AUDITING

HANDOUT 2010

CPA REVIEW --- AUDITING AND ATTESTATION

MODULE 1

A. GAAS [Use as a guide for answering questions].

B. New client

1. Decision to accept

a. Evaluate independence and ability to handle

b. Evaluate communications with predecessor auditor - permission of client

2. If accept - understand client and industry

a. Engagement letter

b. Determine materiality levels [quantitative & qualitative]

c. Evaluate risk AR = IR x CR x DR [RMM x DR]

d. Must do risk assessment procedures and further audit procedures (test of controls, substantive tests)

C. Auditor's responsibility

1. Errors and fraud - reasonable assurance

2. Direct effect illegal acts - reasonable assurance

3. Indirect effect illegal acts - if they come to your attention

D. Fraud (SAS No. 99) [material misstatement due to fraud] {Fraudulent financial reporting and misappropriation of assets]

1. Characteristics of fraud:

• incentive (pressure)

• opportunity

• rationa'/ize (attitude)

2. Discussion among engagement personnel (brainstorming)

3. Identify risks that may lead to material misstatement due to fraud:

• interviews

• brainstorming

• fraud risk factors

• analytical procedures

• client acceptance/continuance

• entity's programs and controls

• revenue recognitionl mgt estimates/inventory quantities

4. Respond to identified risks

• overall (personnel, predictability)

• specific (nature, timing, extent)

• test journal entries

• management override of controls

5. Communicate to management and audit committee

6. Document

1

E. Management assertions [PERCY] (Broken down into more details - see text)

1. Presentation and disclosure

2. Existence and occurrence

3. Rights and obligations

4. Completeness

5. Valuation or allocation

F. Directional testing

~ - - - - - - - ~ ~ - - - - - - - ~> Completeness (understatements)

<- - - - - - - - - - - - - - - - - - Existence (overstatements)

G. Attestations

1. Report on a subject matter, or an assertion about the subject matter that is the responsibility of another party.

2.. Used for anything other than historical financial statement(s) taken as a whole (may be nonfinancial data)

3. Levels - examination, review, agreed-upon procedures (AUP)

4. AUP -- CPA, client, and third party agree on procedures to be used. Third party must assume responsibility for sufficiency of procedures. Report on findings based on specific procedures performed on subject matter.

5. Forecasts and projections

a. Forecast --based on conditions expected to exist

b. Projection - hypothetical assumptions

c. General use - used by anyone (not projections)

d. Limited use - users deal directly with pre parer

e. Accounting services - examination, compilation, AUP

f. "May differ from actual"

g. "No responsibility to update"

H. Quality control standards -- elements (basis for peer review)

1. Leadership responsibilities

2. Relevant ethical requirements

3. Acceptance and continuance of clients

4. Human resources

5. Engagement performance - supervising, consulting

6. Monitoring

2

I. Reviews (limited or negative assurance)

1. Do not deal with internal control

2. Inquiry and analytical procedures

3. Cite measurement or disclosure GAAP departures in an extra paragraph in report

J. Compilations (no assurance)

1. Do not deal with internal control

2. Look over financial statements for logic

3. May omit substantially all disclosures required by GAAP, but must add an extra paragraph to the report

4. Cite measurement GAAP departures in an extra paragraph in the report

K Comparison of audit, review, and compilation:

ITEM AUDIT REVIEW

COMPILATION

1. Standards SAS/PCAOB

2. Independence Required

3. Assurance Reasonable

4. Rep letter Required

5. Engagement letter Required

6. Report date Report

release date

7. Each page marked

8. Understand client/industry

SSARS

SSARS

Required Not required

Negative None

Required Not required

Recommended _a> (except mgt use)

Completion of Completion of

procedures compilation

"See review "See compilation

report" report"

~------------- required -------------7

MODULE 2

A. Internal control

1. Definition process effected by people to achieve entity's objectives

2. Components -- environment, risk assessment, control activities, information and communication, monitoring

3. Control activities - [R I P S1 Reviews, Information processing, physical controls, segregation of duties

(authorization, recording, custody)

4. Basic requirements -- Risk assessment procedures [document - narrative, questionnaire, flowchart]

5. Tests of controls

a. To test operating effectiveness of controls

b. Done ONLY if you wish to rely on controls

c. Includes -- Inquire Observe Inspect Reperform

3

B. Cycles

1. Sales/Accounts Receivable/Cash Receipts .:. Sa.les order

.:. Credit approval

.:. Ship - bill of lading .:. Bill/Collect cash

.:. Records - aging schedule, bad debts, sales returns

2. Purchases/Accounts Payable/Cash Disbursements .:. Requisition

.:. Purchase order .:. Receive goods

.:. Approve for payment/Pay

3. Personnel/Payroll

.:. Authorization - personnel (human resource management) .:. Recording - payroll accounting

