stock and bond certificates) should be
counted at the same time (simultaneously) so that money (or securities) cannot
be shifted from one location to another to conceal a shortage. If simultaneous
count cannot be made, as each fund (or each negotiable asset) is counted, it
should be locked and sealed until all are counted.
3. Kiting is the practice of recording a deposit of an interbank transfer in one

period, but delaying the recording of the disbursement until the next period –
thus double counting the amount of the transfer. It is used to cover up a cash
shortage. Auditors schedule all bank transfers around the year-end and examine
the dates deposited and disbursed per books and the dates deposited and
disbursed per bank. Thus, the auditors can determine if both sides of the
transfers are recorded in the same period and the proper period.
4. A “positive” confirmation is a request for a response from an independent party

who the auditor has reason to expect is able to reply. A “negative” confirmation
is a request for a response from the independent party only if the information is
disputed. Negative confirmations should also be sent only if the recipient can be
expected to detect error and reply accordingly.
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5. Generally, vouching of documentation underlying receivables balances is
deferred until after confirmation. Then vouching is performed in regard to
accounts for which confirmations were mailed but no replies received.
Additionally, vouching may be used to gather evidence about account
discrepancies and disputes indicated on confirmation responses.
6. Sales cutoff is audited by selecting sales invoices, shipping documents, and

contracts created in the period (usually 10 days to two weeks) before and after
the fiscal year-end. The transactions are traced to the sales and receivables
accounts to prove whether they were recorded in the proper period. Similarly,
recorded sales in this period may be vouched to underlying documents to
determine whether recording was in the proper period.
7. Refer to pages 458 to 460; 824 to 825; 827 to 828.
8. To prevent embezzlement through creation of fictitious credit memos, the

internal control system should provide that all credit memos be prenumbered,
controlled, and approved by a party independent of the preparer. Additionally,
credit memos should be approved only with proper supporting documentation,
e.g., a receiving report or correspondence.
9. Auditors get in the most trouble by missing overstated assets and understated
liabilities. Therefore, they need to audit for the existence of assets and the
completeness of liabilities.
10. Notes payable audit evidence obtained from a standard bank confirmation used
in the audit cash. Sales tax liability derived partially from the audit of sales
revenue (also commissions payable and excise taxes payable). Income tax
liability is derived from the net income number (audit of all revenue and
expense accounts).
11. The types of fraud and material misstatement with respect to cash disbursements
include:
1. The sending of checks to a fictitious person or company to accomplices outside
(coupled with internal record alterations).
2. The increasing (altering) of amounts payable to outside accomplices.
3. The intercepting of payments to a bank (coupled with internal record
alterations).
4. The drawing of checks payable to cash or bearer for one’s own use.
The procedures auditors use most frequently to detect cash disbursement embezzlement
schemes include:
1. A proof of cash – a recalculation – which reconciles cash receipts and
disbursements per the bank statement with receipts and disbursements
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recorded in the accounts. The auditor will satisfy himself as to the propriety
of all checks payable to “cash” or bearer, NSF checks, and checks drawn to
officers and other employees.
2. The confirmation with all bank creditors of amounts owed, terms and
activity during the period.
3. The auditor’s test of purchase transactions – vouching, tracing and
recalculation in regard to purchase orders, supplier invoices, cash
disbursement journal and voucher register.
4. The auditor’s obtaining satisfaction of the proper separation of functions:
To establish that a proper separation exist, the auditor will not only examine
internal records purporting a proper separation, he will also examine
documents for compliance and observe personally the flow of operations
and activities.
12. The characteristics that the auditor is looking for in his review of the client’s
inventory-taking instructions include:
1. Names of client personnel responsible for the count.
2. Dates and times of inventory-taking.
3. Names of client personnel who will participate in the inventory-taking.
4. Detail instructions for recording accurate descriptions of inventory items,
for count and double-count, and for measuring or translating physical
quantities.
5. Detail instructions for making notes of obsolete or worn items.
6. Detail instructions for the use of tags, punched cards, count sheets, or other
media devices, and for their collection and control.
7. Plans for shutting down plant operations or for taking inventory after store
closing hours, and plans for having goods in proper places.
8. Plans for counting or controlling movement of goods in receiving and
shipping areas if those operations are not shut down during the count.
9. Detail instructions for compiling the count media (e.g., tags and punched
cards) into final inventory listings or summaries.
10. Detail instructions for pricing the inventory items.
11. Detail instructions for review and approval of the inventory count, notations
of obsolescence, or other matters by supervisory personnel.
13. As is true in other areas of a financial audit, verbal inquiry is a valuable tool for
obtaining preliminary evidence in the audit of inventory and cost of sales. For
example, the auditor can gain information such as the locations of inventory,
dates for the physical count, inventory held by consignees and public
warehouses, the cost-flow assumption used to price cost of goods sold and
inventories, and the pledging of inventory as collateral on loans.
In addition to providing preliminary evidence, verbal inquiry frequently

provides information about the status and value of slow-moving inventory,
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apparently worn, damaged or obsolete inventory, and the existence of large
inventory stockpiles.
14. Cost of goods sold is generally audited through a combination of limited

vouching and extensive analytical procedures.
Inventory balances are generally audited through heavy reliance on observation,

