Solution Manual Auditing and Assurance Services 13e by Arens Chapter 06 PDF

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Chapter 6Audit Responsibilities and Objectives Review Questions6-1 The objective of the audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which the financial statements present financial position, results of operations, and cash flows in c...

Description

Chapter 6 Audit Responsibilities and Objectives  Review Questions

6-1 The objective of the audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which the financial statements present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. The auditor meets that objective by accumulating sufficient appropriate evidence to determine whether the financial statements are fairly stated. 6-2 It is management's responsibility to adopt sound accounting policies, maintain adequate internal control and make fair representations in the financial statements. The auditor's responsibility is to conduct an audit of the financial statements in accordance with auditing standards and report the findings of the audit in the auditor's report. 6-3 An error is an unintentional misstatement of the financial statements. Fraud represents intentional misstatements. The auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are detected, whether those misstatements are due to errors or fraud. An audit must be designed to provide reasonable assurance of detecting material misstatements in the financial statements. Further, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the engagement. Because there is an attempt at concealment of fraud, material misstatements due to fraud are usually more difficult to uncover than errors. The auditor’s best defense when material misstatements (either errors or fraud) are not uncovered in the audit is that the audit was conducted in accordance with auditing standards. 6-4 Misappropriation of assets represents the theft of assets by employees. Fraudulent financial reporting is the intentional misstatement of financial information by management or a theft of assets by management, which is covered up by misstating financial statements. Misappropriation of assets ordinarily occurs either because of inadequate internal controls or a violation of existing controls. The best way to prevent theft of assets is through adequate internal controls that function effectively. Many times theft of assets is relatively small in dollar amounts and will have no effect on the fair presentation of financial statements. There are also the cases of large theft of assets that result in bankruptcy to the company. Fraudulent financial reporting is inherently difficult to uncover because it is possible for one or more members of management to override internal controls. In many cases the amounts are extremely large and may affect the fair presentation of financial statements. 6-1

6-5 True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the auditor must not accept management's representations blindly. The auditor must, whenever possible, obtain appropriate evidence to support the representations of management. As an example, if management represents that certain inventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the inventory is being sold at a price that is higher than the company's cost plus selling expenses. If management represents an account receivable as being fully collectible, the auditor should be able to examine subsequent payments by the customer or correspondence from the customer that indicates a willingness and ability to pay. 6-6 CHARACTERISTIC

AUDIT STEPS

1. Management’s characteristics and influence over the control environment.

 Investigate the past history of the

firm and its management.

 Discuss the possibility of fraudulent

financial reporting with previous auditor and company legal counsel after obtaining permission to do so from management.

2. Industry conditions.

 Research current status of industry

and compare industry financial ratios to the company’s ratios. Investigate any unusual differences.  Read AICPA’s Industry Audit Risk Alert for the company’s industry, if available. Consider the impact of specific risks that are identified on the conduct of the audit. 3. Operating characteristics and financial stability.

 Perform analytical procedures to

evaluate the possibility of business failure.  Investigate whether material transactions occur close to yearend.

6-7 The cycle approach is a method of dividing the audit such that closely related types of transactions and account balances are included in the same cycle. For example, sales, sales returns, and cash receipts transactions and the accounts receivable balance are all a part of the sales and collection cycle. The advantages of dividing the audit into different cycles are to divide the audit into more manageable parts, to assign tasks to different members of the audit team, and to keep closely related parts of the audit together.

6-2

6-8 GENERAL LEDGER ACCOUNT

CYCLE

Sales Accounts Payable Retained Earnings Accounts Receivable Inventory Repairs & Maintenance

Sales & Collection Acquisition & Payment Capital Acquisition & Repayment Sales & Collection Inventory & Warehousing Acquisition & Payment

6-9 There is a close relationship between each of these accounts. Sales, sales returns and allowances, and cash discounts all affect accounts receivable. Allowance for uncollectible accounts is closely tied to accounts receivable and should not be separated. Bad debt expense is closely related to the allowance for uncollectible accounts. To separate these accounts from each other implies that they are not closely related. Including them in the same cycle helps the auditor keep their relationships in mind. 6-10 Management assertions are implied or expressed representations by management about classes of transactions and the related accounts and disclosures in the financial statements. These assertions are part of the criteria management uses to record and disclose accounting information in financial statements. AU 326 classifies assertions into three categories: 1. 2. 3.

Assertions about classes of transactions and events for the period under audit Assertions about account balances at period end Assertions about presentation and disclosure

6-11 General audit objectives follow from and are closely related to management assertions. General audit objectives, however, are intended to provide a framework to help the auditor accumulate sufficient appropriate evidence required by the third standard of field work. Audit objectives are more useful to auditors than assertions because they are more detailed and more closely related to helping the auditor accumulate sufficient appropriate evidence. 6-12 TRANSACTION-RELATED AUDIT OBJECTIVE VIOLATED

RECORDING MISSTATEMENT Fixed asset repair is recorded on the wrong date.