.:. Custody - paycheck distribution

C. Control deficiencies (reportable conditions)

1. Required to the extent that they come to your attention

2. Must be written to management and those charged with

governance

3. Significant deficiencies and material weaknesses

4. Not required to give recommendations

5. Cannot write that "no significant deficiencies found" but may write "no material weaknesses found"

D. Internal auditors

1. Competence

2. Objectivity - To whom do they answer in the client entity?

MODULE 3

A. Evidence

1. Sufficient -quantity

2. Appropriate - quality .:. observe

.:. external -- directly to auditor or held by client .:. internal

.:. oral

B. Substantive tests

1. Trace/vouch

2. Reconcile

3. Analytical procedures

4. Confirm

5. Examine

4

C. Analytical procedures

1. What? Does the number make sense? Includes comparisons, ratios, budgets, nonfinancial data

2. When? Required for planning and overall review. May be used during the audit as a substantive test.

3. Why? Usually very efficient (more than effective)

D. Audit procedures

1. Balance sheet accounts

2. Balances -- cash, AR, inventory, AP

3. Transactions -- PPE, L T debt, investments, capital stock [beg bal + additions - subtractions = end bal]

E. Subsequent discovery of facts

1. Would it have affected report?

2. Is it addressed with other procedures?

3. Can you get clientls permission to do work?

4. Are statements misstated? Encourage client to recall statements and adjust and reissue.

5. If client refuses, you notify all known users of financial statements that they cannot rely on your report.

F. Cash flows statement (CFS) - audits

1. Foot

2. Trace to other financial statements

3. Classification - operating, investing, financing

4. Schedules for various accounts

5. Disclosures

MODULE 4

A. . Audit reports [KNOW WHEN THEY'RE ISSUED AND HOW WORDED]

1. Qualified -- "except for"

Major GAAP departure Major scope limitation

2. Disclaimer -- no opinion

Very major scope limitation

3. Adverse - "not present fairly"

Very major GAAP departure

4. Unqualified explanatory

Emphasis Inconsistency Going concern Share responsibility

5

B. General parts of a report

1. Title (for audits and AUP)

2. Address

3. Service type

4. What we worked on

5. Date of #4

6. Responsibilities of parties

7. Professional standards followed

8. Description of procedures - general

9. Conclusion

10. Inherent limitations - if any

11. Restrict distribution - if applicable

12. Sign and date

C. Special reports

1. Other comprehensive basis of accounting (OCBOA)

a. Use different names for financial statements than GAAP names

b. Disclosures required

2. Specified elements or accounts of financial statements

3. Compliance with contract or regulations as part of audited financial statements

4. Special-purpose financial presentations

D. Negative assurance

1. Review

2. Comfort letter

3. Compliance with contract as part of audit

E. Restrict distribution

1. Control deficiencies --------------1 BY-

2. Specified elements 1 PRODUCT

3. Compliance with contract as part of audit -----------1 REPORT

4. Special-purpose financial presentations

5. Agreed-upon procedures

F. Personal financial statements

1. Statement of financial condition

2. Use market value

3. Estimated liability on difference between market value and book value

6

G. Government auditing standards (yellow Book)

1. Must follow all of GAAS and issue report on financial statements

2. Must issue written report on internal controls

3. Must issue written report on compliance with laws and regulations

4. Must issue additional reports for AM133 audits

MODULE 5 [definitions. internal control. substantive tests]

A. Terminology

1. Risk of assessing control risk too low - overreliance

2. Risk of assessing control risk too high - underreliance

3. Incorrect acceptance

4. Incorrect rejection

8 Attribute sampling -- sample size factors

1. Tolerable rate -- inverse

2. Expected population error rate -- direct

3. Risk of assessing control risk too low - inverse (compliment of confidence level)

C Formula: sample error rate + allowance for sampling risk <

tolerable error rate

D. Variables sampling - sample size factors

1. Confidence level (reliability) -- direct

2. Precision - direct

3. Variability within the population - direct

4. Tolerable misstatement -- inverse

E. Sampling plans

1. Determine objective of test

2. Define population and deviation

3. Determine sample size

4. Select sampling technique

5. Perform sampling plan

6. Evaluate results/Document

7

MODULE 6 [definitions, internal control, substantive tests]

A. EDP department -- Control clerks, Operator, Programmer, Analyst, Librarian [C 0 PAL]

B. General and application controls

C. Batch vs. on-line real time processing

D. Auditing around the computer (without using the computer)

E. Auditing through the computer

1. Test data

2. Integrated test facility

3. Parallel simulation

F. Microcomputers in auditing

1. Spreadsheet

2. Sampling

3. Audit through computer

computer assisted audit techniques -- CAA TS

4. Manage engagement

5. Word processing

G. Electronic evidence

1. Electronic data interchange (EDI) may reduce or eliminate traditional paper trail

2. Auditor may need more test of controls in these environments

3. Auditor may need to do work at interim dates when electronic evidence exists at a certain point in time before this evidence may become non-retrievable (affect nature, timing, extent of tests)

H. IT Advantages

• Speed/accuracy

• Minimize redundancy

• Improve communications

• Remain competitive

• Facilitate additional analysis of data

• Backup/recovery

8

I. IT Disadvantages Cost

Specialized personnel Backup/recovery Compatability

Loss of confidentiality Rely on others

Audit trail

Legal issues

J. Internal control implications General vs application controls Access codes/passwords Backup/recovery

Security over data

Test for accurate processing of data Documentation

9

General Comments

A. Internal control

1. May be simulation

2. May be flowcharts or questionnaires

3. To identify weaknesses in internal control or to design a questionnaire, use control actlvltles [R IPS]

B. Evidence

1. May be simulation

2. Objectives of auditing various accounts developed from assertions

[P E R C V]

3. Simulation

a. Use PERCV and the following table:

P Inquire; Inspect documents E Vouch; Observe; Confirm

R Inspect documents; Inquire; Confirm C Cut-off; Analytical procedures; Trace

V Reconcile; Recalculate; Analytical procedures

b. Other points:

"Review management policies and procedures." "Review subsequent events."

"Review minutes of Board and major committees."

C. Summary

INTERNAL CONTROL

DOLLAR AMOUNTS

Tests of controls Attributes Over/under reliance CR

Sampling:

Discovery

Substantive tests Variables

Incorrect acceptance/rejection DR

Sampling:

PPS

Mean per unit Difference estimation Ratio estimation

10

ProblemS Required:

Ite.ms 1 throUgh 8 present various independent factual simarionsan ;m.ditor nrigbt encounter in conducang an audit Llst A represents the types of opinions the auditor ordinarily would issue and List B represeats the report modiD..CatiOIlll (if any) that would be necessary: For each situation, select one ll:SpODSC from List A and one from List B .. Select as the best answers for each item the action the auditor normally would take" The typeS of opinions in List A and the report modlfications in. List B may be selected o~ce, more than OD.Ce, or notat an.