vouching and recalculation, with much less emphasis on analytical procedures.
15. The auditor can obtain preliminary evidence through physically observing plant
facilities and making verbal inquiries; for example, evidence can be obtained
regarding the quantity and size of assets, their location and apparent physical
condition, the activity surrounding them, and ownership of the facilities.
Further preliminary evidence of existence may be gained by a review of internal

management reports. Examples of such reports include capital expenditure
proposals, capital budgets, construction cost or acquisition cost postanalysis,
maintenance and repair reports, reports of sales or retirements, and insurance
and property tax analyses.
The preliminary evidence should be corroborated by auditor tracing to the

detailed records to ascertain that existing assets are recorded. Further, new asset
acquisitions should be traced to directors’ authorizations for expenditures and to
the capital budget.
16. To obtain relevant audit data about investment securities, auditors’ procedures
include:
1. Inspecting the securities in the presence of a responsible client officer.
2. Personally examining the securities while other negotiable fund sources are
sealed off or are being examined simultaneously.
3. Obtaining a written statement from the client’s representative that the
securities were returned intact.
4. Obtaining the information by confirmation from an independent party (e.g.,
trustee) who holds the securities.
17. Investment cost can be vouched to brokers’ advices, monthly statements and
canceled checks. The auditors can similarly vouch the price of securities sold
and investment income to this documentary evidence and then trace amounts to
income, gain and loss, and cash accounts.
18. If investments are sold at substantial losses early in the period following year-
end, there is evidence that the securities were overvalued at the balance sheet
date. Accordingly, the auditor will consider whether such securities should be
written down in the financial statements of the period under audit.
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19. The long-term liabilities (and fixed assets and owners’ equity) are characterized
by a few large transactions, unlike the current assets and liabilities which have
numerous small transactions. Except for the initial year of an audit, the entire
balance is not verified each year. Only the changes in the account that occurred
in the current period need to be audited. The results of the audit of prior year’s
changes are recorded in “carry-forward” working papers for these accounts.
20. By vouching open purchase orders, inquiry of purchase personnel, and

confirmation with suppliers, the auditor is seeking to learn of commitments to
purchase inventories at fixed prices. If the client faces significant losses on
fixed-price purchase commitments, appropriate provision for the losses should
be made in the period’s financial statements.
21. “Off-balance sheet information” refers to information that relates to obligations

and commitments assumed by the clients that do not appear on the balance sheet
as current or long-term liabilities. Such information should be disclosed by the
client in the footnotes to the financial statements. Therefore, the auditors must
be alert to these items and gather evidence that will allow the auditors to
determine if the footnote disclosure is adequate. Such information includes:
leases, endorsements on discounted notes or others’ obligations, guarantees,
repurchase or remarketing agreements, commitments to purchase at fixed prices,
commitments to sell at fixed prices, legal judgment, litigation, pending
litigation.
22. The following matters are usually covered during the conference with the client
at audit completion:
a. Proposed audit adjustments;
b. Material internal financial control weaknesses;
c. Recommended footnote disclosures;
d. Type of audit report to be rendered.
1. b 5. c 9. b 13. c 17. d
2. b 6. c 10. c&d 14. d 18. a
3. d 7. c 11. b 15. d 19. a
4. d 8. b 12. b 16. c 20. c
Case 1. a. The CPA’s test of the sales cutoff at June 30 should include the following
steps:
1. Determine what JETO’s cutoff policy is, review the policy for
reasonableness, and compare it to the prior year for consistency.
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2. Select a sample of sales invoices (including the last serial invoice
number) from those recorded in the last few days of June and the first
few days of July.
3. Trace these sales invoices to shipping documents and determine that
sales have been recorded in the proper period in accordance with
company cutoff policy.
4. Determine that the cost of goods sold has been recorded in the period of
sale.
5. Select a sample of shipping documents for the same period and trace
these to the sales invoice. Determine that the sale and the cost of goods
sold have been recorded in the proper period.
6. Review the cutoff for sales returns and allowances, determine that it
has been based upon a consistent policy and that there have not been
abnormal sales returns and allowances in July; this might indicate
either an overstatement of sales during the audit period or the need for a
valuation account at June 30 to provide for future returns and
allowances.
b. (1) The CPA will use the July 10 cutoff bank statement in his review of the
June 30 bank reconciliation to determine whether:
(a) The opening balance on the cutoff bank statement agrees with the
“balance per bank” on the June 30 reconciliation.
(b) The June 30 bank reconciliation includes those canceled checks
that were returned with the cutoff bank statement and are dated or
bear bank endorsements prior to July 1.
(c) Deposits in transit cleared within a reasonable time.
(d) Interbank transfers have been considered properly in determining
the June 30 adjusted bank balance.
(e) Other reconciling items which had not cleared the bank at June 30
(such as bank errors) clear during the cutoff period.
(2) The CPA may obtain other audit information by:

(a) Investigating unusual entries on the cutoff bank statement.
(b) Examining canceled checks, particularly noting unusual payees or
endorsements.
(c) Reviewing other documentation supporting the cutoff bank
statement.
Case 2. The procedure followed appears to be appropriate except that the examination of
detail transactions for three months might be considered to be excessive in view
of the exceptionally good internal control. A lighter test of such transactions,
designed to test the effectiveness of the control procedures, might be devised.
The procedures followed should be supplemented by the following:
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1. Review the company’s method of sales cutoff at year-end and test billings
and shipments (including returns) for an adequate period before and after
year-end to establish that cut-off procedures have been adhered to.
2. Examine collections in early part of subsequent period to determine if a
substantial portion of the receivables has been collected.
3. Examine agreements entered into with the distributors. If price protection
clauses are included, review the current price position and distributor
inventory positions to determine whether a reserve for such protection is
needed.
4. When a company deals with a limited number of customers, it is dependent
upon the continued solvency of all such customers.
5. Obtain a representation letter from appropriate company officials covering
the receivables.
Case 3. 1. a. Notes payable are authorized according to company policy (proper

authorization).
b. For each note outstanding or paid during the year, vouch to written
authorizing document.
c. Funds might be borrowed in the company’s name without the
knowledge of responsible officers.
2. a. Recorded notes payable are valid and documented (separation of

duties).
b. Observe the client personnel record-keeping duties.
c. Someone might intercept a check made out to a bank and convert
company funds to his or her own use. Notes payable records could be
falsified for a short time to hide the theft.
3. a. Valid liabilities are recorded and none omitted (sound error checking
practices).
b. Observe client personnel making comparisons. Review correcting
journal entries that result from the comparison.
c. Purchases or other liabilities may fail to be recorded and the error not
detected by any other means.
4. a. Recorded liabilities and cash disbursements valid and documented

(sound record keeping).
b. Inspect notes to see if they are marked “paid.”
c. Notes may get “paid” a second time if put back through the cash
disbursements system (intentionally or inadvertently).
Case 4. a. The fact that the client made a journal entry to record vendors’ invoices
which were received late should simplify the CPA’s audit for unrecorded
liabilities and reduce the possibility of a need for a further adjustment, but
the CPA’s audit is nevertheless required. If the client has not journalized
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late invoices, the CPA is compelled in his testing to substantiate what will
ultimately be recorded as an adjusting entry. In this examination the CPA
should audit entries in the 2004 voucher register to ascertain that all items
which according to dates of receiving reports or vendors’ invoices were
applicable to 2004 have been included in the journal entry recorded by the
client.
b. No. The CPA should obtain a letter in which responsible executives of the
client’s organization represent that to the best of their knowledge all
liabilities have been organized. However, this is done as a normal audit
procedure to afford additional assurance to the CPA and it does not relieve
him of the responsibility for doing his own audit work.
c. Whenever a CPA is justified in relying on work done by an internal auditor,

he should curtail (but not eliminate) his own audit work. In this case, the
CPA should have ascertained early in his examination that Ozone’s internal
auditor is qualified by being both technically competent and reasonably
independent. Once satisfied as to these points, the CPA should discuss the
nature and scope of the internal audit program with the internal auditor and
review his working papers in order that the CPA may properly coordinate
his own program with that of the internal auditor. If the Ozone internal
auditor is qualified and has made tests for unrecorded liabilities, the CPA
may limit his work in this audit area.
d. In addition to the 2005 voucher register, the CPA should consider the
following sources for possible unrecorded liabilities:
1. Unentered vendors’ invoice file.
2. Status of tax returns for prior years still open.
3. Discussions with employees.
4. Representations from management.
5. Comparison of account balances with preceding year.
6. Examination of individual accounts during the year.
7. Existing contracts and agreements.
8. Minutes.
9. Attorney’s bills and letter of representation.
10. Status of renegotiable business.
11. Correspondence with principal suppliers.
12. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and
fixed assets.
Case 5. a. Lourdes should find in the audit working papers a planning memo
describing the client’s inventory-taking plan and notes about the auditor’s
first-hand observation of the instructions being given to counters, along
with a memo about the auditors’ observation of the counting. This memo
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should tell about supervision of the audit staff, and the working papers (test
counts) should show the review signatures of the supervising auditors.
b. Working papers should document performance of these substantive

procedures for the existence and completeness assertions:
1. Conduct an observation of the company’s physical inventory count.
2. Scan the inventory compilation for items added from sources other than
the physical inventory count. . .
3. At year end, obtain the number of the last shipping and receiving
documents . . . Use these to scan the sales, inventory/cost of sales, and
accounts payable entries for proper cutoff.
4. Confirm or inspect inventories held in public warehouses.
Case 6. The three categories of major losses or manipulations in the area of investments
are: theft of diversion of funds, manipulation of accounting, and business
espionage. Business espionage is generally outside the sphere of independent
auditors’ interest.
Case 7. a. The objectives (specific assertions) for the audit of non-current investment
securities are to obtain evidence regarding the:
 Existence of the investment securities at the balance sheet date.
 Ownership of the investment securities.
 Cost and carrying value of the investment securities.
 Proper presentation and disclosure of the investment securities in
the financial statement.
 Proper recognition of interest income.
 Proper recognition of investment gains and losses.
b. The following audit procedures should be undertaken with respect to the

