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When auditing prepaid insurance:

A) for many audits, significant substantive procedures are needed if the control risk is low.

B) companies often have a standard monthly journal entry to reclassify prepaid insurance as insurance expense.

C) the emphasis in the tests of details of balances is on insurance expense.

D) the auditor must prepare the insurance register.

Auditors usually test cost accounting records as part of the

A) acquisition tests.

B) payroll tests.

C) sales tests.

D) All of the above are correct.

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Reid Wolff
Reid WolffLv2
30 Sep 2019

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Angela Walsh is a new staff auditor. On her first three engage-ments, she was assigned to perform tests of controls foracquisitions and payments and test of details of balances foraccounts payable.

The approach taken in each audit is briefly described below:

Audit 1– The client is a medium-sized company. Extensive testsof controls were per- formed for acquisitions and payments. Fairlyextensive substantive analytical proce- dures were also performed.The tests of details of balances of the year-end accounts payablebalance were minimal, and no confirmations were sent (confirmationsare not required for testing accounts payable).

Audit 2– This company is also medium-sized. Extensive tests ofcontrols were also performed, but after these tests were completed,additional substantive tests of trans- actions were performed.Extensive tests of the year-end accounts payable balance wereperformed, although no confirmations were sent.

Audit 3– Although the auditors gained an understanding ofinternal control, no tests of controls were performed overacquisitions and payments. However, extensive sub- stantive testsof transactions were performed, and confirmations were sent as partof the extensive testing of year-end accounts payable. Althoughthis company was smaller than the first two companies, the totalaudit time spent testing accounts pay- able was greater than forthe first two audits.
Angela is confused by the apparent inconsistency in the auditapproach on the three audits, and concludes that the audit approachand amount of audit evidence to collect de- pends on the auditpartner in charge of the engagement.

(A.) Match each engagement with one of the followingdescriptions:

(1) Extensive reliance on controls was planned for this auditengagement, but con- trol risk was increased after tests ofcontrols.

(2.) This audit is likely for a public company, and is also themost efficient audit.

(3.) This company has ineffective controls, and may also havefraud risks present.

(B.) What other factors likely explain the different approachesto the audit of acquisitions
and payments and accountspayable for these three engagements?

(C.) What could Angela’s supervisors have done to improve herunderstanding of the audit strategy for each engagement?

13-35 (Objectives 13-3, 13-4) McClain Plastics has been an auditclient of Belcor, Rich, Smith & Barnes, CPAs (BRS&B), forseveral years. McClain Plastics was started by Evers McClain, whoowns 51% of the company’s stock. The balance is owned by about 20stockholders, who are investors with no operationalresponsibilities. McClain Plastics makes products that have plasticas their primary material. Some are made to order, but mostproducts are made for inventory. An example of aMcClain-manufactured product is a plastic chair pad that is used ina carpeted office. Another is a plastic bushing that is used withcertain fastener systems.

McClain has grown from a small, two-product company, when theyfirst engaged BRS&B, to a successful, diverse company. At thetime Randall Sessions of BRS&B became manager of the audit,annual sales had grown to $200 million and profits to $10.9million. Historically, the company presented no unusual auditproblems, and BRS&B had issued an unmodified opinion everyyear.

The audit approach BRS&B always used on the audit of McClainPlastics was a “substantive” audit approach. Under this approach,the in-charge auditor obtained an understanding of internal controlas part of the risk assessment procedures, but control risk wasassessed at the maximum (100%). Extensive analytical procedureswere done on the income statement, and unusual fluctuations wereinvestigated. Detailed audit procedures emphasized balance sheetaccounts. The theory was that if the balance sheet accounts werecorrect at year-end and had been audited as of the beginning of theyear, then retained earnings and the income statement must becorrect.

Part I

In evaluating the audit approach for McClain for the currentyear’s audit, Sessions believed that a substantive approach wasreally only appropriate for the audits of small nonpubliccompanies. In his judgment, McClain Plastics, with sales of $200million and 146 employees, had reached the size where it was noteconomical, and probably not wise, to concentrate all the tests onthe balance sheet. Furthermore, although McClain is not a publiccompany, Sessions recognized that similar public companies arerequired by Section 404 of the Sarbanes–Oxley Act and related PCAOBstandards to have an integrated audit of the financial statementsand internal control over financial reporting. Therefore, hedesigned an audit program that emphasized identifying internalcontrols in all major transaction cycles and included tests ofcontrols. The intended economic benefit of this “reducing controlrisk” approach was that the time spent testing controls would bemore than offset by reduced tests of details of the balance sheetaccounts.

In planning tests of inventories, Sessions used the audit riskmodel included in auditing standards to determine the number ofinventory items BRS&B would test at year-end. Because of thenumber of different products, features, sizes, and colors,McClain’s inventory consisted of 2,450 different items. These weremaintained on a perpetual inventory management system that used arelational database.

