AFM202 Lecture Notes - Lecture 5: Audit Evidence, Financial Statement, Audit Risk

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OC2146671

27 Sep 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM202

Professor

Alan Mc Naughton

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Document Summary

Conclusions and evidence underlying the overall opinion on the fs. Saae = includes the evidence used to identify and assess the rmm for the assertion and the evidence gathered to support an opinion on whether violations of the assertion have caused mm in their account. Recalculate: reperform a mathematical calculation on the client"s financial statements. Sufficient appropriate evidence in auditing: an auditor needs enough evidence of a high enough quality to form a conclusion with respect to the audit opinion. It is persuasive: quantity of evidence obtained determines its sufficiency, appropriateness refers to the quality of evidence, accounting records are evidence but not sufficient appropriate evidence for an audit opinion, need to obtain corroborating evidence. Hierarchy of audit evidence reliability: most reliable, physical inspection, confirmation, external documentation, recalculation, reperformance. Internal documentation with good internal controls: observation, analytical procedures with specific data.

Related Questions

Part A

(a) How does the materiality of a condition that might lead to a departure affect the auditorâs choice of audit opinions? Discuss in detail naming the various types of audit opinions that may be issued given the different amounts of misstatements detected. (10 marks)

(b) For each of the following independent situations, indicate the type of audit report you would issue and provide your reasons. You may assume that each item is material. (10 marks)

(i) On 2 January 2017, the Hot Wheels Auto Parts Limited received a notice from its primary supplier that, effective immediately, all wholesale prices would be increased by 10%. On the basis of this notice, Hot Wheels Auto Parts revalued its 31 December 2016 inventory to reflect the higher costs. The inventory constituted a material proportion of total assets; the effect of the revaluation was material to current assets but not to total assets. The increase in valuation is adequately disclosed in the notes to the financial statements.

(ii) Your client holds a significant investment in Iraq. Due to recent political instability sparked off by a series of terrorist acts by the militants, Iraqâs communication with the outside world has been completely cut-off. You are thus unable to obtain sufficient and appropriate evidence regarding your clientâs investment in Iraq.

Part B

During an examination of financial statements, an auditor needs to verify managementâs assertions that are part of the financial statements. In doing so, the auditor must choose the quality and quantity of evidence, and the timing of the tests to be performed.

(a) Describe five factors that influence the quality or appropriateness of audit evidence. (5 marks)

(b) Why is it necessary to obtain corroborating evidence for inquiry and for observation? (5 marks)

(c) Describe the highest quality form(s) of evidence an auditor would normally obtain to verify each of the following assertions. Be sure to state the type of audit evidence/audit procedure technique being used, e.g. inquiry. (10 marks)

(i) ownership of share certificates held in a safe deposit box

(ii) valuation of gross trade accounts receivable

(iii) completeness of additions of fixed assets

(iv) validity of trade accounts payable

(v) valuation of finished goods inventory

Part C

An auditor is required to obtain sufficient understanding of each element of a companyâs internal control system in order to properly plan the audit of the companyâs financial statements and to assess control risk for the assertions included in the account balances.

How does the quantity of evidence differ between procedures to obtain an understanding of internal control and tests of internal controls? (4 marks)

(b) Distinguish between a compliance/reliance strategy and a substantive strategy. (6 marks)

(c) For each of the following, give an example of a physical control the client can use to protect the asset or record: (5 marks)

(i) cash received by retail clerks

(ii) accounts receivable records

(iii) raw material inventory

(iv) manufacturing equipment

(v) marketable securities

(d) Explain what is meant by independent checks on performance! (5 marks)

performance review and give two specific examples.

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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

1. For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. (10 points, 1 point each).

Components: Inherent Risk (IR), Control risk (CR), or Detection Risk (DR)

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 entityâs 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 entityâs warehouse personnel count the raw materials inventory.

h. performing test counts of the warehouse personnelâs count of the raw material.

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

j. tracing the prices used by the entityâs billing program for pricing sales invoices to the entityâs 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)

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14. (1) In violation of company policy, Lowell Company erroneouslycapitalized the cost of painting its warehouse. The auditorsexamining Lowell's financial statements would most likely detectthis when:

A) Discussing capitalization policies with Lowell'scontroller.

B) Examining maintenance expense accounts.

C) Observing, during the physical inventory observation, that thewarehouse had been painted.

D) Examining the construction work orders supporting itemscapitalized during the year.

15. Which of the following is not one of the auditors' objectivesin auditing depreciation?

A) Establishing the reasonableness of the client's replacementpolicy.

B) Establishing that the methods used are appropriate.

C) Establishing that the methods are consistently applied.

D) Establishing the reasonableness of depreciationcomputations.

16. The scope of an internal audit is initially defined bythe:

A) Audit objectives.

B) Scheduling and time estimates.

C) Preliminary survey.

D) Audit program.

17. For audit purposes, a corporation's articles of incorporationare normally:

A) Copied and placed on the owners' equity lead schedule.

B) Copied and placed in the permanent file.