audit of Tess’ investment securities:
 Inspect and count securities in the company’s safe and safe deposit
box.
 Examine brokers’ statements to obtain assurance that all
transactions were recorded.
 Examine documents in support of purchases and sales of
investment securities.
 Inspect the minutes of the board of directors meetings.
 Review the audited financial statements of the (25 percent)
investee.
 Verify the equity method of accounting was used for carrying value
of the investment in Dee Industrial.
 Obtain a client representation letter that confirms the client’s
representations concerning the noncurrent investment securities.
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 Verify the calculation of interest income.
 Review the propriety of the presentation and disclosure of the
securities in the financial statements.
 Make certain that the client representation letter includes the
proper assertions concerning accounts payable.
 Investigate and resolve confirmation exceptions and other matters
requiring follow-up.
Case 8. a. The audit objectives in the examination of long-term debt are to determine
that:
1. All liabilities were properly recorded.
2. Items recorded as liabilities are bona fide obligations.
3. Interest expense and/or amortization was properly computed and
recorded.
4. The client is not in violation of restrictions or requirements imposed on
it by the terms of the loan agreement.
5. Satisfactory authority existed to enter into long-term obligation
agreements.
6. All long-term obligations are properly classified in the balance sheet.
7. Assets pledged as security are adequately disclosed.
b. The following procedures should be included in an audit program for the

examination of the long-term note between Odette and First National Bank:
1. Confirm the loan and terms of the agreement with the bank.
2. Review the agreement between Odette and the bank to determine that:
a. The debt is long-term (by reference to dates).
b. Provisions of the agreement have not been violated, e.g., that
Odette is complying with any restrictions on the payment of
dividends, on the amount of working capital to be maintained, or
on the uses to which the funds may be employed and is
maintaining the plant pledged as security for the loan.
c. The agreement was signed by person(s) having authority.
3. Trace the receipt of funds into the bank account and cash receipts book.
4. Check the computation of interest expense for the period May 1 to June
30, and trace the recording of the expense and the accrual on the books.
5. Determine that authority to borrow was granted and is recorded in the
board of directors’ minutes.
CHAPTER 25
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AUDITING FAIR VALUE MEASUREMENTS
AND DISCLOSURES
I. Review Questions
1. Refer to page 856, paragraph 1 of the textbook.
6. Refer to page 861, no. 5 of the textbook.
7. Refer to page 863, no. 8 of the textbook.
8. Refer to page 864, no. 9, 3rd paragraph of the textbook.

1. b
2. b
3. d
4. d
5. c
CHAPTER 26
USING THE WORK OF OTHERS
I. Review Questions
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1. An auditor who reports on the financial statements of a combined entity when he
or she audited the major part of the combined entity is the principal auditor.
Auditing standards identify procedures to be followed by a principal auditor.
To be able to serve as auditor of a combined entity, an auditor must determine

that he or she is able to be the principal auditor based on the materiality of
the portion of the financial statements that he or she has examined, his or
her knowledge of the overall financial statements, and the importance of the
components he or she has audited.
2. The principal auditors must perform one or more of the following procedures:
 Visit the auditor.
 Review the audit programs.
 Review audit work papers.
 Perform additional audit procedures.
3. Refer to page 879.
4. Refer to pages 879 to 880.
5. While the external auditor has sole responsibility for the audit opinion expressed
and for determining the nature, timing, and extent of external audit procedures,
certain parts of internal auditing work may be useful to the external auditor.
The external auditor should obtain a sufficient understanding of internal audit
activities to assist in planning the audit and developing an effective audit
approach.
Effective internal auditing will often allow a modification in the nature and
timing, and a reduction in the extent of procedures performed by the external
auditor but cannot eliminate them entirely. In some cases, however, having
considered the activities of internal auditing, the external auditor may decide
that internal auditing will have no effect on external audit procedures.
The external auditor’s preliminary assessment of the internal audit function will
influence the external auditor’s judgment about the use which may be made of
internal auditing in modifying the nature, timing and extent of external audit
procedures.
1. c 3. d 5. b
2. b 4. b 6. c
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a. Tan should ask San Nicolas to authorize Andres to respond fully to her inquiries.
If San Nicolas refuses or limits the responses, Tan should request San
Nicolas to explain the reasons. After obtaining the explanation, Tan should
consider whether to continue pursuing the engagement.
b. Tan will have to (1) obtain additional information about the client and
possibly about the industry, which Andres would have obtained in prior
years, (2) make a more detailed evaluation of whether to accept this
client, (3) obtain information about the client’s internal control, which
Andres would have obtained in prior years, and (4) obtain evidence about
beginning balance sheet balances, which Andres would have obtained in
prior years.
CHAPTER 28
THE AUDITOR’S REPORT ON FINANCIAL STATEMENTS
I. Review Questions
1. Scope paragraph
(a) The objects of the audit are the financial statements – balance sheet(s), income
statement(s), and cash flow statement(s), and related footnote disclosure,
not the “books and records.”
(b) The description of the audit means:

(1) the auditors were trained and proficient.
(2) the auditors were independent.
(3) due professional care was exercised.
(4) the work was planned and supervised.
(5) internal controls was properly studied and evaluated.
(6) sufficient competent evidential matter was obtained.
(7) the GAAS reporting standards were followed.
* Professional judgment was exercised in performing the tests and choosing the
procedures to perform in the circumstances.
2. Report and the evidence dimension
Fully sufficient Isolated

competent evidence Pervasive lack
evidence deficiency of evidence
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Unqualified opinion X
Adverse opinion X
Opinion qualified for a
departure from SFAS X
Paragraph for
inconsistent GAAP
application X
Paragraph for an
uncertainty X
Disclaimer of opinion X
3. Major reasons for departure from the standard unqualified report

