Chapter 16 - Auditing Operations and Completing the Audit

CHAPTER 16

Auditing Operations and

Completing the Audit

Review Questions

16-1 Revenue accounts that are verified during the audit of balance sheet accounts are the following
(only three required):

Balance Sheet Item Revenue

Accounts Receivable Sales

Notes Receivable Interest
Securities and other investments Interest, dividends, gains on sale, share of investee's
income
Property, plant, and equipment Rent, gains on sales
Intangible assets Royalties

16-2 Many analytical procedures are used in the verification of revenue. Typical are the following:

(1) Comparison of this year's revenue to last year's.

(2) Comparison of month-by-month revenue increments in the current year.

(3) Comparison of revenue for each of the current year's months with the revenue of the prior
year's comparable months.

(4) Comparison of budgeted to actual revenue for each month of the current year.

(5) Comparison of revenue to sales or production in units of product.

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Any unusual variations developed in the above comparisons should be thoroughly investigated and
the reasons therefor obtained.

16-3 Items often misclassified as miscellaneous revenue include the following (only three required):

(1) Collections on previously written-off receivables; these should be credited to the allowance
for doubtful accounts and notes receivable.

(2) Write-offs of old outstanding checks or unclaimed wages; in states having unclaimed
property laws these write-offs should be credited to a liability account.

(3) Proceeds from sale of scrap; these are generally applied to reduce cost of goods sold.

(4) Rebates or refunds of insurance premiums; these should be offset against the related
insurance expense or unexpired insurance.

(5) Proceeds from sales of plant assets; these should be accounted for in the determination of
gain or loss on the assets sold.

16-4 Expense accounts that are verified during the audit of balance sheet accounts are the following
(only three required):

Balance Sheet Item Expense

Accounts and notes receivable Uncollectible accounts and notes expense

Inventories Purchases and cost of goods sold
Property, plant, and equipment Depreciation, repairs and maintenance, and depletion
Intangible assets Amortization
Accrued liabilities Related expenses, such as commissions, fees,
bonuses, product warranty expenses, and others
Interest bearing debt Interest

16-5 For income tax returns, the auditors should obtain or prepare analyses of officers' salaries and
expenses, directors' fees, travel and entertainment, taxes, contributions, and casualty losses.

16-6 The department heads and other supervisors who direct operations and authorize expenditures
should participate in the development of each year's budget and should receive frequent reports
comparing actual revenue and cost data with the budget figures. When the budget is used in this
way, it serves as a goal and as a measure of performance. The department head who helps set the
budget figures for a department feels a personal responsibility for achieving the planned results.
Regular reports keep the supervisor informed on variances between the budget and operating
results and draw attention to matters requiring managerial attention.

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16-7 The reasonableness of selling, general, and administrative expenses may be ascertained by
obtaining or preparing comparative analyses of monthly expenses, including expenses expressed as
percentages of net sales for both the current and preceding years. Study of the monthly and yearly
relationship of individual expense accounts to net sales should reveal any material variation
requiring detailed investigation.

16-8 Performing analytical procedures for expenses includes the following four steps:

 Develop an expectation of the amount of the expense balance by considering amounts such as
budgeted amounts, prior year audited amounts, industry averages, and amounts developed by
expected relationships among financial data or relevant non financial data.

 Determine, based on materiality, the amount of the difference from expectations that can be
accepted without investigation.

 Compare the amount of the expense to the expectations.

 Investigate any significant deviation from the expectation.

16-9 The functions of (1) employment (human resources), (2) timekeeping, (3) payroll preparation and
recordkeeping and (4) distribution of pay to employees should be lodged in separate departments to
achieve maximum internal control over payroll.

16-10 If wages are paid in cash, it is particularly important that the person compiling the payroll not be
responsible for filling the pay envelopes or distributing them to employees. Segregation of the
functions of timekeeping, payroll preparation, and payroll distribution is essential to effective
internal control.

16-11 Unclaimed wages should be deposited in the bank and credited to a special liability account. When
the employee calls for unclaimed pay, a new check is drawn and a receipt obtained from the
employee. If the paymaster or cashier is permitted to retain unclaimed wages, an incentive to
payroll padding is created along with an opportunity for intermingling these with other funds and
thus concealing shortages.

16-12 The "tests of controls over payroll transactions" includes tracing names and wage rates to human
resources department records, tracing hours to time reports, tracing deductions to employee
authorization forms, testing extensions and footings, comparing amounts to labor cost records,
testing reconciliations of the payroll bank account, investigating the handling of unclaimed wages,
and comparing of payroll data with payroll tax returns.

16-13 A complete review by the auditor of all correspondence in the client's files is usually out of the
question. This would consume an enormous count of time and would yield only incidental benefits.
The auditor's use of the correspondence files will usually be limited to a request for letters bearing
on issues arising during the examination of other records. These are generally letters to banks and
other financial institutions, attorneys, and governmental agencies.