C) Confirmed with the transfer agent.

D) Ignored since they are not normally considered to be related tothe internal control structure.

18. Arel, CPA, was engaged by a group of royalty recipients toapply agreed-upon procedures to financial data supplied by ModitCo. regarding Modit's written assertion about its compliance withcontractual requirements to pay royalties. Arel's report on theseagreed-upon procedures should contain a(n):

A) Disclaimer of opinion about the fair presentation of Modit'sfinancial statements.

B) List of the procedures performed (or reference thereto) andArel's findings.

C) Opinion about the effectiveness of Modit's internal controlactivities concerning royalty payments.

D) Acknowledgment that the sufficiency of the procedures is solelyArel's responsibility

19. The auditor's primary means of obtaining corroboration ofmanagement's information concerning litigation is a:

A) Letter of audit inquiry to the client's lawyer.

B) Letter of corroboration from the auditor's lawyer upon review ofthe legal documentation.

C) Confirmation of claims and assessments from the other parties tothe litigation.

D) Confirmation of claims and assessments from an officer of thecourt presiding over the litigation.

20. An auditor identified a material weakness in internal controlin August. The client was informed and the client corrected thematerial weakness prior to year-end (December 31); the auditoragrees that the correction eliminates the material weakness priorto year-end. The appropriate audit report on internal control underPCAOB standards on reporting on internal control is:

A) Adverse.

B) Unqualified.

C) Disclaimer.

D) Qualified.

21. Which of the following auditing procedures is ordinarilyperformed last?

A) Reading of the minutes of the directors' meetings.

B) Confirming accounts payable.

C) Obtaining a management representation letter.

D) Testing of the purchasing function

22. When an auditor has concluded there is substantial doubt aboutan entity's ability to continue as a going concern for a reasonableperiod of time beyond the current financial statement date(9/30/X1), the auditor's responsibility includes:

A) Preparing prospective financial information to verify whethermanagement's plans can be effectively implemented.

B) Projecting conditions and events from one year prior to thisyear's date (9/30/X0) to 9/30/X1.

C) Issuing an adverse or negative assurance opinion, depending uponmateriality, due to the possible effects on the financialstatements.

D) Considering the adequacy of disclosure about the entity'spossible inability to continue as a going concern.

23. Which of the following manipulations would understate accountspayable on the financial statements?

A) Overstatement of purchases.

B) Closing the cash disbursements journal prior to year-end.

C) Leaving the cash receipts journal open after year-end.

D) Overstating purchase returns

24. An example of an internal control weakness is to assign thepayroll department the responsibility for:

A) Preparing the payroll expense distribution.

B) Preparing the payroll checks.

C) Authorizing increases in pay.

D) Preparing journal entries for payroll expense

25. In governmental accounting, emphasis is placed on:

A) Total assets owned by the governmental entity.

B) Generating income form funds employed.

C) Expenditures of funds.

D) The flow of funds through the income statement.

26. In auditing long-term debt, an auditor would be most likelyto:

A) Perform analytical procedures on the bond prenumbered discountaccounts.

B) Examine documentation of assets purchased with bond proceeds forliens.

C) Compare interest expense with the long-term debt amount forreasonableness.

D) Confirm the existence of individual long-term debt holders atyear-end.

27. Which of the following tests of controls most likely would helpassure an auditor that goods shipped are properly billed?

A) Scan the sales journal for sequential and unusual entries.

B) Examine shipping documents for matching sales invoices.

C) Compare the accounts receivable ledger to daily salessummaries.

D) Inspect unused sales invoices for consecutivepre-numbering.

28. Which of the following audit procedures is best for identifyingunrecorded trade accounts payable?

A) Reviewing cash disbursements recorded subsequent to the balancesheet date to determine whether the related payable applies to theprior period.

B) Investigating payables recorded just prior to and justsubsequent to the balance sheet date to determine whether they aresupported by receiving reports.

C) Examining unusual relationships between monthly accounts payablebalances and recorded cash payments.

D) Reconciling vendors' statements to the file of receiving reportsto identify items received just prior to the balance sheetdate.

29. Which of the following is true about the auditors' observationof the client's physical inventory?

A) The count must be made at year-end.

B) The auditors should supervise the client's personnel.

C) The auditors' observation addresses the existenceassertion.

D) The auditors should justify any omission of the observation inthe audit report.

30. Which of the following is not a reason for the specialsignificance attached by the auditors to the verification ofinventories?

A) The determination of inventory valuation directly affects netincome.

B) The existence of inventories is inherently difficult tosubstantiate.

C) Special valuation problems often exist for inventories.

D) Inventories are often the largest current asset of anenterprise.

31. (1) When the auditors obtain an understanding of internalcontrol for the financing cycle documentation will frequentlyinclude a written description as well as a(n):

A) List of audit objectives.

B) Decision table.

C) Summary of tests of controls.

D) Internal control questionnaire.

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AFM202 Lecture Notes - Lecture 5: Audit Evidence, Financial Statement, Audit Risk

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