1. Disagreement with management regarding the acceptability of the accounting
policies selected, the method of their application or the adequacy of
financial statement disclosure.
2. Limitation on scope of the audit (resulting in a lack of evidence).
3. Using extra paragraph(s) to emphasize significant matters.
4. Different opinion on prior year comparative statements.
5. Relying on the work and reports of other independent auditors.
6. Required supplementary data omitted or departs from guidelines.
7. “Other information” inconsistent with financial statements or contains
material misstatement of fact.
8. Auditor is not independent.
4. Students may identify more than one description of the “most important”
distinction between an opinion and a disclaimer. All the following are valid,
although (a) is intended to be the “Most Important:”
a. An opinion (unqualified, qualified or adverse) is an explicit statement of the
auditor’s conclusion(s), while a disclaimer is an (empty) assertion of “no
conclusion.”
b. An (unqualified) opinion is the highest level of assurance, while a
disclaimer is the lowest level (no assurance).
c. An opinion requires evidence as a basis, while a disclaimer results from
lack of evidence.
d. Auditors must be independent to give an opinion, while a disclaimer can
result from a CPA’s lack of independence.
5. A material scope restriction occurs when the auditor is unable to gather

sufficient competent evidence to support an unqualified opinion on the financial
statements. Scope restrictions may be client-imposed or they may result from
other circumstances, e.g., appointment of the auditor after the client’s physical
inventory has been taken. A material scope restriction need not result in a
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modification of the auditor’s opinion provided the auditor can obtain satisfaction
by alternate means.
6. A principal auditor is one who has examined the major portion of the combined
entity.
7. When financial statements of the prior year are presented together with those of
the current year, a continuing auditor must report on both years. In “updating”
the prior year’s report, the auditor must decide whether to restate the report in its
same form or modify it to reflect current information not available at the date of
issuance of the prior report.
8. A continuing auditor can update a previously-issued report by obtaining and

evaluating information during the current engagement. Thus, an updated report
is a previously-issued report that has been reevaluated in light of current
information and evidence. (The updated report itself may be a compilation
report, a review report, or an audit report).
The reevaluation may cause the updated version to be different from the report
previously issued (for example, a new reason to write a qualification may be
found).
An updated report carries a current date, not the date of the previous report.
A predecessor auditor usually does not have the current information necessary
to update a report.
Either a continuing auditor or a predecessor auditor can reissue previously-

reissued report. The process does not contemplate consideration of information
and evidence obtained during a current engagement. Thus, a reissued report is a
current release of a previously-issued report without benefit of any additional
examination or review of the subject financial statements. The report date
should be the date of the end of field work for the original issue of the report.
9. A principal auditor is the one who (a) audits a material portion of a reporting
entity’s assets, liabilities, revenues and expenses (usually over 50 percent) and
(b) knows enough about the whole entity to sign the audit report.
10. The principal auditor’s reference in his report to another auditor is not a
qualification in scope. The reference only shows the divided responsibility for
the audit work.
11. When an auditor is not independent with respect to a client, a disclaimer of

opinion must be rendered. The disclaimer must be issued because the statements
cannot be audited in accordance with generally accepted auditing standards.
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(An accountant, not an auditor, is the person associated with compiled and
reviewed financial statements. An accountant can give a compilation –
disclaimer – report on compiled unaudited financial statements).
12. When the “going concern assumption” is in doubt, auditors have serious
reservations about the recoverability and amounts of reported assets and the
amount and classification of reported liabilities. These opinions may be used,
depending on the circumstances:
a. Standard unqualified report with an uncertainty notice paragraph calling
attention to the going concern problem.
b. Disclaimer of opinion to express unwillingness to give an opinion on the
presentation.
c. Opinion qualified or adverse for departure from GAAP if all appropriate
disclosures are not made.
13. According to PSA 700,

“In certain circumstances, an auditor’s report may be modified by adding an
emphasis of matter paragraph to highlight a matter affecting the financial
statements which is included in a note to the financial statements that more
extensively discusses the matter. The addition of such an emphasis of matter
paragraph does not affect the auditor’s opinion. The paragraph would preferably
be included after the opinion paragraph and would ordinarily refer to the fact
that the auditor’s opinion is not qualified in this respect.
The auditor should modify the auditor’s report by adding a paragraph to

highlight a material matter regarding a going concern problem.
The auditor should consider modifying the auditor’s report by adding a

paragraph if there is a significant uncertainty (other than a going concern
problem), the resolution of which is dependent upon future events and which
may affect the financial statements. An uncertainty is a matter whose outcome
depends on future actions or events not under the direct control of the entity but
that may affect the financial statements.”
14. Whether to divide responsibility or accept full responsibility is a function of:

a. Relationship of the principal auditor to the other auditors; and
b. Materiality of the component(s) examined by other auditors.
15. The auditor may decide to disclaim an opinion when confronted by a material
scope limitation that precludes gathering sufficient evidence to support an
opinion as to overall fairness of financial presentation. The auditor may also
disclaim an opinion if his/her name is associated with financial statements for
which an audit was not intended (e.g., compilations and reviews), or if the
auditor is not independent.
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16. Two conditions are necessary for an unqualified opinion:

a. No material scope restrictions have prevented the auditor from collecting
sufficient, competent evidence; and
b. The financial statements, including footnote disclosures, contain no material
departures from GAAP.
17. An auditor may agree with a departure from a designated principle only when, in
his/her judgment, application of the designated principle would make the
financial statements materially misleading.
18. The audit opinion does not extend to the other information, and therefore, the
opinion is not affected by omission or inconsistency or incorrect supplemental
information.
19. The auditor must evaluate, on every audit, the ability of the entity to meet its
obligations on a continuing basis during a reasonable period (usually 12 months)
following the balance sheet date. Although the auditor is not required to apply
additional procedures in making the initial evaluation, if he/she has substantial
doubt as to ability of the client to continue, added procedures may have to be
applied to resolve the issues.
20. The auditor should add an explanatory paragraph regarding a material

uncertainty, provided the outcome of the events surrounding the uncertainty
cannot be reasonably estimated by management. If the probability of an
unfavorable outcome is remote, the explanatory paragraph is not needed. If a
material loss is probable, but is not susceptible to reasonable measurement, and
is properly footnoted, the auditor should add an explanatory paragraph directing
the reader’s attention to the footnote.
The greater the materiality, and the higher the probability of loss, the more
inclined will be the auditor to add the explanatory paragraph.
21. Upon learning of a change in accounting principle, the auditor should first
determine the materiality and appropriateness of the change. If material and the
auditor agree with the client’s justification for the change, an explanatory
paragraph should be added following the opinion paragraph. The paragraph will
refer to the footnote describing the change. If the change is not properly
accounted for or is inadequately disclosed, the auditor should consider issuing a
qualified or adverse opinion.
1. c 11. c 21. c 31. b
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2. d 12. b 22. c 32. c
3. a 13. d 23. a 33. b
4. c 14. a 24. d 34. c
5. c 15. b 25. c 35. d
6. c 16. d 26. a 36. b
7. c 17. d 27. a 37. d
8. a 18. a 28. c 38. a
9. d 19. b 29. c 39. d
10. c 20. c 30. b 40. b
Case 1. You must determine whether an unqualified opinion satisfies the GAAS
reporting standard, in particular:
a. Determine whether the financial statements are presented in conformity
with GAAP.
1. Read the footnote description of accounting policies.
2. Use a GAAP checklist.
3. Review the working papers for any indication of accounting policies
not described in the footnote or ones apparently not in conformity with
GAAP.
4. Determine if:
(i) The accounting principles are generally acceptable, having
authoritative support.
(ii) The accounting principles are appropriate in the circumstances.
(iii) The financial statements are informative.
(iv) The information is reasonably summarized.
(v) Material adjustments have not been waived without good reasons.
b. Determine whether any accounting changes have been made and whether
accounting principles have been applied consistently.
c. Determine whether the footnote disclosures are adequate to inform users of
any material information evident in the working papers.
Case 2. 1. The auditor is reporting to the body that has engaged the auditing services.
While the report may be read and used by others who are indirect
beneficiaries of the audit, current custom is not to address the report to the
unknown class of users.
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2. The scope paragraph should specifically identify the audited statements by

name so that there can be no mistake about the subject of the report. The
alternative language is not as precise.
3. The standard language effectively bases the audit on an extensive body of

written auditing standards that are known to others and can be cited in case
of controversy. The alternative language, on the other hand, seems to break
loose from profession-wide quality norms and make the audit quality
depend more on “the circumstances,” which introduces an element of
mystery and lack of definition into the report.
4. The alternative wording is similar to the typical British audit report, and
they seem to be able to live with it, but American auditors believe that
“opinion” connotes belief or judgment stronger than impression but less
strong than positive knowledge. American auditors do not wish to appear to
have full, positive knowledge about the statements on the grounds that it’s
not feasible to know all there is to know about the financial statements.
Also, the standard language leans heavily on GAAP as the criteria for fair
presentation whereas the alternative language contains no reference to
authoritative accounting criteria.
Case 3. 1. Title. The report needs a title referring to Rose as the independent auditor
or independent accountant.
2. Notice of audit. The report does not give the proper declaration of an audit
of the financial statements, especially the part about “in accordance with
your instructions,” which suggest that Rose surrendered some audit
independence. The reference to a “complete audit” is ill advised because it
suggests a 100% investigation, which is contradicted by the sentence about
“tests of the sales records.”
3. Responsibilities. The report says nothing about the auditor’s responsibility
for the audit report.
4. Opinion. The opinion sentence should not be modified with the phrase
“with the explanation given above.”
5. Opinion. The opinion sentence should not mention “minor errors we
consider immaterial,” but it should contain the phrase “presents fairly in all
material respects.”
6. Opinion/Identification of Financial Statements. The opinion should not
include reference to cash flows because the introductory paragraph did not
state that the cash flow statement was audited. This may be a deficiency in
the identification of the financial statements that were actually audited.
18-108
7. Opinion. The opinion paragraph refers improperly to ASC
pronouncements. It should refer to “generally accepted accounting
principles.”
8. Date. The date accompanying Rose’s signature should be September 23 –
the day the field work was completed – not the company’s fiscal year-end
date.
9. Other. The commentary on the economy and the strike are not generally
appropriate for an audit report. Even if the auditor wanted to draw attention
to these matters, their relevance for understanding the financial statements
and their manner of expression are both questionable.
10. Other. The negative assurance (concerning the recording of sales) is not
permitted in audit reports.
Case 4.
Independent Auditor’s Report
To the shareholders and board of directors of Various Fabrics, Inc.:
We have audited the accompanying balance sheets of Various Fabrics, Inc. as of
January 31, 2004 and 2003 and the related statements of income, retained earnings,
and cash flows for the years then ended. These financial statements are the
responsibility of the company’s management. Our responsibility is to express an opinion
on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Various Fabrics, Inc. as of January 31, 2004 and 2003
and the results of its operations and its cash flows for the years then ended in conformity
with generally accepted accounting principles.
Aya de Jesus, CPA