(IS to 15 minutes)

Assume;

• The aadisor is independent.

• The auditor previously expressed an unqualified opinioo on the prior year s financial stammellllS.

• Only single-year (not comparative) starem.cnlS ere presented for the current yea;;.

• The conditions for an unqualified opinion exist unless contradicted by the facts.

• The can ditions stated in the factual siwations arc material.

• No report modifications are til be made except in response to the factlU!.l situation. Items to be lDIS'I/iIued

1. An auditor hires an actl1a:l:y to ~ in corroboraIing a client's complex pension calculations eoaceramgaccrued pension liabilities that aceounrfor 35% of the client's total liabilities .. The acmary's findings are reasonably close to the client's calculations and support the financial statements,

2. A client holds a note receivable consisting of principal and accrued interest payable in 2004. The note's maker recently filed a voluntary bankJuptcy petition, but the client fuiled to reduce the recorded value of the noo: to its net realizable value, which is approximately 20% of the recorded amount,

3. An auditor is engaged to aUiiit !I. client's financial statements after the annual physical inventory count. The accounting records are not sufficiently reliable to enable the auditilr to become satisfied .DS til the year--end inventory balances.

4. Big City is required by GASBco present supplemenr.ary infonnation outside the basic financialstatements concerning the disctosure.of pension information. Big City's auditor determines thaI the supplementary informanon, which is DOt required to be pan of the basic financial statements, is omitted.

S. A client's financial statements do u.ot disclose certain long-term lease obligations. The auditor determines that taeomitted disclosures are required. by F ASH.

6. A principal audi~ decides not 10 rake responsibility for the work. of another CPA who audited a wholly owned subsidiary of the principal. aadltor's.clieat, The total assets and revenues of the subsidiary represeat 27% and 28%, respectively> of the related consolidated totals..

7. A client changes its method of accounting for the cost of inventories from FIF'O to LIFO. The auditor COIICUIS with the change although it has a maierlaI. effect on the comparability of the financial statements.

8. Due to losses and adverse key financial ratios, an auditor has substlUltial doubt about a client's ability to continue as II going concern for II reasonable period of time. The client: bas adcquaIcly disclosed its financial difficulties in a note to its financial statements, which do DOt include anyadjustmeats that might ICSUit from the outcome of this uncertainty.

11

MODULE 4 REPORTING

Li.ftA

ListB

Types of opinions

Report modificaIions

A. Eirber an "except for" qualified opinion or anadverse opinion

B. Either a disclaimer of opinion or an "except for" quali~

fled opinion

C. Either an adverse opinion or a disclaimer of optniOil

D. An "except for" qualified opinion

E. An unqualified opinion

F. All adverse opinion

G. A disclaimer of opinion

H. Describe the circumstances in an explanatory paragraph ~jthoUJrrwdifying the three standard paragraphs.

I. Describe the circumstnnces in an explanatory paragraph and nwdijy the opinion paragrnpl:L

J. Describe the circumstances in an explanatory paragrap.h and modify the scope and opinion paragraphs.

K.. Describe the circumstances in an explanatory paragraph and modify the introductory, scope, and opinion paragraphs.

L. Describe the circumstances within thesoope paragraph wiiboUladding an explanatory paragraph.

M. Describe the circumstances within the opinion peragraph without adding an explanatory paragraph,

N. Describe the circumstances within the scope and opinion paragraphs without adding an explanatory paragraph,

O. Describe the circumsrances within tbe introductory, scope. and opinion paragraphs without adding an explanatory paragrap.h.

P. Issue the standard auditor's report witlwu.t modificaiion,

Problem 6

(15 to 25 minutes)

Perry & Price, CP As, audited the consolidated financial StEUemc:nts of Bond Company for the year ended December 31, 200t, and expressed an adverse opinion because Bondcarried its plant and equipment at appraisal values. and provided for de-

preciation on the basis of such values. .

Perry & Price also andited Bond's financial stEUel;Qents for the year ended December 31, 2002. These consolidated financial statements are being presented. on :1 comparative basis wl.1h those of the prior year and an unqualified o pinion. is being expressed.

Smith, the engagement supervisor, instructed Adler,anassistant on the engagement. to draft me auditor's report on May 3.

2003, the date of completion of the fieldwork. In dmftin.g the report below, Adler considered the following: .

Bond recently changed its method of accou.nting-fOT plant and equipment and restated its 2001 consolidated financial statements to conform with GMP. Consequently, the CPA fum's present opinion on those stntemems is different (unqualified) from the opinion expressed on May 12, 2002.

L.arlcin & Lake, CP As. audited the financial statements of BX, Inc., a consolidated subsidiary of Bond, for tl1.e year ended December 31. 2002. The subsidiary's financial statements reflected total a.ssetsand revenues of 2% and 3%, respectively, of the consoli~ totals. Larkin & Lakcexpressc:d an unqualified opinion and furnished Perry-& Price with a copy of the auditor's report, Perry & Price bas decided. to assume respoosibility for the work of Larkin & Lake insofar as it relates to tile _ expression of an opinion on Ibeconsolid.a.tcd financial statemenlS taken as II. whole.

Bond is a defendan.t in a lawsuit alleging patent ~gemenl Ttris is ruiequalely disclosed in the notes 10 Bond' s financial statemcnts. but DO provisioo for liability has been reecrded because tbe ultiniatc outcome of the litigation cannot presently be determined.