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16-14 Analytical procedures performed as a part of the overall review assist the auditors in assessing the
validity of the conclusions reached, including the opinion to be issued. The final review may
identify areas that need to be examined further as well as provide a consideration of the adequacy
of the data gathered in response to unusual or unexpected relationships during the audit.

16-15 The audit procedures that are completed near the end of field work include:
(1) Search for unrecorded liabilities.
(2) Review the minutes of meetings.
(3) Perform final analytical procedures.
(4) Perform procedures to identify loss contingencies.
(5) Perform the review for subsequent events.
(6) Obtain the representation letter.

16-16 Loss contingencies are possible losses, stemming from past events, which will be resolved as to
existence and amount by some future event. Prior to the occurrence of the future event, uncertainty
exists not only as to the amount of the loss, but also as to whether any loss has actually been
sustained. Loss contingencies should be disclosed in notes to the financial statements whenever it
is reasonably possible that a loss has been sustained (or when disclosure is warranted by
tradition). If both (1) it is probable that a loss has been incurred and (2) the amount of the loss
may be reasonably estimated, loss contingencies should be recognized as actual losses in the
financial statements.

16-17 The usual procedure followed by the independent auditors in obtaining evidence regarding pending
and threatened litigation against the client is a letter of inquiry (or lawyer's letter) sent to the client's
legal counsel. The auditors obtain from management a list of such litigation and ask the client's
attorney to comment on this list, add any items to make it complete, and indicate any differences of
opinion with management regarding the probable outcome.

16-18 An unasserted claim is a potential legal claim for which no claimant has demonstrated an intent to
pursue legal remedies. Often, however, it is merely a matter of time before an unasserted claim
becomes pending litigation. It is not the act of litigation being filed which creates a loss
contingency for the defendant. Rather, it is having performed the acts which provide the basis for
that litigation. To illustrate an unasserted claim involving the likelihood of loss, assume an airliner
crashes in a populated area. For a short period of time, no claimant may exhibit intent to sue. In
the long run, however, litigation is inevitable.
FASB ASC 450 requires disclosure of unasserted claims when it is (1) probable that a
claim will be asserted and (2) reasonably possible that the outcome will be adverse. Unasserted
claims not meeting these criteria need not be disclosed.

16-19 No. The status of the IRS's review is not generally disclosed in the notes to the financial
statements. However, the auditors should review the prior year returns to make certain that any
contingent liabilities for prior taxes are appropriately reflected in the financial statements.

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16-20 The term commitment means a contractual obligation to carry out a transaction at a specified time
in the future. Examples include commitments to sell merchandise at fixed prices, to buy goods at
fixed prices, and to employ an executive at a stipulated salary for several years in the future. If
commitments are a material factor in a company's operation, they should be disclosed in a note to
the financial statements.

16-21 General risk contingencies are the many factors in the business environment of a particular entity
which involve some risk of causing future loss. Examples include the risk of natural catastrophes,
competition, strikes, and future raw material shortages. General risk contingencies should not be
disclosed in financial statements. In the event that a loss actually occurs, that loss, of course, will
be recognized in the financial statements.

16-22 "Subsequent events" are events occurring after the date of the balance sheet under audit but prior to
completion of the audit and issuance of the report.

16-23 In evaluating their audit findings, the auditors consider (1) known misstatements, (2) projected
misstatements and (3) other estimated misstatements. By accumulating these types of
misstatements, the auditors obtain an estimate of the total likely misstatement in the client's
financial statements. If, based on this estimate of the total likely misstatement, the auditors
conclude that there is an unacceptable high risk of material misstatement in the financial
statements. They should then attempt to get the client to adjust their financial statements for the
known misstatements, or perform additional tests to determine if the likely misstatements actually
exist.

16-24 A disclosure checklist is a list of specific disclosures required by the FASB, the GASB, and the
SEC. The purpose of the checklist is to assist the auditors in evaluating the adequacy of the
disclosures contained in a set of financial statements.

16-25 Auditors read the other information and consider whether it is materially inconsistent with
information appearing in the audited financial statements. If the other information is inconsistent,
and the auditors conclude that neither the audited financial statements nor the audit report requires
revision, they should request the client to revise the other information. If the client will not revise
the information, the auditors should include an additional paragraph in their report indicating the
inconsistency, or withdraw from the engagement. The auditors should also be alert for, and discuss
with the client, other types of material misstatements included in the other information.

16-26 No. Because the supplemental information is considered unaudited, misstatement of it does not
result in a qualified or adverse opinion. An emphasis of matter paragraph is added to the audit
report.

