Arens auditing 14ce ism c10 pdf PDF

Preview

Summary

ACCO 360 Solutions to Chapter 10 - Develop Risk Response Audit strategy and Audit program...

Description

Chapter 10 Develop Risk Response: Audit Strategy and Audit Program Concept Check Questions C10-1 How is the audit strategy linked to the audit risk assessment processes? Risk assessment includes the assessment of client business risk, inherent risk, and control risk, with audit risk set by the auditor in response to the anticipated users of the financial statements (this may be adjusted for specific accounts). The overall audit strategy considers these risks in assessing financial reporting risk and determining the resources for the audit. The audit strategy for each cycle considers these risks, as well as the risk of material misstatement, by designing audit tests to determine whether controls support the assessed control risk and to quantify potential material misstatements using substantive tests. C10-2 Explain the purpose of the five types of audit tests. Note: Multiple examples are possible, two are provided for each type. Risk assessment procedures: Obtain information about hardware wholesaler or retailing industry trends; discuss corporate governance processes with management. Update flowchart descriptions of each cycle; update descriptions of general controls over program changes. Tests of controls: Observe data entry procedures to see whether passwords are in use by employees; check bank reconciliation for initials of controller. Substantive Tests: Note: Substantive procedures consist of detailed analytical procedures and tests of details. Analytical procedures can also be used for planning and for end of engagement assessment. Substantive tests of transactions: Select a sample of sales invoices and agreeing the details with shipping documents Analytical procedures: Calculate gross margin and compare to prior years; calculate gross margin by product and compare to authorized gross margin used in pricing. Tests of details of balances: Confirm accounts receivable with major suppliers; recalculate baddebt allowance. C10-3 Which audit test is the least costly to develop and conduct? Why? Analytical procedures are least costly, because they involve calculations and comparisons rather than examining documentation.

Copyright © 2019 Pearson Canada Inc. 10-1

Instructor’s Solutions Manual for Auditing, Fourteenth Canadian Edition

C10-4 If an auditor conducts tests of controls but finds that controls are not functioning effectively, what is the effect upon substantive tests? Why? The auditor will likely need to conduct more substantive tests, as control risk will need to be increased. C10-5 List the type of information that would be included in an audit program. The audit program identifies the auditor’s response to assessed risks, by audit assertion. Audit tests listed by assertion would be any or all of tests of control, analytical procedures, and tests of detail. C10-6 Describe the type of testing required when the auditor has identified an assertion to have a significant risk of material misstatement. The auditor is required to understand the internal controls associated with the assertion and to conduct tests of detail. Tests of control and analytical procedures are optional.

Review Questions 10-1 Overall audit strategy sets the scope, timing and direction of the overall audit and guides the development of the overall audit plan. The auditor will focus on: the features of the overall engagement (such as are there multiple divisions or subsidiaries) to determine the scope, the reporting requirements, auditor resources to used (in other words who to assign to the engagement and how the team will be managed) and the results of preliminary activities (particularly fraud risks and significant changes since the last audit). The audit strategy at the assertion level means the auditor is focusing on a particular account and its assertions. This involves using the risk assessment from the client acceptance and planning stage to identify significant risk and to assess inherent risk for the account. The auditor will also consider entity-level controls as well as assess the specific controls (control activities) for the relevant cycle. These will help the auditor determine if control tests are appropriate. The RMM (inherent risk plus control risk) will determine what level of substantive testing is needed to provide the auditor with the necessary assurance. 10-2 The five types of tests used by auditors to determine whether financial statements are fairly stated are:  risk assessment procedures  tests of controls  substantive tests of transactions  analytical procedures  substantive tests of details of balances

Copyright © 2019 Pearson Canada Inc. 10-2

Chapter 10: Develop Risk Response: Audit Strategy and Audit Program

While risk assessment procedures (procedures to gain an understanding of the entity and its environment, including internal control) help the financial statement auditor obtain information to make an initial assessment of control risk, tests of controls must be performed to support an assessment of control risk that is below maximum. The purpose of tests of controls is to obtain evidence regarding the effectiveness of controls in support of an assessment of control risk below maximum. If controls are found to be effective and functioning, the substantive evidence may be reduced. Substantive evidence is obtained to reduce detection risk. Substantive evidence includes evidence from substantive tests of transactions, analytical procedures, and tests of details of balances. 10-3 The purpose of risk assessment procedures is to assess the likelihood of material misstatement (inherent risk plus control risk) in the financial statements. By identifying the nature of risks, these procedures help the auditor decide the extent of the other audit procedures to be conducted. These procedures help the auditor find out how the organization functions and the risks it is exposed to, similar to procedures used to obtain an understanding of internal control. These two types of tests are different from the remaining three types of tests that focus upon transactions, balances and dollar amounts in the accounts. 10-4 Tests of controls are audit procedures designed to verify whether the client’s controls are being applied in the manner described in the flowchart and internal control questionnaire, or other documentation of internal controls. Examples include:  The examination of vendor invoices for indication that they have been clerically tested, compared to a receiving document and purchase order, and approved for payment.  Examination of employee time cards for approval of overtime hours worked.  Examination of journal entries for proper approval.  Examination of approvals for the write-off of bad debts. Substantive tests are procedures designed to test for dollar errors – either in transactions or financial statement balances. Examples of substantive tests of transactions:  Recalculation of amounts (quantity times unit selling price) on selected sales invoices and tracing of amounts to the sales journal.  Examination of vendor invoices in support of amounts recorded in the acquisitions journal for purchases of inventories.  Recalculation of gross pay for selected entries in the payroll journal. Examples of substantive tests of details of balances are:  Reconciliation of balances indicated in vendor statements.  