Timing

Repair is capitalized as a fixed asset instead of an expense.

Classification

6-3

6-13 The existence objective deals with whether amounts included in the financial statements should actually be included. Completeness is the opposite of existence. The completeness objective deals with whether all amounts that should be included have actually been included. In the audit of accounts receivable, a nonexistent account receivable will lead to overstatement of the accounts receivable balance. Failure to include a customer's account receivable balance, which is a violation of completeness, will lead to understatement of the accounts receivable balance. 6-14 Specific audit objectives are the application of the general audit objectives to a given class of transactions, account balance, or presentation and disclosure. There must be at least one specific audit objective for each general audit objective and in many cases there should be more. Specific audit objectives for a class of transactions, account balance, or presentation and disclosure should be designed such that, once they have been satisfied, the related general audit objective should also have been satisfied for that class of transactions, account, or presentation and disclosure. 6-15 For the specific balance-related audit objective, all recorded fixed assets exist at the balance sheet date, the management assertion and the general balance-related audit objective are both "existence." 6-16 Management assertions and general balance-related audit objectives are consistent for all asset accounts for every audit. They were developed by the Auditing Standards Board, practitioners, and academics over a period of time. One or more specific balance-related audit objectives are developed for each general balance-related audit objective in an audit area such as accounts receivable. For any given account, a CPA firm may decide on a consistent set of specific balance-related audit objectives for accounts receivable, or it may decide to use different objectives for different audits. 6-17 For the specific presentation and disclosure-related audit objective, read the fixed asset footnote disclosure to determine that the types of fixed assets, depreciation methods and useful lives are clearly disclosed, the management assertion and the general presentation and disclosure-related audit objective are both "classification and understandability." 6-18 The four phases of the audit are: 1. 2. 3. 4.

Plan and design an audit approach. Perform tests of controls and substantive tests of transactions. Perform analytical procedures and tests of details of balances. Complete the audit and issue an audit report.

The auditor uses these four phases to meet the overall objective of the audit, which is to express an opinion on the fairness with which the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows in conformity with GAAP. By accumulating sufficient appropriate evidence for each audit objective, the overall objective is met. The accumulation of evidence is accomplished by performing the four phases of the audit. 6-4

 Multiple Choice Questions From CPA Examinations

6-19

a.

(2)

b.

(2)

c.

(1)

6-20

a.

(1)

b.

(2)

c.

(1)

 Discussion Questions And Problems

6-21

a.

b.

6-22 a.

b.

c.

d.

The purpose of the first part of the report of management is for management to state its responsibilities for internal control over financial reporting. The second part of the report states management’s responsibility for the fair presentation of the financial statements. The auditor’s responsibility is to express an opinion on the fairness of the presentation of the financial statements and an opinion on the effectiveness of internal control over financial reporting. Professional skepticism. Auditors are required to perform the audit with an attitude of professional skepticism as the financial statements (F/S) may contain material misstatements which may or may not be intentional on the part of management. The responsibility lies with: i. Management. Auditors must also develop an estimate for comparison purposes, but auditors do not record their estimate on the F/S. ii. Auditors. Management may also test the A/R Allowance as an internal audit function, but they are not required to do so. iii. Management and Auditors. Both must evaluate the adequacy of the A/R Allowance. iv. Management. ONLY management is responsible for the ultimate presentation of A/R Allowance on the F/S. A misstatement would be considered material if it is probable that the decisions of a reasonable person relying on the information would have been changed or influenced by the uncorrected errors or fraud. If the A/R Allowance estimate developed by management and the auditors is different, the auditor must determine if the amount is material. If the auditor determines the amount is material, the auditor must ask the client to make an adjustment. If the client does not want to make the adjustment, the auditor may consider a qualified or adverse opinion, or withdrawal from the engagement, depending on materiality.

6-5

6-23

CLASS OF TRANSACTIONS

a. FINANCIAL STATEMENT BALANCE

b.

c.

TITLE OF JOURNAL

TRANSACTION CYCLE

PURCHASE RETURNS

Purchase returns & allowances

Acquisitions Journal

Acquisition & Payment

RENTAL REVENUE

Rent revenue

Revenue Journal

Sales & Collection

CHARGE-OFF OF UNCOLLECTIBLE ACCOUNTS

Bad debts

Adjustments Journal

Sales & Collection

ACQUISITION OF GOODS AND SERVICES

Repair and maintenance

Acquisitions Journal

Acquisition & Payment

RENTAL ALLOWANCES

Rental allowances

Adjustments Journal

Sales & Collection

ADJUSTING ENTRIES (FOR PAYROLL)

Rental allowances

Adjustments Journal

Sales & Collection

Accrued payroll

Adjustments Journal

Payroll & Personnel

PAYROLL SERVICE & PAYMENTS

Sales salaries

Payroll Journal

Payroll & Personnel

CASH DISBURSEMENTS

Accounts payable

Cash Disbursements Journal

Acquisition & Payment

CASH RECEIPTS

Accounts receivable

Cash Receipts Journal

Sales & Collection

d.