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Questions Requiring Analysis

16-27 The subsequent events evidence supports the removal of the account receivable from the bankrupt
company from current assets, and its reclassification as a note receivable under the "Other Assets"
classification. Any portion of the note due within the longer of one year or the client's next
operating cycle should be classified under current assets. A note to the financial statements should
describe the subsequent event. Auditors should use all available evidence—including evidence
provided by subsequent events—to ascertain the fair presentation and disclosure of items in the
client's financial statements.

16-28 Since the events or conditions that should be considered in the financial accounting for and
reporting of litigation, claims, and assessments are matters within the direct knowledge, and often
control of management of an entity, management is the primary source of information about such
matters. Accordingly, the independent auditor's procedures with respect to the existence of loss
contingencies arising from litigation, claims, and assessments should include the following:

(1) Inquire of and discuss with management the controls adopted for identifying, evaluating,
and accounting for litigation, claims, and assessments.

(2) Obtain from management a description and evaluation of litigation, claims, and
assessments that existed at the date of the balance sheet being reported on, and during the
period from the balance sheet date to the date the information is furnished, including an
identification of those matters referred to legal counsel. Wong also would obtain
assurances from management, ordinarily in the form of a representation letter, that they
have disclosed all such matters required to be disclosed by generally accepted accounting
principles (FASB ASC 450).

(3) Examine documents in the client's possession concerning litigation, claims, and
assessments, including correspondence and invoices from lawyers.

(4) Obtain assurance from management, ordinarily in the form of a client representation letter,
that it has disclosed all unasserted claims that the lawyer has identified as probable of
assertion and must be disclosed in accordance with generally accepted accounting
principles (FASB ASC 450). In addition, the auditor, with the client's permission, should
inform the lawyer that the client has given the auditor this assurance. This client
representation may be communicated by the client in the inquiry letter or by the auditor in
a separate letter. The auditor also should request the client's management to send a letter
of inquiry to those lawyers with whom it consulted concerning litigation, claims, and
assessments. Examples of other procedures undertaken for different purposes that might
also disclose litigation, claims, and assessments are the following:

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(a) Reading minutes of stockholders', directors', and appropriate committee meetings

held during and subsequent to the period being examined.
(b) Reading contracts, loan agreements, leases, and correspondence from taxing or
other governmental agencies.
(c) Reviewing correspondence with financial institution regarding guarantees and
accommodation endorsements.
(d) Inspecting other documents for possible guarantees by the client.

16-29 No, the senior is in error. No loss has occurred. The senior auditor is concerned about the
possibility of a future loss. All businesses face the risk of loss from numerous factors called
general risk contingencies. A general risk contingency represents a loss that might occur in the
future, as opposed to a loss contingency that may have occurred in the past. The risk of future loss
in inherent in the business and is a general risk contingency rather than a loss contingency.

16-30
(a)
New Used
Course Course General Insignia
Books Books Books Supplies Items Other
Sales 543,400 234,100 45,500 63,400 45,300 34,200
Cost of sales 396,682 154,974 27,300 40,893 27,633 20,178
Gross margin 27.0% 33.8% 40.0% 35.5% 39.0% 41.0%

(b) The answer to this question will depend on the statistics at the time the student accesses the
National Association of College Stores’ homepage. However, the students should find that
the following gross margins appear to be unusual:
New Course Books
General Books
Other

16-31 (a) A "subsequent event" is an event or transaction that occurs subsequent to the
balance sheet date, but prior to the issuance of the auditor's report. The subsequent event
may have a material effect on the financial statements and therefore may require
adjustments to or disclosure in, the financial statements.
The first type of subsequent event includes those events that provide additional
evidence with respect to conditions that existed at the balance sheet date and affect the
estimates inherent in the process of preparing financial statements. This type of
subsequent event requires that the financial statements be adjusted for any changes in
estimates resulting from of such additional information.
The second type of subsequent events includes those events that provide evidence
with respect to conditions coming into existence after the balance sheet date. These events
should not result in adjustment to the financial statements, but may be of such a nature to
require disclosure to prevent the financial statements from being misleading.

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(b) The specific auditing procedures that the auditors should apply at or near the completion
of field work to disclose subsequent events include:

(1) Review the latest available interim financial statements.

(2) Review the minutes of stockholders', directors', and appropriate committees'
meetings through the date of the audit report.
(3) Make inquiries of appropriate client officials.
(4) Obtain a letter from the client's attorney describing any pending litigation,
unasserted claims, or other loss contingencies.
(5) Obtain a letter of representations from the client concerning subsequent events.
This letter should be dated as of the date of the audit report.