Recalculation of amounts accrued for various liabilities. Confirmation of accounts receivables.

10-5 A reperformance procedure is an audit procedure in which the auditor performs the same procedure that client personnel did, to make sure that the monetary amounts are correct. An Copyright © 2019 Pearson Canada Inc. 10-3

Instructor’s Solutions Manual for Auditing, Fourteenth Canadian Edition

example is matching a receiving report to a supplier invoice to determine that only goods that were received are being paid for. A recalculation is also a type of reperformance, but it is limited to recalculation of amounts. An example is to multiply unit selling prices times quantity on duplicate sales invoices to make sure the client calculated the amounts correctly. These types of test are often dual-purpose tests because they can be used to both determine whether the control is functioning correctly (e.g., is the calculation being completed correctly) and to quantify the dollar magnitude of error (a substantive test). 10-6 The auditor resolves the problem by making assumptions about the results of the tests of controls and performing both the tests of controls and substantive procedures on the basis of these assumptions. Ordinarily the auditor assumes effective internal control with few or no deviations planned. If the results of the tests of controls are as good as or better than the assumptions that were originally made, the auditor can be satisfied with the substantive procedures, unless the substantive procedures themselves indicate the existence of misstatements. If the tests of controls results were not as good as the auditor assumed in designing the original tests, expanded substantive procedures must be performed. 10-7 When the results of analytical procedures are different from the auditor’s expectations and thereby indicate that there may be a misstatement in the balance in accounts receivable and sales, the auditor should extend his or her tests until he or she determines why the ratios are different from his or her expectations. Confirmation of accounts receivable and cut-off tests for sales are two procedures that can be used to do this. On the other hand, if the ratios are approximately what the auditor expects, the other tests can be reduced. This says that the auditor can satisfy the evidence requirements in different ways and that analytical procedures and confirmation are complementary when the results of the tests are both good. 10-8 The auditor must gain an understanding of internal control sufficient to assess risks and plan the audit under either approach. In a combined audit approach, the auditor plans to assess control risk below maximum and perform tests of controls to confirm that assessment; reduced substantive testing will be required because of this reliance on internal control. In a substantive audit approach, the auditor assesses control risk as high (or at maximum) and gains all his or her assurance from substantive procedures. A combined approach would be appropriate for the acquisitions and payment cycle if there were internal controls in place and working that provided assurance that all purchases made by the company were recorded in accounts payable; in this case the auditor would likely assess control risk below maximum with respect to the completeness assertion. If, on the other hand, controls over the recording of purchases were weak or non-existent, control risk would be assessed at maximum and the auditor would verify the completeness assertion by substantive procedures. 10-9 The audit of permanent asset additions normally entails the examination of invoices in support of the additions and possibly the physical examination of the additions. These procedures are normally performed on a test basis with a concentration on the more significant additions. If Copyright © 2019 Pearson Canada Inc. 10-4

Chapter 10: Develop Risk Response: Audit Strategy and Audit Program

the individual responsible for recording new acquisitions were known to have inadequate training and limited experience in accounting, the sample size of the audit procedures should be expanded to include a larger sample of the additions for the year. In addition, inquiry as to what additions were made during the year may be made by the auditor of plant managers, the controller, or other operating personnel. The auditor should then search the financial records to determine that these additions were recorded as permanent assets. Care should also be taken when the repairs and maintenance expense account is analyzed since lack of training may cause some depreciable assets to be expensed at the time of purchase. 10-10 The following shows which types of evidence are applicable for the five types of tests. Type of Evidence

Types of Tests

Inspection

Risk assessment, Tests of controls, Substantive tests of details (mostly balances)

Observation

Risk assessment, Procedures to obtain an understanding of controls and tests of controls

Inquiries of the client

All five types

Confirmation

Substantive tests of details of balances

Recalculation

All except analytical procedures

Reperformance

Tests of controls, substantive tests of details (balances and transactions)