Allditor~s Report

We have audited the accompanylng consolidated balance sheets of Bond Company and subsidiaries as of December 31, 2002 and 200 1. and the related ccnsolidared statements of income, retainedeamings.and cash flows for the yem'S then ended. These financial sl:atemeUts are Ibe respomIbjlit)' of the Company's management, Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audilll in accordance with US generallyaccepted auditing standards. Those standards require Ibat we plan and perform the audit to obtain. reasonable assurance about whether the financial starememsare free ·uf material misstatement. An a.udit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial Statements. An audit also includes assessing the accounting prin<:{ples used, as well as evaluming t:be overall financial statement presentation. We believe Ilut our audits provide a reasonable basis for our opinion.

In our previous report, we expressed an opinion that the 2001 financial statements did not fairly present financial position, results of operations, and cash flows inconformity with US generally accepted accounting principks because the Compa.oy carried its plant and equipment at appraisal values and provided fOT depreciation on the basis of such values. As described in Note 12, the Company has changed its method of accounting for these items and restated its 2001 financial statements to conform with US generally accepted accounting pdnciples. Accordingly, our present opinion on the 2DO I financial statements. as presented herein. is different from Ibat expressed in our previous report.

12

ProblemS

(15 to 25 minutes)

Webb & Weber, CPAs, audited the consolidated financial statements of Quest Co. and all but one of its subsidiaries for the year ended September 30,2001, and expressed a qualified opinion because Quest capitalized certain research and development expenditures that should have been expensed.

Webb & Weber also audited Quest's consolidated financial statements and all but oueof its subsidiaries for the year ended September 30, 2002. These consolidated financial statements are being presented on a comparative basis with those of the prior year and an unqualified opinion is being expressed.

Webb, the engagement partner, instructed Perry. an assistanr on the engagement. to draft the auditor's report on November 4, 2002, the date of completion of the fieldwOIL In drafting the report Perry considered the following:

• In preparing its 2002 financial statements, Quest changed its method of accounting for research and development costs and properly expensed these amounts. Quest also restated its 2001 financial statements to conform with GAAP. Consequently. Webb & Weber's present opinion on the 2001 financial statements is different (unqualified) from the opinion expressed on November 5, 2001.

Hill & Hall. (:PAs, audited the financial statements of Biotherm. Ine., a consolidated' subsidiary of Quest, fOF the years ended September 30, 2002 and 2001. The subsidiary's financial statements reflect total assets eonstimting 23% and 22% at September 30, 2002 and 2001, respectively, and total revenues consrimting 21 % and 20% in 2002 and 2001, respectively, of the consolidated totals .. Hill & Hall expressed an unqualified opinion each year and fumisbed Webb & Weber with a copy of each year's-auditor's report, Webb & Weber have decided not to assume responsibility for the work. of Hill & Hal] insofar as it relates to the expression of QJl opirrion on the consolida.!ed financi:alstatements taken as a wl:lole because of the materiality of Biotherm's financial statements to the consolidated financial statements. Hill & H.a.ll's report will not be presented together with that of Webb & Weber.

Quest is the subject of a grand jury investigation into possible violations of federal antitrast laws and possible related crimes. Related civil class actions are pending. "This is adequately disclosed in Note 12 to Quest's consolidated financial Slatements. Because of the early stage of the investigation. the ultima1e oetcome of these matters cannot presently be determined. Therefore, no provision fot QIly liallility that may result has been recorded.

Quest experienced a net loss in 2002 and is currently in default under substantially all of its debt agreements. Management's plans in regard to these matters ate adequately disclosed in Note 14 to Quest'S consolidated financial statements, although the financial statements do not include !IIl)' adjustments tha.l migh.t result from the outcome of this uncertainty. These matters raise substantial doubt about Quest's ability to continue as D. going concern.

Webb reviewed Perry's draft and indicated in Webb's Review Notes that there were many deficiencies in Perry's draft.

Independs1ft Auditor's Report

We have audited the consolidated financial statements of Quest Co. and subsidiaries as of September 30, 2002 and 200 1, and the related consolidated statements of income, changes in'stockholders' equity, and cash flows for the year.> then ended .. These financial statements are the responsibility of the Company's management Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Biotbenn, Inc., a wholly owned subsidiary, which statements reflect total assets COIlStinJ.ting 23% and 22% at September 30,2002 and 2001. respectively, and total revenues constituting 21 % and 20% in 2002 and 200 1. respectively. of the consolidated totals. Those statements were audited by Hill & Hall. CP As, whose reports have been furnished to us. and our opinion, insofar as it relates to the amounts included for Biothenn, Ine., is based solely OIl their reports.

We conducted our audits in accordance with US ge.nerolly accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the firumcial statements are free of material miss wement. An audit includes examining. on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used, as well as assessing control risk. We believe chat our audits provide a reasonable basis for our opinion,

In our previous report dated November 5, 2001, we expressed a q~ed opinion that., except for the effects on the 2001 financial statemects of not expensing certain research and development costs, the 2001 financial statements present fairly, in all material respects. the financial position of Quest Co. and subsidiaries as of September 30. 2001. and the results of its operations

13

MODULE 4 REPORTING

and its cash flows for the year then ended: in conformity with US gencn:illy acceptedaceounting principles. As described in Note 10, the Company has changed its method of accounting for these items and restated its 2001 financial statements to con. form with US gcnernlly accepted acccunting principles. Accordingly, our present opinion on the 2001 financial statements, as

presented herein, is diff=nt from thatexpressed in our previous report, -

In our opinion. based OD our audits and the reports of the other auditors. the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Quest Co. as of September 30, 2002 and 2001, inconformity witb. US generally accepted accounting principles, except for the uncertainty, wbich is discussed in Note 12 to tlIe consolidated finan.cial statements.