16-32 Neither alternative advanced by the controller is acceptable. No liability was created at the date of
signing the agreements; Lane Company's obligation arises only as the ex-president fulfills his
obligations under the agreements. In the case of the first agreement, the company is obligated to
make the payments only if the ex-president honors his agreement not to compete; in the second
agreement, payments are required only if advisory services are provided. In effect, both
agreements are commitments that should be fully described in a note to the financial statements.

16-33 (a) The two approaches to considering the effects of prior misstatements that were not
corrected are
the rollover approach and the iron curtain approach. The rollover approach considers only
the amount of misstatement originating in the current income statement. It ignores the
effect of misstatements that have accumulated in the balance sheet.
The iron curtain approach considers the effect of correcting the entire amount of
the misstatements in the current year regardless of when the misstatements originated.

(b) SEC Staff Accounting Bulletin No. 108 requires the auditors to consider both approaches.
If considering the misstatements under either approach results in financial statements that
are material misstated the auditors should propose that the financial statements be
corrected.

16-34 Ward should immediately investigate the $170,000 liability for consulting services. If he
determines that the liability existed at June 30, 20X0, he should request the controller of Dexter
Company to immediately mail a notice to the 150 shareholders and to the creditors who received
the company's June 30, 20X0, annual report. The notice should state that the financial statement
and audit report are no longer to be relied upon. Since Dexter Company is not subject to the
jurisdiction of the SEC, that agency need not be notified.
If management of Dexter Company refuses the auditor's request, he should immediately
notify all members of the company's board of directors of management's refusal. Ward should also
inform the board that if the directors refuse to act, he will have to inform the state corporation
regulatory authority. If possible, it would also be appropriate for Ward to notify all known
shareholders and creditors who are presently relying upon Dexter's June 30, 20X0 annual report
that his report on Dexter's financial statements can no longer be relied upon.

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16-35 (a) Using the iron curtain approach, Tanner would consider whether $150,000 understatement
of
prepaid expenses (and related understatement of expenses) is material to the 20X5
financial statements.

(b) Using the rollover approach, Tanner would consider whether only the $50,000
understatement of
prepaid expenses (and related understatement of expenses) is material to the 20X5
financial statements.

(c) SEC Staff Accounting Bulletin No. 108 requires the auditors to consider both approaches.
If considering the misstatements under either approach results in financial statements that
are material misstated the auditors should propose that the financial statements be
corrected. Therefore, if the $150,000 or the $50,000 misstatement is considered material,
an adjustment should be proposed.

Objective Questions

16-36 Multiple Choice

(a) (4) Testing whether employee time reports are approved by

supervisors is an example of a test of a control, not a substantive procedure.

(b) (3) The best procedure for the detection of a fictitious employee is a
surprise observation of the distribution of paychecks. The fictitious employee’s
paycheck will ordinarily not be picked up, and further audit procedures performed
by the auditors may reveal that this is a fictitious employee.

(c) (4) The purpose of analytical procedures is to locate potential misstatements

in the financial statements. The auditors should investigate this significant
fluctuation to determine whether it results from a financial statement misstatement.

(d) (1) The three sections of a statement of cash flows relate to

operations, financing, and investing. Capitalization is not one of the sections.

(e) (3) The search for unrecorded liabilities should be completed as of the last
day possible—ordinarily near the date of the audit report.

(f) (1) The total likely misstatements composed of(a) known misstatements, (b)
projected misstatements and (c) other misstatements.

(g) (2) A loss contingency is a possible loss stemming form past events that will
be resolved in the future.

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(h) (3) A Type 1 subsequent event relates to a condition that came into effect
before year-end; Type 1 subsequent events result in an adjusting journal entry. In
this situation, the customer’s check may be assumed to have been uncollectible at
year-end, and therefore it would be considered to be a Type 1 subsequent event.
The other three replies refer to events most ordinarily considered to be Type 2
events—the events came into existence after year-end.

(i) (3) The representation letter should be dated as of the date the audit was
completed.

(j) (4) The performance of analytical procedures is a required part of the final
review stage of an audit and is therefore most likely to be included in that stage of
the audit.

(k) (2) When the auditor becomes aware of facts existing at the report date that
would have affected the report, s/he should next determine whether there are
persons relying or likely to rely on the financial statements who would attach
importance to the information. If such persons are believed to exist, the next step
is to determine the best manner in which to disclose the information.

(l) (3) The settlement of litigation is most likely to result in an adjusting entry
(i.e., be a "Type 1 subsequent event) because the cause of the litigation most likely
occurred before 20X2.

16-37 (a) Adjustment. The additional liability for the ore shipment would be handled by
adjusting the financial statement amounts for purchases, ending raw material inventory,
and accounts payable by the amount of the additional charge, $36,256.