Analytical procedures

Risk assessment, Substantive analytical procedures

10-11 Before a reduction in substantive procedures is permitted, internal controls must be effective and the auditor must have found the results of the tests of controls satisfactory. Cost effectiveness of reduced assessed level of control risk should be considered in making the decisions as to whether to test controls. The cost effectiveness of reduced control risk is an audit efficiency issue. 10-12 It is desirable to design tests of details of balances before performing tests of controls to enable the auditor to determine if the overall planned evidence is the most efficient and effective in the circumstances. In order to do that the auditor must make assumptions about the results of the tests of controls. Ordinarily the auditor will assume no significant errors or control problems in tests of controls unless there is reason to believe otherwise. If the auditor determines that the tests of controls results are different from those expected, the amount of testing of details of balances must be altered. 10-13 Auditors frequently consider it desirable to perform audit tests throughout the year rather than waiting until year-end because of the PA firm’s difficulty of scheduling personnel and the client’s need for timely financial statements. Due to the uneven distribution of the year-end dates of their clients, there is a shortage of personnel during certain periods of the year and excess available time at other periods. The procedures that are performed at a date prior to year-end are often dependent upon adequate internal controls and when the client will have the information available. Copyright © 2019 Pearson Canada Inc. 10-5

Instructor’s Solutions Manual for Auditing, Fourteenth Canadian Edition

(Another point to add - for audits of public companies listed on the US securities exchanges, auditors must begin their testing of controls earlier in the year to ensure they are able to test a sufficient sample of controls for operating effectiveness. Some controls may only be performed monthly or quarterly. Thus, the auditor of a US public company must begin testing early in the year so that there are a sufficient number of months or quarters to test.) 10-14

1.

Control #1 – Computer verification of the customer’s credit limit. The presence of effective general controls over software programs and master file changes can significantly reduce the auditor’s testing of automated controls such as control #1. Once it is determined that control #1 is functioning properly, the auditor can focus subsequent tests on assessing whether any changes have occurred that would limit the effectiveness of the control. Such tests might include determining whether any changes have occurred to the program and whether these changes were properly authorized and tested prior to implementation. These are all tests of general controls over software programs and master file changes.

2.

Control #2 – The accounts receivable clerk matches bills of lading, sales invoices, and customer orders before recording in the sales journal. This control is not an automated control, but is rather a manual control performed by an employee. General controls over software programs and master file changes would have little effect on the auditor’s testing of control #2. If the auditor identifies control #2 as a key control in the sales and collection cycle, he or she would most likely examine a sample of the underlying documents for the accounts receivable clerk’s initials and reperform the comparisons.

10-15 Refer to Figure 5-1 in Chapter 5 for assistance Audit Process Component

Involves Risk Assessment

Types of Procedures

Client Acceptance

Yes

Risk assessment

Audit Planning

Yes

Risk assessment (including procedures to understand internal control) Analytical Procedures

Assess Risk of Material

Yes

Misstatement

Risk assessment (including procedures to understand internal control) Analytical Procedures

Copyright © 2019 Pearson Canada Inc. 10-6

Chapter 10: Develop Risk Response: Audit Strategy and Audit Program

Develop Risk Response

Yes

In this stage developing procedures and audit programs (which could be updated based upon results of control tests and substantive analytical procedures)

Perform Risk Response

Yes

Tests of Controls Substantive tests of transactions Substantive analytical procedures Substantive tests of balances

Conclusion

Yes

Analytical Procedures Substantive tests of balances (subsequent event review)

Reporting

Substantive tests of balances (update subsequent event review)

Copyright © 2019 Pearson Canada Inc. 10-7

Instructor’s Solutions Manual for Auditing, Fourteenth Canadian Edition

Multiple Choice Questions and Task-Based Simulations 10-16 (1)

10-17 (2)

10-18 (3)

10-19 (3)

10-20 Audit Procedure Foot the accounts payable trial balance and compare the total with the general ledger. Confirm accounts payable balances directly with vendors.

Procedure Type (4) TD of BRecalculation (4) TD of B Confirmation Account for a sequence of cheques in the cash disbursements journal to (1) T of C determine whether any have been omitted. Inspection Examine vendors’ invoices to verify the ending balance in accounts (4) TD of B Inspection payable. Compare the balance in payroll tax expense with previous years. The (3) AP comparison takes the increase in payroll tax rates into account. Analytical procedures Examine the internal auditor’s initials on monthly bank reconciliations (1) T of C Inspection as an indication of whether they have been reviewed. Examine vendors’ invoices and other documentation in support of (2) ST of T recorded transactions in the acquisitions journal. Inspection Multiply the commission rate by total sales and compare the result with (3) AP commission expense. Analytical procedures Examine vendors’ invoices and other supporting documents to (2) or (4) TD of T or B determine whether large amounts in the repair and maintenance account Inspection should be capitalized. Discuss the duties of the cash disbursements clerk with him and (1) T of C observe whether he has responsibility for handling cash or preparing Inquiry and the bank reconciliation. observation Inquire about the accounts payable supervisor’s monthly review of a (1) T of C computer-generated exception report of receiving reports and purchase Inquiry orders that have not been matched with a vendor invoice. 10-21 Procedure After gaining an understanding of internal controls in the sales cycle, the auditor decided to select a sample of customers and verify that for each customer a credit review form was completed and the form was signed by the manger. After gaining an understanding of internal controls in the payroll cycle, the auditor decided to select a sample of reconciliations between timesheets and

Strategy Combined – after gaining an understanding of internal controls the auditor decided to test the controls.

Combined - after gai...