The acc.ompanying consolidated financial statements have been prepared assuming thm. the Company will continne in existenee fora reasonabl.e period of time .. As discussed in Note \4 to thecoosolidaIed finaocilll statements, the COInpany suffered a net loss in 2002 and is currently in default under substantially all of its debt agreements. Management's plans in regard to these ma.tters arealso described in Note 14. The consolidated: financial statements do not include any adJustmetlts that might result from the outcome of this un.certainty.

Webb & Weber, CPAs

November 4, 2002

Required:

Items 1 fbrougb 16 represent the deficiencies noted by Webb. POI: each deficiency, indicate whether w.. Webb's review note is correct,

P. Perry's draft is correct

B. Both Webb's review note and Perry's draft ~ incorrect, An answer may be selected once, more than once, or not Mall.

Webb', Revi4w Not"

1. The reference to the subsidiary. Biotaerm, and the magnirude of its financial statements should be in the scope paragraph rather than in the opening (introductory) paragmph.

2.. The other independentandimrs, Hill & Hall should be named in the scope paragraph rather than in the opening (introductory) pamgraph.

3. The reference in the scope paragraph to "the financial statements arc free of.material misstatement" should be followed by

the phrase "wbether caused by error or fraud."

4. The required reference in the scope paragmpb to assessing "Significant estimates made by management" has been omitted. S. The reference in the scope paragraph to "assessing control risk:" is inappropriate and should be omitted from the report

6. The required reference in the scope paragraph to "evaluating the overall financial sratemenr presentation" h8ll been omitted.

7. A separate explanatory paragraph describ:ing the gnmdjury investigation. into pOMible violaecas of federal nntitrust laws is required to be placed between the scope and opinioD p~.

S. The reference in the first explanlitory paragraph (between the scope and opinion paragraphs) to the q.uali.fied opinion on the

2001 financial statements is not properly placed .. It should be placed in the opinion paragraph. .

9. The reference in the first explanatory parngrapb (between the scope and opinion pamgrnphs) to Note 10 docs nOI express our concw:reo.cc with Quest's change in aeeounring princigle. Our concurrence should be specifically expressed in this pamgraph.

10. The reference to the oth.er auditors in the opinion paragraph is in.rompiete. It should specifically include tile words "unqualified opinion" to describe the type of opinione~ by Hill & Hall

H. The opinion paragraph should cxtend the auditor's opinion beyond: financial position to include the-results of Quest's operations and its changes in stockholders' equity.

U. The reference to tl;le unccriainty in the opinion p~h is incomplete .. It should describe the nature of the uncertainty as pertaining to the grand jury investigation into possible viol.ations offederol antitrust laws ...

13. The cxplanatory paragraph following the opinion p~h does not include the termt'substantial doubt," This teIm is required to be used in this pamgraph under tbesecacumsmnces,

14. The explanatory paragraph following the opinion puagmph does not include the term "going concern:' This term is required to be used in this paragraph under these eireumstaaces,

15. The explanatory paragraph following thc opinion paragrnph includes an inappropriate statement that "the consolidated financial ssatements do not incluOe any adjustments that might result from theoutcome of this uncertainty." 'this statement is misleading and should be omitted.

16. The auditor's report.is not correctly dated. It should be dual dared because of Note 12, the grandjury investigation, and also because of Note 14. the gomg concern uncertainty.

14

MODULE 4 REPORTING

Problem 8

I. (P) The report correctly includes the reference in Iile introductory pamgraph.

2. (B) Botha.re incorrect because when the other auditor's report is not being presented that audnor should not be named (AU 543).

J. (P) The report is correct because the term "whether caused by error or fraud" is not included in the audit report.

4. (W) The reviewer is COl'l'CCt because the scope paragmph should refer to "significant esti~ made by management," S. (W) The reviewer is correct because the audit report does not refer to "assessing control risk,"

6. (W) The reviewer is correct because the scope paragr,wb should include "evaluating theoveral.J. financial statement presentation."

7. (P) The report is not required to include such a paragraph.

S. (p) The first exp1.aruuory paragraph is properly placed prior to the opinion paragraph,

9. (P)The report is correct since auditors do not express concurrence with an accounting change.

10. (P) The opinion. paragraph.should not .speci.fi.cally include the words "unqualified opinion" to describe the other auditor's opinion,

11. (8) Bach are incorrect since the report should. extend to results of operations and cash flows in addition to financial position.

ll. (B) Both are incorrect since any menti~m of uncertainty should be handled as an "emphasis of a matter paragraph" as described in AU 508--lhe opinion paragraph is not qnalified for such a matter.

13. (W) The reviewer is correct that the term "substantial doubt" should be included.

14. (W) The reviewer is correct that the term "going concern' should be included.

IS. (P) The report is correct in SWing that .. the consolidated financial statements do not include any. adjustmeuts that might result from the outcome of this uncertainty."

16. (P) Tbe draft: is correctly dated.

Most audit reporting guidance ill incl:uded in AU- 508. Otb.et sources of gmdance for this question include AU 341-Reporting on Going Concern

AU 420-Reporting on Consistency

15

MODULE 5 AUDIT SAMPUNG

PROBLEMS Problem 1

(15 to 25 minutes)

Sampling for attributes is often used to allow an auditor to reach a conclusion concerning a rate of occurrence in a population. A common use in auditing is to test the rate of deviation from a prescribed internal control procedure to determine whether the planned assessed level of control risk is appropriate.

Requ:in!d:

a. When an auditor samples for attriblUeS, identify the factors that should influence the audilor's judgment con-

cerning the~terminatioD of .

1. Acceptable level of risk of assessing control· risk

too low. .