(b) Note. The details of the agreement to purchase the treasurer's stock would be disclosed in
a note because the use of company cash for the repurchase of stock and the change in the
amount of stock held by stockholders might have a significant impact on subsequent years'
financial statements. Usually, a management change, such as the treasurer's resignation,
does not require disclosure in the financial statements. The details underlying the
separation (personal disagreements and divorce) should not be disclosed because they are
personal matters.

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(c) No disclosure. Disclosure of the reduced sales is not necessary.

(d) Adjustment. The condition was in effect as of December 31, 20X3. Therefore an
adjusting entry is appropriate.

(e) No disclosure. Analysts’ reports are being issued frequently. One such as this will not
ordinarily be disclosed.

16-38 (a) Adjustment. The receipt of the shipment of raw materials by Flowmeter on
January 3 provides additional evidence with respect to conditions that existed at the
December 31 balance sheet date. The raw materials in transit at year end with terms of
FOB shipping point were the property of Flowmeter. Consequently, the financial
statements should be adjusted to take into account this new information becoming
available after the balance sheet date. The adjustment consists of an increase in
inventories and the recording of a related liability.

(b) Adjustment. Flowmeter's liability for the accident came into existence in March of 20X3
when the accident occurred. The reason that the liability had not been accrued in the
accounts as of December 31, was merely that no reasonable estimate could be made of the
dollar amount. The settlement of the litigation provides additional information permitting a
reasonable estimate of the amount of the liability. Therefore, this additional information
should be used to adjust the financial statements.

(c) Disclosure. The purchase of a new business does not provide evidence with respect to
conditions existing at the balance sheet date; thus, it is not necessary to adjust the financial
statements. However, such an event would usually be of such importance that its
disclosure would be required to keep the financial statements form being misleading. If the
acquisition is significant enough, the auditor should consider requesting the client to
supplement the primary financial statements with pro-forma statements indicating the
financial results if the two firms had been consolidated for the year ended December 31,
20X3.

(d) Disclosure. Losses attributable to floods occurring after the balance sheet date do not
provide evidence as to conditions existing at the balance sheet date; thus, the financial
statements should not be adjusted. However, disclosure of the damage caused by the flood
is necessary to prevent the financial statements from being misleading.

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(e) Disclosure. The sale of bonds or capital stock after the balance sheet date does not relate
to conditions existing at the balance sheet date. However, such an event usually is
significant enough that it should be disclosed to prevent the financial statements from being
misleading.

16-39
(a) 1
(b) 2
(c) 6
(d) 4
(e) 8
(f) 7
(g) 3
(h) 5

Problems

16-40 SOLUTION: Maxwell Company (Estimated time: 20 minutes)

MAXWELL COMPANY
Proposed Adjusting Journal Entry
April 30, 20X2

Accumulated Depreciation: Machinery 8,000

Miscellaneous Revenue 15,424
Cost of Goods Sold 5,843
Unclaimed Checks 1,100
Allowance for Doubtful Accounts 4,381
Machinery 10,000
Gain on Sale of Machinery ($3,500 - $2,000) 1,500
Unexpired Insurance (11/12 x $600) 550
Insurance Expense (1/12 x $600) 50

To correct allocation of items erroneously credited to Miscellaneous Revenue.

16-41 SOLUTION: Traders Restaurant (Estimated time: 20 minutes)

The auditing procedures that would be employed to verify the total annual sales of Traders
Restaurant include the following:

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(1) Examine the lease to determine the exact terms defining the kinds of sales to be included in
or exempt from the rental calculation.

(2) Obtain a copy of the restaurant's annual financial statements (or a trial balance of the
general ledger) and trace significant amounts to the general ledger.

(3) Test the footing of the daily sales journal and compare with sales entries recorded in the
general ledger. Foot the general ledger Sales account and compare the year's sales with the
sales reported to the lessor. Scan the general ledger Sales account and investigate unusual
entries.

(4) Test the sales figures entered in the daily sales journal by comparison with the source of
the figures, which may be the cash register tapes, or the auditors' adding machine tapes of
the restaurant checks.

(5) If the daily sales figures are obtained from a cumulative sales register in the cash register
and if the register cannot be turned back to zero, ascertain whether the total sales for the
year can be computed by comparing the register dial reading at the beginning of the year
and at the end of the year. If the daily sales are summarized on a daily cash report before
being entered in the daily sales journal, review these reports and compare them with daily
sales. Inquire about any abnormal cash overages or shortages.

(6) Review the daily sales journal for deviations from sales patterns and obtain explanations
for the deviations. On a test basis, for days showing such deviations, obtain all the
restaurant checks and add the check totals to verify the total daily sales. In addition,
determine that there was a proper cutoff of sales at year-end.

(7) Test the files of restaurant checks to determine that the checks are being used in numerical
sequence and that all are accounted for. Review invoices from the supplier of restaurant
checks to determine, if possible, that all checks purchased are accounted for. Inspect
inventory of unused sales checkbooks.