March 2, 2004
Case 5. 1. F, L 5. B, I
2. B, I 6. B, I
3. B, Q 7. E, J
4. A, J
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Case 6. A. 1, 7c.
B. 2, 7a.
C. 4.
D. 1.
E. 6.
F. 5.
G. 2 (Note: The change in principle should be described in the descriptive
paragraph following the scope paragraph.)
H. 3, 7c.
I. 2, 7b.
J. 3, 7d.
K. 6. (given the materiality of property, plant, and equipment)
L. 1, 7e.
M. 1, 7b and 7e.
CHAPTER 29
PROCEDURES AND REPORTS ON SPECIAL PURPOSE

AUDIT ENGAGEMENTS
I. Review Questions
1. The report simply states: “The financial statements are not intended to be
presented in conformity with generally accepted accounting principles.” The
opinion expression thereafter refers to a description of the comprehensive basis
used.
Non-GAAP accounting bases include:

1. Statutory or regulatory accounting requirements
2. Tax basis accounting
3. Cash and modified cash bases
4. General price level-adjusted statements
5. Any other basis having “substantial support” (Auditing standards do not
explain how non-GAAP accounting can have “substantial support.” In
practice, accountants will report on any reasonable accounting basis, which
explains why reports exist on diverse types of current value financial
statements.)
2. The following are four comprehensive bases of accounting other than GAAP:
18-110
1. A basis of accounting to comply with the requirements of a governmental
regulatory agency (for example, insurance companies use a basis of
accounting pursuant to the rules of the insurance commission)
2. A basis of accounting used to file an income tax return
3. The cash receipts and disbursements basis of accounting (cash basis) and
modifications to the cash basis, such as recording depreciation on fixed
assets or accruing income tax.
4. A definite set of criteria having substantial support that is applied to all
material items in the financial statements, such as the price-level basis of
accounting.
3. A CPA may be asked to report on the application of GAAP by another auditor’s

client who disagrees with the auditor’s view of proper accounting for the
transaction. Auditing standards apply when a CPA in public practice, either in
connection with a proposal to obtain a new client or otherwise, provides oral or
written advice on the application of accounting principles to a specific
transaction or the type of opinion that may be rendered on an entity’s financial
statements. In forming a judgment, the CPA should perform the following
procedures:
 Obtain an understanding of the form and substance of the
transaction(s).
 Review applicable GAAP.
 If appropriate, consult with other professionals or experts.
 If appropriate, perform research or other procedures to ascertain and
consider the existence of creditable precedents or analogies.
 The reporting CPA is required to consult with an entity’s continuing
CPA to ascertain all the relevant facts. The continuing CPA can provide
information about the form and substance of the transaction, how
management has applied accounting principles to similar transactions,
and whether the method of accounting recommended by the continuing
CPA is disputed by management.
4. The following difficulties might arise:
Prior-year statements were unaudited: The auditor should label the prior-year
columns “Unaudited” and modify the report by adding a paragraph that
disclaims an opinion on the statements.
Audited by another auditor:

 Alternative 1: Predecessor auditor reissues report.
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 Alternative 2: If predecessor’s report is not presented, the auditor
indicates in the introductory paragraph (1) that the financial statements
of the prior period were audited by another auditor (but does not name
the predecessor auditor), (2) the date of the report, (3) the type of report
issued by the predecessor auditor, and (4) if the report was not a
standard unqualified report, the substantive reasons therefor. When the
predecessor auditor’s report is not presented, the audit report would
have an added sentence at the end of the first paragraph, and the
opinion paragraph would refer only to the current-year statements.
Different reports on comparative statements: An auditor may issue modified

reports on either of the financial statements reported on comparatively. In this
situation, the auditor must exercise care to relate the opinion to the appropriate
year’s financial statements.
1. b 5. b 9. a 13. d 17. b
2. a 6. a 10. a 14. a 18. c
3. c 7. a 11. d 15. a 19. b
4. a 8. a 12. d 16. a 20. a
Case 1.
To the Board of Directors of Neiny Ltd.:
We have reviewed the accompanying balance sheet of Neiny Ltd. as of December 31, 2004,
and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with standards established by the Auditing Standards and Practices
Council. All information included in these financial statements is the representation of the
management of Neiny Ltd.
A review consists principally of inquiries of company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an examination in accordance
with generally accepted auditing standards, the objective of which is the expression of an
opinion regarding the financial statements taken as a whole. Accordingly, we do not express
such an opinion.
Based on our review, we are not aware of any material modifications that should be made to
the accompanying 2004 financial statements in order for them to be in conformity with
generally accepted accounting principles.
The financial statements for the year ended December 31, 2003, were audited by us, and we
expressed an unqualified opinion on them in our report dated February 27, 2004, but we have
not performed any auditing procedures since that date.
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Modelle & Co.