Rental revenue is likely to be recorded in the cash receipts journal at the time the cash is received from renters. It is therefore likely to be recorded as a debit to cash receipts and a credit to rental revenue. The journal will be summarized monthly and posted to the general ledger. There will be required adjusting entries for unearned rent and for rent receivable. A record will be kept of each renter and a determination made whether rent is unpaid or unearned at the end of each accounting period. The entries that are likely to be made in the adjustments journal are posted to the general ledger. Then the financial statements are prepared from the adjusted general ledger. Reversing entries may be used to eliminate the adjusting entries.

6-6

6-24 a.

CYCLE

BALANCE SHEET ACCOUNTS

INCOME STATEMENT ACCOUNTS

SALES AND COLLECTION

Accounts receivable Cash Notes receivable—trade Allowance for doubtful accounts Interest receivable

Sales Bad debt expense Interest income

ACQUISITION AND PAYMENT

Income tax payable Accounts payable Unexpired insurance Furniture and equipment Cash Accumulated depreciation of furniture and equipment Inventory Property tax payable

Income tax expense Advertising expense Travel expense Purchases Property tax expense Depreciation expense— furniture and equipment Telephone and fax expense Insurance expense Rent expense

PAYROLL AND PERSONNEL

Cash Accrued sales salaries

Sales salaries expense Salaries, office and general

INVENTORY AND WAREHOUSING

Inventory

Purchases

CAPITAL ACQUISITION AND REPAYMENT

Bonds payable Common stock Cash Notes payable Retained earnings Prepaid interest expense

Interest expense

b.

The general ledger accounts are not likely to differ much between a retail and a wholesale company unless there are departments for which there are various categories. There would be large differences for a hospital or governmental unit. A governmental unit would use the fund accounting system and would have entirely different titles. Hospitals are likely to have several different kinds of revenue accounts, rather than sales. They are also likely to have such things as drug expense, laboratory supplies, etc. At the same time, even a governmental unit or a hospital will have certain accounts such as cash, insurance expense, interest income, rent expense, and so forth.

6-7

6-25 a.

Management assertions about transactions relate to transactions and other events that are reflected in the accounting records. In contrast, assertions about account balances relate to the ending account balances that are included in the financial statements, and assertions about presentation and disclosure relate to how those balances are reflected and disclosed in the financial statements.

MANAGEMENT ASSERTION

b. CATEGORY OF MANAGEMENT ASSERTION

c. NAME OF ASSERTION

a. All sales transactions have been recorded.

Classes of transactions

Completeness

b. Receivables are appropriately classified as to trade and other receivables in the financial statements and are clearly described.

Presentation and disclosure

Classification and understandability

c. Accounts receivable are recorded at the correct amounts.

Account balances

Valuation and allocation

d. Sales transactions have been recorded in the proper period.

Classes of transactions

Cutoff

e. Sales transactions have been recorded in the appropriate accounts.

Classes of transactions

Classification

f. All required disclosures about sales and receivables have been made.

Presentation and disclosure

Completeness

g. All accounts receivable have been recorded.

Account balances

Completeness

h. There are no liens or other restrictions on accounts receivable.

Account balances

Rights and obligations

i. Disclosures related to accounts receivable are at the correct amounts.

Presentation and disclosure

Accuracy and valuation

j. Recorded sales transactions have occurred.

Classes of transactions

Occurrence

k. Recorded accounts receivable exist.

Account balances

Existence

l. Sales transactions have been recorded at the correct amounts.

Classes of transactions

Accuracy

f. Disclosures related to sales and receivables relate to the entity.

Presentation and disclosure

Occurrence and rights and obligations

6-8

6-26 SPECIFIC BALANCERELATED AUDIT OBJECTIVE

MANAGEMENT ASSERTION

COMMENTS

a.

There are no unrecorded receivables.

2. Completeness

Unrecorded transactions or amounts deal with the completeness objective.

b.

Receivables have not been sold or discounted.

4. Rights and obligations

Receivables not being sold or discounted concerns the rights and obligations objective and assertion.

c.

Uncollectible accounts have been provided for.

3. Valuation or allocation

Providing for uncollectible accounts concerns whether the allowance for uncollectible accounts is adequate. It is part of the realizable value objective and the valuation or allocation assertion.

d.

Receivables that have become uncollectible have been written off.

3. Valuation or allocation

This is part of the realizable value objective and the valuation or allocation assertion. There may also be some argument that this is part of the existence obje...