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(8) As an analytical test of sales, obtain the restaurant's bank statements. Reconcile the total
cash deposits for the year, adjusted for miscellaneous cash disbursements such as freight
charges, withdrawals, etc., with total annual sales.

(9) As another overall analytical test, determine the restaurant's net cost of food for the year
and apply a markup percentage to arrive at the approximate total annual sales. The net
cost of food should be adjusted for meals furnished to employees.

(10) Compare the total sales reported to the lessor with sales reported on the restaurant's sales
tax or gross receipts return, if any, and on its income tax returns.

16-42 SOLUTION: Internal Control, Tests of Controls, Substantive Procedures (Estimated time: 20
minutes)

(a) (1) Separation of the human resources and approval functions is designed to
prevent overpayment of payroll amounts or payments to fictitious employees.
(2) If the same employees perform the functions of timekeeping and distribution, they
have an opportunity to report the attendance of individuals who have resigned, and
divert their payroll checks to their own use.

(b)(1) and (2) Segregation of duties is tested by making inquiries as to which employees
performed specific tasks throughout the year, and observing personnel performing
those tasks. The auditors also should make inquiries as to who performs assigned
tasks under unusual circumstances, such as prolonged illness of an employee.

(c)(1) and (2) To test for fictitious payroll transactions, the auditors might observe the
distribution of paychecks on a surprise basis. Analytical procedures applied to
payroll expenses, such as comparisons of this year's amounts to budgeted amounts
or comparable amounts for prior years, might reveal a significant overstatement of
payroll expenses.

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16-43 SOLUTION: Olympia Company (Estimated time: 30 minutes)

Possible Misstatements
or Discrepancies Control

Step A
(1) Time worked may be im- (a) Timekeeping for payroll hours should be an
properly reported by em- independent function.
ployees. (b) Time clocks should be used under the observa-
tion of timekeeping employees.
(c) Strict rules should be enforced requiring em-
ployees to punch their own time cards.
(d) Timekeeping personnel should make periodic
floor checks of employees on duty.

(2) Payroll may be padded by A procedure for authorization of overtime should be

timekeeper devised, and timekeeping personnel should determine
that required authorizations are obtained.

(3) Employees may work unau- A procedure for authorization of overtime should be
thorized overtime hours. devised, and timekeeping personnel should determine
that required authorizations are obtained.

Step B
(4) Employees may not work Employees should report hours by job, and preferably
effectively. Also, they may should use a time clock. Supervisors should review and
disguise inefficiencies by approve time tickets, and timekeeping personnel should
spreading excess hours to see that these approvals are obtained. Employees
other jobs. should be instructed to assign actual hours to jobs.

Timekeeping personnel should verify required authori-

(5) Overtime work on a job zations and appropriately note hours that should be
may not be authorized, and charged at the premium rate.
the job may not be charged
at the premium overtime
rate.

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Step C
(6) Job tickets and time cards Absolute balancing may be impractical or unnecessary
may not be in balance. for cost accumulation, allocation, or control; reasonable
difference limits should be established by appropriate
authority. Assuring that differences fall within
established limits can be accomplished by having the
timekeeper or computer balance hours per time card
with job tickets and follow-up on any differences.

Step D
(7) Time cards and job tickets (a) Timekeeping should promptly forward time
may be lost in transition cards and job tickets accompanied by a trans-
from timekeeping to payroll mittal slip denoting the number of employees
audit and control. for which time is being reported. Payroll audit
and control should reconcile the number of
employees reported with the master payroll
record, considering employees on vacation,
illness, etc.
(b) To assure that all time cards have been ac-
counted for, timekeeping can prepare a hash
total of employee numbers for both time cards
and job tickets. These totals can be included in
the transmittal slip described under (a) above.

(8) Payroll audit and control If this is a frequent error, payroll audit and control
may total hours incorrectly should recompute all control totals. If it is an infre-
in preparing the control quent occurrence, it can be handled as an exception
total for the batch transmit- printout from the computer.
tal form.

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Chapter 16 - Auditing Operations and Completing the Audit

Step E
(9) Time cards and job tickets Payroll audit and control should batch time cards and
may be lost in transit from related job tickets. A consecutively numbered trans-
payroll audit and control to mittal sheet should accompany each batch and contain a
data input. control total, such as total hours. This control total
should be compared to the total shown by the computer
reports.

(10) Data input personnel may Errors also should be detected through use of batch
transcribe data incorrectly. controls.

(11) The employee identification Employee identification numbers should contain a self-
number may have been re- checking digit and the computer should be programmed
corded or carried forward to test the validity of each employee's number.
improperly.