March 3, 2006
Case 2. a. The assertions that are incorrect and should otherwise be deleted are the
following:
1. Report should be addressed to Ms. Clean Corporation’s Board of
Directors.
2. Delete the entire paragraph describing the scope except for the
reference to cash in banks and accounts receivable.
3. Delete the opinion rendered on cash in banks and accounts receivable.
4. Delete the recommendation to acquire Ajacks.
b. The assertions that are missing and should be inserted are the following:
1. Date of the report.
2. Statement limiting the distribution of the report to Ms. Clean’s
management.
3. Description of the procedures performed.
4. Statement that the agreed-upon procedures applied are not adequate to
constitute a GAAS audit.
5. Description of the accountant’s findings.
6. Disclaimer of an opinion concerning cash in banks and accounts
receivable.
7. Statement limiting the report only to cash in banks and accounts
receivable and indicating that the report does not extend to the
financials taken as a whole.
Case 3.
Independent Auditor’s Report
[Addressee]
We have audited the statement of assets, liabilities, and capital (income tax [cash] basis) of
Vanda & Corona, a partnership, as of December 31, 2004, and the related statements of
revenue and expenses (income tax [cash] basis) and statement of changes in partners’
capital accounts (income tax [cash] basis) for the year then ended. These financial
statements are the responsibility of the company’s management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
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As described in Note X, the partnership’s policy is to prepare its financial statements on the
accounting basis used for income tax purposes; consequently, certain revenue and related
assets are recognized when received rather than when earned, and certain expenses are
recognized when paid rather than when the obligation is incurred. Accordingly, the
accompanying financial statements are not intended to present financial position and results
of operations in conformity with generally accepted accounting principles.
In addition, the company is involved in continuing litigation relating to patent infringement.
The amount of damages resulting from this litigation, if any, cannot be determined at this time.
In our opinion, the financial statements referred to above present fairly the assets, liabilities,
and capital of the Vanda & Corona partnership as of December 31, 2004, and its revenue and
expenses and changes in its partners’ capital accounts for the year then ended, on the
income tax (cash) basis of accounting as described in Note X, which basis has been applied
in a manner consistent with that of the preceding year.
[Sterling & Co.]

[Date]
18-114

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What are the key considerations involved in judging an acceptable risk of assessing control risk too high?

What are the key considerations involved in judging an acceptable risk of assessing control risk too high?

What are the potential consequences of assessing control risk too low?

What are the potential consequences of assessing control risk too low?

CHAPTER 11

A RISK-BASED AUDIT APPROACH – PART II

1. Use the model AR = IR x CR x DR to solve for different values of Audit Risk

2. a. Risk of Assessing Control Risk Too Low or Overreliance is a matter of

4. The important consideration involved in judging an acceptable risk of assessing

Other auditors want to minimize their work (within acceptable professional

The probability of finding 1 or more deviations when the population rate is

6. An incorrect acceptance decision directly impairs the effectiveness of an audit.

An incorrect rejection decision impairs the efficiency of an audit. Further

9. An auditor would assess control risk to be at maximum when (1) effective

14. The audit risk model is

II. Multiple Choice Questions

1. d 12. d 23. c 34. c

Case 3. a. The audit risk model gives the following results:

(1) 2.5% (4) 3.33%

b. (1) 3 (tied) (4) 2

Case 4. a. (1) Medium (4) Low

b. (1) Least (4) 2 (tied)

Case 6. 1. a. Sales and collection

1. “Procedures” relate to acts to be performed. “Standards” deal with measures of

2. A “substantive audit procedure” is any action (resembling a specific variation of

The timing of a procedure is the period during which it is performed – usually

3. Inspection techniques include physical examination of assets, examination of

4. Vouching and tracing are two types of commonly performed documentation.

5. An inquiry involves requesting information from client personnel and receiving

8. Vouching is relevant to testing the existence of sales; tracing is not. Tracing is

II. Multiple Choice Questions

III. Comprehensive Cases

Case 2. Types of procedures used by auditors in general, with examples:

Case 3. a. An audit confirmation is a written statement to the CPA from someone

b. The two main characteristics a confirmation should possess are:

Case 4. 1. Scanning for debit balances in accounts payable

b. A decline in the miscellaneous revenue account balance, or the absence of a

c. Unrecorded accounts payable at year-end would cause an increase in

d. An apparent increase in accounts receivable turnover may, in fact, be the

Case 6. a. This is an inappropriate application of cost/benefit to auditing. The second

b. This is an appropriate application of the cost/benefit concept. Confirmation

1. Refer to page 494, 2nd and 4th paragraphs of the textbook.

2. Refer to page 494, 3rd paragraph of the textbook.

3. Refer to page 496, 3rd paragraph of the textbook.

4. Refer to page 497, 1st paragraph of the textbook.

5. Refer to page 497, 2nd paragraph of the textbook.

6. Refer to page 498, 4th paragraph of the textbook.

7. External documentary evidence is evidential matter obtained from the other

External-internal documentary evidence is documentary material that originates

Internal documentary evidence consists of documentary material that is

8. Auditors can help the effectiveness of confirmation requests by:

13. Auditing standards define an accounting estimate as “an approximation of a

14. In evaluating the reasonableness of accounting estimates, an auditor should

II. Multiple Choice Questions

III. Comprehensive Cases

Case 1. a. Evidential matter obtained from independent sources outside an enterprise

b. Accounting data and financial statements developed under satisfactory

c. Direct personal knowledge obtained by the independent auditor through

Case 2. 1. Types of evidence