2.. Tolerable deviation rate. and

3. Expected population ~vill.tinn tale.

b. State the effect on sample size of an increase in each of the following factors, assuming all other factors are held constant:

1. Acceptable level of risk of assessing control risk too tow,

2. Tolerable deviation rate, and

3. Expected. population deviation rate.

c. Evaluate the sampleresults of a test for attributes if authorizations are found to be missing on seven che¢k requests our of a sample of 100 tested. The population CODsista of 2500 check requests, the tolerable deviation rate is 8%, and the acceptable level of ds:k of assessingcontrol risk too low is considered to be: low.

d. How may the use of statistical sampling assist the auditor in evaluating the sample ~ described. in Co, above?

Problem 2. (15 to 25 minutes)

IibJum, CPA. is planning to use attribute sampling in order to determine the degree of reliance to be placed on an .. audit client's system. of intemal control over sales. Jiblum has begun to develop an outline of the main steps in the sampling plan as·follows:

1. State the objective(s) of the audit test (e.g., to test the reliability of internal control over sales). 2.Ocfine the population (define the period covered by the test; define the sampling unit, define the completeness of the population).

3. Define the sampling unit (e.g., client copies of

sales invoices).

Reqnirel:k

a. What are me remaining steps in Ihe above outfine

w hich JibJum should incw de in the stansticaltest of sales invoices? Do net presen.t a detailed analysis of tasks which must be performed to carry out the objectfves of each m.p. Pareotbetica1 esamples need not be provided..

b. How does stansdcal methodology help the auditor to develop a satisfactory sampling p1.an?

Problem 3

(151025 minutes)

Smith. CPA. bas decided 10 rely all. an auditclienl's affecring receivables. Smith plans to use sampling to obtain

substantive evidence concerning the reasonableness of the elienr'saeeoums receivable balances. Smith has identified the first few steps. in an outline of the sampling plan as follows.

1. Determine the a.udit objectives of the test,

2. Define the population.

3. Define the sampling unit.

4. Consider the completeness ofthe population.

5. Identify individually significant items. .Requind:

Identify the remaining steps which Smith should include in. the" outline of the sampling plan. Dlusttationsand

e~les need not be provided. .

Problem 4

(15 to 25 minutes)

. Edwards ~ decided to use probability-proportionai-to~ (PPS~ samp~g, ~times caIl~ dollar-unit sampling, m the audit of a. client s accounts receivable balance. Few, if .any. misstatements of account balanoe overstatement are eX11CCted.

Edwards plans to use the following PPS samplirlgtab\e.:

TABLE

Rellabillty F'actor,; tor OYersl'.atelneftts

Numbuaj RiD: 2i.in,orrg_t !If::£ml!!!!(~
ovenrUlU·
IMIlU Jj! 5% ~ 15% 20%
0 4.61 3.00 2.31 1.90 L61
1 6.64 4.15 3.89 3.38 3.00
Z 8.41 6.30 5.33 4.72 428
3 10.05 7.76 6.69 6.02 5.52
4 11.61 9.16 8.00 7.27 6.73 Required:

a. Identify the advantages of using PPS sampling over classical variables sampling.

NOTE: R~quiremenu b. aM C. Il.n! 1101 relased:

b. Caleulate tbe sampling interval and the sample size Edwards should~ given the following information:

Tolmbk minWeTrlClltS SIS.roo

Risk of inoolTCCt ~ce .. 5%

N~of~!!lmll3a1lowed 0

RecmIaI. iiIIIlIUUI of 3II:COO!l1li receivable S300,OOO

NOTE: Requinmenu .11. aM c. llf"l!' IIOt related:

Co Calcu.late!.he tom! projected misstarement if the following three misstatemen.1S were discovered in a PPS sample:

&roniaJ Audb Sampling

amp!!IIl<lmOlUll im",""al

S 400 S 320 $1,000

500 0 1,000

s.eoo 2.500 1 ,000

\$1. mi.ssweJDellt 2nd IltistaIemem 3Id IIWstmmcnI

ProblemS

(15 to 25 minutes)

Baker. CPA, was engaged to audit Mill Company's fiaancial statements for the year ended September 30, 200 1. After obtaining an undemanding of Min's internal control, Baker decided to obtain evidential manerabout the effe-ctiveness of both the design and operation of the conrrols that may support a low assessed level of control risk concerning Mill's shipping and billing functions. During the prior

16

MODULE 5 AUDIT SAMPUNG

years' audits Baker used nonsta.tistical sampling. but for the current year Baker used a statistical sample in !he tests of controls to eliminate the need for judgment.

Baker wanted to assess control risk at a low level, so a tolerable rate of deviation or acceptable upper precision limit (UPL) of 20% was established. To estimate the population deviation rate and the achieved UPL, Baker decided to apply a discovery sampling technique of attribute sampUng that would use a population expected error mre of 3% for tbe 8,000 shipping documents, and decided to defer consideration of allowable risk of assessing control risk too low (risk of overreliaace) until evaluating the sample resullS.Baker used the tolerable rate, the population size. and the expected population error rate to detenni.ne that a sample siZe of eighty would be sufficient When it WIIS subsequently detennined that the actual population was about 10.000 shipping documents, Baker increased the sample size to 100.

Baker's objective was to ascertain wb.etbcr Mill' 5 shipments had been properly billed. Baker took a sample of 100 invoices by selecting the fust twenty-five invoices from the first month of each quarter'. Baker then compared the invoices to the corresponding prcnumbered shipping doeuments,

When Baker tested the samPle. eight errors were discovered. Additionall'y, one shipment that shooJd have been billed at srO,443 was acmally billed at $10,434. Baker consider this $9 to be immaU:rial and did not count it as an enor.