(12) Time cards and job tickets Supplementing the programmed computer checks,
may be lost in transit from payroll audit and control should check the computer
data preparation to the output hours against its input log.
computer.

(13) Errors detected by pro- Payroll audit and control should maintain an error log.
grammed computer controls
may not be reentered in the
system.

16-44 SOLUTION: Rowe Manufacturing Company (Estimated time: 20 minutes)

To improve internal control for factory hiring practices and payroll procedures, Rowe
Manufacturing Company should first make the following basic changes:

(1) Appoint a current administrative employee as human resources administrator.

(2) Install a time clock in the factory.

(3) Transfer one of the two payroll clerks to the function of timekeeper.

(4) Obtain a supply of prenumbered payroll checks.

(5) Obtain a three-part preprinted form for initiating all new hires, terminations, and wage rate
changes.

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Chapter 16 - Auditing Operations and Completing the Audit

16-45 SOLUTION: City Loan Company (Estimated time: 35 minutes)

(a) Internal control has many weaknesses because of the reliance on one person, the branch
manager. Funds may be diverted in the following ways:

(1) Fictitious new employees might be "hired and released" within a short time.
(2) Fictitious part-time or temporary personnel might be placed on the payroll.
(3) A terminated employee might be continued on the payroll for some time before a
termination notice is forwarded.
(4) Unclaimed wages might be diverted.
(5) The branch manager might overpay himself by not deducting for unauthorized
absences.

Through the device of changing the payroll figures after the employee's signature has been
obtained:

(6) Legitimate salary increases on promotion might be diverted.

(7) Deductions for withholding tax and net pay might be changed.
(8) Hours might be increased and salary recomputed.

(b) In addition to the usual payroll audit procedures, the audit program should include special
procedures directed to the areas of internal control weaknesses such as:

(1) Determine by inquiry and by scanning payroll sheets and minutes of the salary
committee which offices had high turnover in personnel. Scanning of payroll
sheets might reveal alterations of salaries and deductions.
(2) For selected offices, foot a representative number of payrolls.
(3) Verify computation of salaries and deductions.
(4) Trace payroll deductions to the branch office's accounting statements.
(5) Trace earnings and deductions to individual payroll records.
(6) Compare signatures on payroll sheets with signatures on W-4 forms or other
human resources forms.
(7) Compare questionable signatures with handwriting samples of the branch
manager.
(8) Compare payroll sheets and minutes of the salary committee for agreement as to
starting dates, terminations, promotions, salary adjustments, and transfers.
(9) Compare dates on W-4 forms and other human resources forms with payroll sheets
as further indication of correct starting date.
(10) Review reports submitted by the area supervisors for references to personnel.
(11) Consider the relationship of the number of personnel and salary costs in
comparison to the business volume.
(12) Prepare negative confirmations to be mailed with W-2 forms. Investigate any
unclaimed W-2 forms.
(13) Observe a salary distribution or, if that is not possible, include in branch audit
program the requirement that the field auditor should identify and list personnel
working in the office for subsequent comparison to the payroll records.

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Chapter 16 - Auditing Operations and Completing the Audit
16-46 SOLUTION: Payroll deficiencies (Estimated time: 30 minutes)

Conditio Control Violated? Possible Consequences Corrective action needed

n

I Segregation Yes The payroll is computed by Assign the input function to

of multiplying a rate of pay times both human resources and the
incompatible a time period. If the human employee's department. Human
functions resources department prepare resources would provide the
the payroll, then one office rate of pay, while the
controls the input, processing employee's department would
and output of the payroll provide the time period. The
preparation. Since one person payroll department would use
can control the whole system, these data to compute the
there is no way that errors or payroll. The output would be
irregularities resulting from the sent to: (1) the comptroller's
system would be detected office for recording, and (2) the
within a timely period. treasurer's office for preparation
and ultimate distribution.
II Competence Yes Placing an inexperienced Identify the
and integrity person in charge of human education/experience
of personnel resources places the company at characteristics necessary for the
great risk of violating various human resources manager, then
federal laws relating to human employ such a person.
resources matters. Alternatively, perhaps the son
may be trained to adequately
perform the function.
III Appropriate Yes If the human resources Assign the treasurer's office the
limitation of department distributes the responsibility of making the
access to payroll checks, the system is distribution of checks. Any
assets (and susceptible to fraud. A payroll checks not properly distributed
segregation clerk could destroy the would be retained in the
of documentation relating to the custody of the treasurer's
incompatible termination of a salaried department until appropriate
functions, employee, continue to process a distribution could be made.
which has check for that employee, and Such distribution would require
previously cash the check. some method of identification
been used) of the recipient.
IV No N/A N/A
Comparison
of existing
records with
records
required.
V Execution of No N/A N/A
activities as
authorized.
VI Proper Yes Because no one is assigned to Randomly assign someone to
recording of verify the proper recording of check the human resources files
events. personnel actions, the system is that were changed on any given
subject to error or fraud since day. This person would be
any entry could be made given the task of verifying that
inaccurately. all authorized chances have
been accurately recorded.