In using the audit risk model for inventories, Sessions believedthat an audit risk of 5% was acceptable. He assessed inherent riskas high (100%) because inventory, by its nature, is subject to manytypes of misstatements. Based on his understanding of the relevanttransaction cycles, Sessions believed that internal controls wereeffective. He therefore assessed control risk as low (50%) beforeperforming tests of controls. Sessions also planned to usesubstantive analytical procedures for tests of inventory. Theseplanned tests included comparing gross profit margins by month andreviewing for slow-moving items. Sessions believed that these testswould provide assurance of 40%. Substantive tests of details wouldinclude tests of inventory quantities, costs, and net realizablevalues at an interim date two months before year-end. Cutoff testswould be done at year-end. Inquiries and substantive analyticalprocedures would be relied on for assurance about events betweenthe interim audit date and fiscal year-end.

Required

Decide which of the following will likely be done under both areducing control risk approach and a substantive approach:

Assess inherent risk.

Obtain an understanding of internal control.

Perform tests of controls.

Perform substantive analytical procedures.

Assess planned detection risk.

What advantages does the reducing control risk approach Sessionsplanned to use have over the substantive approach previously usedin the audit of McClain Plastics?

What advantages did the substantive approach have over thereducing control risk approach?

Part II

The engagement partner agreed with Sessions’s recommendedapproach. In planning the audit evidence for detailed inventorytests, the audit risk model was applied with the followingresults:

PDR=AATIR×CR×APR

where:

PDR=PlanneddetectionriskAAR=acceptableauditriskIR=inherentriskCR=controlriskAPR=analyticalproceduresrisk

Therefore, using Sessions’s assessments and judgments asdescribed previously,

PDR=.051.0×.5×.6PDR=.17

Required

Explain what .17 means in this audit.

Calculate PDR assuming that Sessions had assessedcontrol risk at 100% and all other risks as they are stated.

Explain the effect of your answer in requirement b. on theplanned audit procedures and sample size in the audit of inventorycompared with the .17 calculated by Sessions.

Part III

Although the planning went well, the actual testing yielded somesurprises. When conducting tests of controls over acquisitions andadditions to the perpetual inventory, the staff person performingthe tests found that the deviation rates for several key controlswere significantly higher than expected. As a result, the staffperson considered internal control to be operating lesseffectively, supporting an 80% control risk rather than the 50%level used. Accordingly, the staff person “reworked” the audit riskmodel as follows:

PDR=.051.0×.8×.6PDR=.10

A 10% test of details risk still seemed to the staff person tobe in the “moderate” range, so he recommended no increase inplanned sample size for substantive tests.

Required

Do you agree with the staff person’s revised judgments about theeffect of tests of controls on planned substantive tests? Explainthe nature and basis of any disagreement. If BRS&B was alsoissuing a report on internal control over financial reporting,describe the implications of these results on the auditor’sinternal control report.

1 - The most appropriate procedure an auditor can use toensure integrity of the sales and collection cycle isto:

a) Confirm accounts receivables balances.

b)Ensure the bank reconciliations are preparedby one who also handles sales returns so missing items can beaccounted for timely.

c)Recalculate the sales list price of allproducts in the computer files that are accessed by salepersonnel.

2 - When performing audit procedures, which of thefollow must be set prior to testing a sample?

a)Achieved upper precision limit

b) Computed error rate

c) Tolerable error rate

3 - When auditing the inventory cycle the auditor shoulddo all of the following EXCEPT:

a)Adjust the balance in the inventory accountto reflect the perpetual inventory counts

b)Assess the value of obsolete or damagedinventory

c)Review the procedures for the count ofphysical inventory.

4 - Tests of controls for the acquisition and paymentcycle are usually done by:

a)Inquires and documentation of management'srepresentation.

b)Recalculating sales tax amounts

c)Sending out confirmations for amounts under$10,000

5 - Cash is the most desirable asset for people tomisappropriate, when determining risk as part of the audit process,cash would have a higher:

a) Control risk

b)Detection risk

c) Inherent risk

6 - When an auditor looks at a report with over 500purchases and decides to review all of the purchase over $1,000,000this is an example of what type of sampling:

a)Judgmental sampling

b)Statistical sampling

c)This is not sampling

7 - Upon review of your audit findings your discovercash receipts from sales on account have been misappropriate. Whichof the following internal controls may have preventedthis:

a)Ensuring the same person that receives thepayments from customers does not enter transactions into thejournal and post to the ledger

b) Do a background check on all accountspayable personnel before they are hired

c)Verify that the person who receives thepayments does not also write the checks

8 - Upon review of your audit findings you not weakinternal control system that allows a department supervisor to"clock in" for a fictitious employee and then approve theemployee's time card at the end of the pay period. This fraud wouldbe detected if other controls were in place, such as having anindependent party:

a)Compare the date of the recorded check in thepayroll journal with the date on the canceled checks and timecards

b)Distribute paychecks

c)Recompute hours worked from time cards

9 - Different professional standards apply to differenttypes of services offered by a CPA. Assurance services performed bya CPA would include:

a)Audits of financial statements

b)Bookkeeping and accounting system consultingservices

c)Tax service

10 - A CPA may perform all of the following services fordifferent clients EXCEPT:

a)Audits

b)Legal advice relating to accounting ethicsviolations

c)Tax preparation

11 - If an auditor discovers material misstatement afterthe audit report is issued the auditor's first step should benotify

a)The audit firm's legal council

b)The audit committee of the client

c) The client

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