In evaluating. the-sample results Bake:c made the iIlitial determination that a reliability }evel of 95% (risk of assessing control risk too low 5%) was desired and, using the appropriate statistical sampling table, determined- that for eight observed deviations from a sample size of 100, !he achieved UPL was 14%. Baker then calculated the allowance for sampling risk 10 be 5%, !he difference between the actual. sample deviation rate (8%) and the expected error rate (3%). Baker reasoned that the actual sample deviation rate (8%) plus the allowance for sampling risk (5%) was less than the achieved UPL (14%); therefore, the sample supported a low level of control risk.

Required:

Descnbe each incorrect assumption, statement, and inappropriate application of attribute sampling in Baker's pr0- cedures.

Problem 6 (15 to 25 minutes)

Mead, CPA, was engaged to audit Jiffy Co.' s financial statements for the year ended August 31, 2001. Mead is applying samplia.g procedures,

During the prior years' audits Mead used classical variables sampling in petfonning tests of controls on Jiffy's accounts receivable. For the current year Mead decided to use probability-proportiooal-to-size (pPS) sampling (also known as dollar-unit sampling) in confirming accounts receivable because PPS sampling uses each account in the population as a separate sampling unit. Mead expected to discover many overstatemellts, but presumed that the PPS sample still would be smaller than the corresponding size fOT classical variables sampling.

Mead reasoned that the PPS sample would automatically result in a stratified sample because each account woUld nave an equal chance of being selected for eonfirmation, Additionally, the selection of negative (credit) balances would be facilitated without special considerations.

Mead computed the sample size using the risk of incorrect acceptance, the total recerded book amount of the receivables. and tile number of misstated accounts allowed .. Mead divided the total recorded book amount of the receivables by the sample size 10 determine the sampling interval, Mead then calculated the standard deviation of the doUar amounts of tbc accounts selected for evaluation of the receivables.

Mead's calculated sampieslz.c was sixty and the sampling iruerval was determined to be $10.000. However, ouly fifty-eight different accounts were selected because two accounts were so large that the sampliDg interval caused each of them to be selected twice. Mead proceeded to send confirmation requests to fifty-five of the fifty-eight customers. Three selected IICCOWllS each had insignificant recorded balances under .$20. Mead. ignored these three small uccounts and substituted the three largest accounts that had not been selected in the sample. Each of tbese accounts had balances in excess of 57,000, so Mead. sent confinnation requests to those customers.

The confumarion process revealed two differences.

Oae accOIii1t with anliUdited amount-of 53.000 bad been recorded at $4,000. Mead projected this to be a Sl ,000 misstatcJnent Another account with an audited amount of $2,000 had been recorded at $1.900. Mead did not count the 5100 difference because the purpose of the teSt. was to detect overstatements.

In evaluating the sample results, Mead. determined that the accounts receivable balance was not overstated because the projected misstatement was less than the allowance for sampling risk.

llequind:

Descnbc each incorrect assumption. statement, and inappropriate application of smnpling in "Mead's procedures.

17

MODULE 5 AUDIT SAMPUNG

UNOFFICIAL ANSWER· Problem 1 Attribute Sampling

a. 1. In determining an acceptable level of the risk of assessing control risk too low, an auditor should consider the importance of the control to be Wired in determining the extent to which substantive tests will be restricted and the planned assessed level of control risk,

2. In deten:ni:ning tile tolerable deviation rate. an audi" tor should consider the planned assessed level of control risk and bow materially the financial SlalEllleDts would be af· fected if the control does not function properly. For example. bow likely is !he control to prevent or detect ~ errors.

3. In detennining the expected population deviation rare, an auditor should consider the results of prior years' tests, the overall control environment, or utilize a preliminary sample.

b. L There is a decrease in sample size if the acceptable level of the risk of assessing control risk too low is increased.

2. TIt.ete is a decrease insample size if the tolerable deviation rate is increased.

3. There is an increase in sample size if the population deviation rate is increased.

Co For a low risk ofassessing control risk too loW it is generally appropriate to reconsider the planned risk as the calculated estimate of the popuiaJion deviation rate identified in the sample (7%) approaches tile tolerable deviation rote (8%). 'This is because there may bean unacceptably high sampling risk that these sample results could have QC. curred with an actual populruion deviation mte higher dum the tolerable deviation rate.

d. If statistical sampling is used, an allowance for sampling risk can be calculated. If tile calculated estimate of the population deviation rate plus th.e allowance for sampling risk is greater than tile tolerable deviation rate. tile sample results should be interpreted as DOt supporting the planned level of assessedcontrol risk,

.. Because rile nquinmenlsO/ this ~ couid ~answ",.t.d by lim uf.il=u we have IWf inl;:ll¥kd an oU/1ine of rile wluJion.

UNOFFICIAL .\NSWER'"

Problem 2 Steps in a Test of Controls Smnpling Plan a. The remaining steps are as follows:

4. Define the attributes (clwacreristics) Qf interest to be tested (including the criteria for establishing the existence of errors or deviant conditions).

5. Set the maximum. rate of deviations from a pte. scribed control procedure tbal would suppan the planned reliance on the control (tolerable rate),

6. Select a risk of assessing control risk too low

(overreliance ).

7. Estimate the population error rote (deviation rate).

8. Determinethe sample sire.

9. Choose a method for mndomly selecting a.sampie.

10. Perfonnthe tests of controls

11. Perform misstatement "analysis (calculate the de. viation rate and consider the qualitative aspects. of the deviations).

12. Interpret sample results (calculate a population deviation rate).

13. Decide on the acceptabilityoftbe results of the

sample.

b. Stalistical sampling methodology helps the auditor

(a) to design an efficient sample, (b) to measure the sufficiency of the evidential matter obtained, and (c) to evaluate the sample results. By using a statistical sampling methodology tile .auditor can quantify sampling risk to assiit in Urn· iring it to an acceptable level.