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Chapter 16 - Auditing Operations and Completing the Audit

16-47 SOLUTION: Robertson Company (Estimated time: 10 minutes)

The major casualty of Thompson Corporation, a significant customer of Robertson Company, has
an impact upon Robertson's financial statements at December 31, 200X. However, the casualty
occurred subsequent to that date; consequently, it would be inappropriate for the auditors to
recommend an increase in the December 31, 200X, allowance for uncollectible accounts. The
casualty loss of Thompson Corporation should be disclosed in a note to Robertson Company's
December 31, 200X, balance sheet.

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Chapter 16 - Auditing Operations and Completing the Audit
In-Class Team Case

16-48 (a) KCN Total Likely Misstatement to nearest dollar (Estimated time: 45 minutes)

Keystone Computers & Networks, Inc.

Total Likely Misstatement
December 31, 20X5
Overstatement (Understatement)

W/P Current Noncurrent Current Noncurrent Owners' Inc. Before Tax

ref. Assets Assets Liabilities Liabilities Equity Taxes Expense

Uncorrected Known Misstatements

1. Unrecorded liabilities (6,440) 6,440 6,440

1,610 (1,610) 1,610

Projected Misstatements

2. Understatement of accounts receivable (2,042) (2,042) (2,042)

(confirmation results) (511) 511 (511)

3. Overstatement of inventory (price tests) 9,510 9,510 9,510

2,378 (2,378) 2,378

Other Estimated Misstatements

4. Understatement of allowance for 5,000 5,000 5,000

uncollectible accounts 1,250 (1,250) 1,250

Total Likely Misstatements $12,468 ------- ($ 1,713) -------- $ 14,181 $18,908 $ 4,727

Amount Considered Material $50,000 $75,000 $ 50,000 $75,000 $100,000 $65,000 ----------

b. The amount of total likely misstatements is low enough to result in a sufficiently low level of audit risk to justify our opinion.

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Chapter 16 - Auditing Operations and Completing the Audit
Research and Discussion Case

16-49 SOLUTION: Interstate Land Development Corporation (Estimated time: 45 minutes)

(a) In connection with registration audits, auditors may be liable for any losses to persons acquiring
the security that are proximately caused by the auditors' ordinary negligence. This is a higher
standard of liability than the gross negligence standard existing under common law (Ultramares
approach) and under the Securities Exchange Act of 1934. In addition to being liable for losses
attributable to ordinary negligence, a considerable portion of the burden of proof is transferred by
the 1933 Act to the defendants. Thus, the auditors must prove "due diligence," rather than the
plaintiffs having to prove negligence.

(b) The IRS investigation constitutes a subsequent event—that is, information coming to the auditors'
attention subsequent to the balance sheet date. As indicated in the text, the Securities Act of 1933
extends the auditors' attention to subsequent events to the effective date of the registration
statement. Since this IRS investigation has come to light prior to that date, the auditors are
responsible for proper financial statement presentation of these facts.
The $800,000 tax liability is a loss contingency, in that there exists some uncertainty as to
whether or not the loss has actually occurred. FASB ASC 450, dealing with contingencies,
establishes criteria for accruing, disclosing, or ignoring loss contingencies. If the loss is "probable"
and can be "reasonably estimated," it should be accrued in the 20X4 financial statements. If either
one of these criteria has not been met, but it is still at least "reasonably possible" that a loss has
been incurred, disclosure is required. Only if the prospects of a loss having been incurred are
"remote" can this contingency be ignored in the financial statements. Thus, the auditors must make
a judgmental decision as to whether it is appropriate to ignore, disclose, or accrue a loss relating to
this matter in the 20X4 financial statements.
Prior to making this decision, the CPA firm should investigate the potential tax liability of
Interstate, rather than merely relying upon Dunkirk's evaluation. The auditors should review
Interstate's tax returns for the years in question. They should also review all correspondence
between Interstate and the IRS in order to determine the areas under challenge and to judge the
validity of the IRS's assessment. Furthermore, the CPAs should obtain Interstate's legal counsel's
evaluation of the situation. In all probability, Marshal and Wyatt should at least insist upon
complete disclosure of this situation in the financial statements; they may even need to insist upon
accrual of a liability for some or all of the $800,000, depending upon the outcome of their
investigation.

(c) No. Although a minority of state courts apply the privileged communication rule to the CPA-client
relationship, the federal courts do not follow this rule of evidence. Hence, the CPA firm had no
choice but to honor the subpoena even though it did not prepare the client's tax returns.

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