AFM202 Lecture Notes - Lecture 4: Internal Audit, Financial Statement, Internal Control

A424

Homework #3

Due Tuesday, February 28

Worth 100 Points

Note: Students are expected to work independently (i.e., on your own) on all homework assignments. Please type and post to Canvas.

Part I. Risk Assessments

a. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly.

b. Cash is more susceptible to theft than an inventory of coal.

c. Confirmation of receivables by an auditor fails to detect a material misstatement.

d. Disbursements have occurred without proper approval.

e. There is inadequate segregation of duties.

f. A necessary substantive audit procedure is omitted.

g. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls.

h. Technological developments make a major product obsolete.

i. The client is very close to violating debt covenants.

j. XYZ Company, a client, lacks sufficient working capital to continue operations.

2. Read Case 1.6, Nextcard, Inc. from our Casebook. Pretend you are the auditor for Nexcard, Inc. in the planning phase of the audit for FY 2000 and perform the following risk assessment procedures. That is, just focus on the information in the case prior to the discovery of the fraud (pages 83-86). (50 points total)

a. Perform a risk assessment as part of your audit plan for fiscal year 2000. Set or assess each component/factor of the audit risk model. Describe in detail how you set or assessed each factor (i.e., include specific risk factors from the case and explain how they influenced your assessment). (25 points)

b. Perform a fraud risk assessment for the risk of material misstatement due to fraudulent financial reporting. That is, identify and briefly describe specific fraud risk factors (i.e., more than 1) for each of the three components of the fraud risk triangle, specific to fraudulent financial reporting. (15 points)

c. Identify and describe one significant pervasive risk present during the Nextcard audit. In doing so, explain how the pervasive risk affects the risk of material misstatement. Then, describe how the auditor could respond to that pervasive risk (how could they change the audit plan to address that risk). (5 points)

d. Identify and describe one significant specific risk present during the Nextcard audit. In doing so, explain how the specific risk affects the risk of material misstatement. Then, describe how the auditor could respond to that specific risk (how could they change the audit plan to address that risk). (5 points)

Part II. Evidence and Management Assertions

1. For each of the following specific audit procedures, indicate the type of audit procedure it represents: (1) inspection of records or documents, (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) reperformance, (8) analytical procedures, and (9) scanning. (10 points, 1 point each)

a. sending a written request to the entity’s customers requesting that they report the amount owed to the entity

b. examining large sales invoices for a period of two days before and after year-end to determine if sales are recorded in the proper period.

c. agreeing the total of the accounts receivable subsidiary ledger to the accounts receivable general ledger account.

d. discussing the adequacy of the allowance for doubtful accounts with the credit manager.

e. comparing the current-year gross profit percentage with the gross profit percentage for the last four years.

f. examining a new plastic extrusion machine to ensure that this major acquisition was received.

g. watching the entity’s warehouse personnel count the raw materials inventory.

h. performing test counts of the warehouse personnel’s count of the raw material.

i. obtaining a letter from the entity’s attorney indicating that there were no lawsuits in progress against the entity.

j. tracing the prices used by the entity’s billing program for pricing sales invoices to the entity’s approved price list.

2. For each of the audit procedures listed above in Part II. 1. (a-j), identify the category (assertions about classes of transactions and events, or assertions about account balances) and identify the primary management assertion being tested. (30 points, 3 points each)

Which of the following statements is most correct regarding the independent auditor's reliance on the tests of controls performed by the internal auditors to reduce their substantive testing?

The term "materiality" as used in auditing is best described as the

Prior to accepting an audit client an auditor has a professional obligation to

Which of the following best represents financial statement fraud?

Sampling risk is the risk that

Control risk that is assessed excessively high (i.e. the auditor believes control risk is high when in reality it is moderate or low) leads to:

The purchasing process consists of each of the following phases except

2–31. Simulation
Casa Royale, Inc., a nonpublic company, retained Ying and Company CPA to perform an
audit of the fi nancial statements for the current year. Howard Smythe, the partner in charge of
the audit, drafted the following unmodifi ed report:

To the Management of Casa Royale, Inc.:
We have examined the accompanying consolidated balance sheet of Casa Royale, Inc., and
its subsidiaries, as of December 31, 20X1, and the related consolidated statements of income,
retained earnings, and cash fl ows for the years then ended.
Management’s Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these consolidated
fi nancial statements in accordance with accounting principles generally accepted in the United
States of America; this includes the design, implementation, and maintenance of internal control
relevant to the preparation and fair presentation of consolidated fi nancial statements that are
free from material misstatement, whether due to fraud or error.
Auditor’s Responsibility
Our responsibility is to express an opinion on these fi nancial statements based on our audit. We
conducted our audit in accordance with auditing standards generally accepted in the United
States of America. Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the consolidated fi nancial statements are free of material
misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures
in the consolidated fi nancial statements. The procedures selected depend on the auditor’s
judgment, including the assessment of the risks of material misstatement of the consolidated
fi nancial statements, whether due to fraud or illegal acts. In making those risk assessments, the
auditor considers internal control relevant to the entity’s preparation and fair presentation of
the consolidated fi nancial statements in order to design audit procedures that are appropriate
in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of
the entity’s internal control. An audit also includes evaluating the appropriateness of accounting
policies used and the reasonableness of signifi cant accounting estimates made by management,
as well as evaluating the overall presentation of the consolidated fi nancial statements.
We believe that the audit evidence we have obtained is adequate to provide a basis for our audit
opinion.
Opinion
In our opinion, the consolidated fi nancial statements referred to above present fairly, in all material
respects, the fi nancial position of Casa Royale, Inc., and its subsidiaries as of December 31,
20X1, and the results of their operations and their cash fl ows for the years then ended in accordance
with auditing standards generally accepted in the United States of America.
Howard Smythe , Partner
Phoenix, Arizona
February 12, 20X2
Reviewer’s Comments
Comment Is
Correct (yes or no)
a. The report should not be addressed to management.
b. The report should indicate that we have “audited,” rather than “examined,”
the fi nancial statements (fi rst paragraph after introduction).
c. The report should not indicate anything concerning management’s
responsibility for internal control.
d. The report should state that the auditors’ responsibility is to express
“reasonable assurance,” not an opinion (fi rst paragraph under “auditor’s”
responsibility).
e. The audit is designed to assess risks of material misstatements due to
errors or fraud; the term “illegal acts” is incorrect (second paragraph
under auditor’s responsibility).
f. The report should not refer to the auditors “evaluating the appropriateness
of accounting policies,” since those are the responsibility of management.
g. The evidence should be suffi cient and appropriate rather than “adequate”
(third paragraph under auditor’s responsibility).

Reviewer’s Comments
Comment Is
Correct (yes or no)
h. The opinion should not include “in all material respects” since the auditors
are providing an opinion on the accuracy of the fi nancial statements
(opinion paragraph).
i. The opinion should be on “accounting principles generally accepted in the
United States of America,” not on auditing standards (opinion paragraph).
j. The signature on the report should be that of the CPA fi rm, not that of
the partner.