• BlIcmue li1l1"tquirel1U!lIU .of this lJW!,ftWlI could be tmSWtnJi by lists uf i.um3 Wt have not included l1l'i owlw of 1M solllria",-

UNOFFICIAL ANSWEIl"'

Problem 3 Steps in a Substantive Sampling Plan The remaining steps are as follows:

6.. Treat the individually significant itenpl as a separate population.

7. Choos.e an audit sampling technique ..

8. Determine the SlllQPle size, giving consideration for

a. VariatiOrul within the population.

b. Acceptable level of risk.

c. Tolerable misstatement.

d.. Expected amount of misstatement. e. Population size.

9. Determine the method of selecting a representative sample.

10. SeJec:t the sample items.

11. Apply appropriate audit procedures to the sample iteais.

12. Evaluate tJle sample results.

a. Project the misstatement to the population .UD.d consider sampling risk.

b. Consider the 'qualitative aspects of misstatements and reach an overall conclusion.

13. Document the samp.ling procedure.

• Btcmue rile ~ of this ~tiorl could 1M Q1ISWtrtd by lists ofiiems wt' have.OOI int:.bukd an OUl/iM (Jfrhe sahaion;

UNOFFICIAL ANSWER· Problan 4 PPS Problem

a. The advantages of PPS SlUllPling over classical variilblessampling are as follows:

PPS sampling is generally easier to use than classical variables sampling.

Size of a PPS sample is not based on the estimated variation of audited amoun[S.

PPS sampling automatically results in a stratified

sample.

Individually significant items are automatically identified.

Ifno misstatements are expected. PPS sampling will usually result-in a smaller sample size than classical variables sampling.

18

MODULE 5 AUDIT SAMPliNG

A PPS sample can be easily designed and sample selection can begin before the complete population is available.

b.

.: Book valu.e of PODui<ltiOD ): Reliabilitv factor

Sample size _ Tdlernble misstatement _

(Expected misstatement x Expansion factor)

5300,000 x 3.0

1'115.000 _ (O)

D.Q

Sampling interval

Book value of oooulation Sample size

$]00.000

60

$5000

c.

AJuilI Sumpling Proj=ed
~ 1ai/uir:l!! im.~A'f1i miulart'm~(..f
S 320 20% SI.ooo 5 200
0 \1)0'1, 1.000 1.000
UOO 1.000 .....:ill!!
H.lllD I sr misstatement S . 400

2nd .m..stal<:meul 500

3rd misstarement 1.000

Tourl Projected Misstatement

* Because the requirements Dflhis question could be answered bv

lists of items we have not included an outline of the solution. .

,

UNOF~~SWER* .

Pr~AnulYZe Attributes Sample

L 'Statistical sampling does not eliminate the need for professional judgment.

2. The tolerable rate of deviation or acceptable upper precision limit (UPL) is too high (20%) if Baker plans to assess control risk at a low level (substantial reliance).

3. Discovery sampling is not an appropriate sampling technique in this attribute sampling application.

4. The sampling technique empl_oyed is not discovery

sampling. . ..

5. The increase in the population size has little or DO effect on determining sample size.

6. Baker failed to consider the allowable risk of assessing control risk too low (risk of overreliance) in determining the sample size. .

7. The population from which the sample was chosen (invoices) was an incorrect population.

8. The sample selected was not randomly selected.

9. Bakerfailed to consider the difference of an immaterial amount to be an error.

10. The allowance for sampling risk was incorrectly calculated.

11. Baker's reasoning concerning the decision that the sample supported a low assessed level of control risk was erroneous.

$: Because th« requirements of chis question could be answered by ltsis of items we have not included an alllline of the solution. .

ANSWER OUTLINE

Problem 6 Analyze Sampling Plan

1. Classical variables sampling not for test of controls

2. PPS uses $ ~!iampling unit 19

3. PPS inefficient when misstatements increase because sample size also increases

4. The account's probability of selection not equal bur based on account's $ amount

5. Negative balances require special considerations

6. Tolerable misstatement omitted in sample size calculation

7. Expected misstatement excluded in sam ole size calcula-

tion '

8. Standard deviation not required for PPS sampling

9. Ignore or replace the three insisnificant balances

10. Incorrect calculation of the projected misstatement ($1,000), when actual $2.500

11. Include $100 difference for calculating projected misstatement in understated account

12. Comparison of projected misstatement with allowance for sampling risk is incorrect basis for a decision

UNO~A.NSWER

Pro, em 6 alyze Sampling Plan

The . trect assumptions, statements, and inappropriate

applications of sampling are as follows:

1. Classical variables sampling is not designed for tests of conrrols,

2.. PPS sampling uses each dollar in the population. not each- account, as a separate sampling unit

3. PPS sampling is not efficient if many misstatements are expected because the sample size can become larger than the corresponding sample size for classical v-ariabies sampling as the expected amount of misstatement increases.

4. Each account does not have an equal chance of being selected; the probability of selection of the accounts is proportional to the accounts' dollar amouats.

5. PPS sampling requires special consideration for nesa-

rive (credit) balances. -

6. Tolerable misstatement was not considered in calculating the sample size.

7. Expected (anticipated) misstatement was not considered

in calculating the sample size. .

8. The standard deviation of the dollar amounts is nor required for PPS sampling.

9. The three selected accounts with insignificant balances should not have been ignored or replaced with other accounts.

10. The account with the $1,000 difference (recorded amount of$4,OOO and audited amount of $3.000) was incorrectly projected as a $1.,000 misstatement: projected misstatement for this difference was actually $2,500 ($1,000/$4,000 x $10,000 interval).

11. The difference in the understated account {recorded amount of $1 ,900 and audited amount of $2.000) should Dot have been omitted from the calculation of projected misstatement

12. The reasoning (the comparison of projected misstatement with the allowance for sampling risk) concerning the decision that the receivable balance was not overstared was erroneous.