A4: Audit Evidence

Question 1

Sufficient Appropriate Evidence

Answer 1

• cost/difficulty not valid basis to omit procedure when no alternative tests
• sufficiency: quantity; risk of misstatement and quality of evidence
• appropriateness: quality; reliable and relevant to particular assertion

Question 2

Hierarchy of Evidence (Reliability)

Answer 2

A – Auditor’s direct knowledge (observation, examination, inspection, recalculation)
E – External evidence (independent sources)
I – Internal evidence (more reliable when strong internal controls)
O – Oral evidence

Question 3

Analytical Procedures

Answer 3

• required in planning: understand entity, determine areas needing attention in audit
• required in final review: reasonableness of account balances
• substantive analytical procedures not required: to obtain supporting evidence about management’s assertions

Question 4

Substantive Analytical Procedures

Answer 4

• more useful for income statement accounts (more predictable relationships); less useful for accounts with management discretion
• documentation requirements: auditor’s expectation, factors consideration in making expectation, results of comparison, add’l procedures performed in response to differences, results of add’l procedures

Question 5

Directional Testing

Answer 5

Vouch – test for existence/occurrence (risk of overstatements: revenues/assets)
Trace – test for completeness (risk of understatements: expenses/liabilities)

Question 6

Confirmations

Answer 6

• direct written response to auditor from 3rd party
• auditor must control the entire process
• oral responses are not confirmations
• confirm accuracy of email/fax responses
• positive (agree or disagree w/ confirm) or negative (only respond if disagree)
• nonresponse: add’l confirm requests, add’l audit procedures
• mgt refuses confirms: consider why, impacts on RMM/fraud risk/NET of audit procedures

Question 7

Types of Audit Procedures

Answer 7

F – Foot (add down), crossfoot (add across), recalculation (recomputed amounts)
I – Inquiry (request info from internal and external parties)
V – Vouching (support for amounts in records and books; existence/occurrence assertions)
E – Examination/inspection (examine records/ documents/assets; ‘scan’; usually existence)
C – Confirmation (inquiry by auditor seeking written representations from third parties)
A – Analytical Procedures (includes ‘scanning’ if looking for unusual amounts in books)
R – Reperformance (re-perform client’s procedure or control)
R – Reconciliation (compare amounts in independent sources; existence/valuation)
O – Observation (watch process performed by others)
T – Tracing (trace from source documents to books/records; completeness)
C – Cutoff review (review of year-end transactions; esp inventory/cash/purchases/ sales/accruals)
A – Audit related accounts simultaneously
R – Representation letter
S – Subsequent events review

Question 8

Relevant Assertions

Answer 8

Balances (CVER): Completeness, Valuation allocation and accuracy, Existence and occurrence, Rights and obligations (assets → existence, liabilities → completeness)
Transactions (COVEU): Completeness, cutoff, Valuation allocation and accuracy, Existence and occurrence, Understandability and classification (revenue → occurrence; expenses → completeness)
Disclosure (CVRU): Completeness, Valuation allocation and accuracy, Rights and obligations and occurrence, Understandability and classification

Question 9

Assertions → Audit Procedures

Answer 9

Completeness → Tracing, Analytical review, Observation
CutOff → Cutoff procedures
Valuation Allocation and Accuracy → Inspection of docs, Footing, Recalculation, Reconciliation
Existence and occurrence → Confirmation, Observation/Inspection/Examination, Vouching
Rights and obligations → Inspection of docs
Understandability and classification → Inspection of docs, Review of disclosures, Inquiry of mgt

Question 10

Revenue Cycle Risks

Answer 10

• presume high risk of material misstatement
• fraud risks around revenue/cash
• concern w/ overstatement of assets/revenue

Question 11

Revenue Cycle – Internal Controls

Answer 11

• Sales: sales dept receives order & preps sale order, credit approval by credit dept (valuation), shipping dept preps bill of lading, billing dept preps sales invoice & matches against shipping docs/sales order, acct dept records sale & receivable
• A/R: independent reconciliations of general ledger & A/R subsidiary ledger, aging schedule sent to credit dept for collection program, A/R write-offs authorized by treasurer, credit memos for returns prepped by someone who doesn’t collect $ on A/R
• Cash Receipts: mail received by one w/o access to A/R books, listed in detail before cash sent to cashier, cashier preps deposit summary before sending to bank, acct matches remittance from customer/cash listing/deposit summary before entering in records, bank lockbox ideal safeguard

Question 12

A/R Confirmations

Answer 12

• evidence about existence, and rights
• positive confirms: best when large $ amounts, expect errors/disputes, weak internal controls
• blank confirms provide greater assurance, but may have lower response rates
• negative confirms: low risk, large number of small balance accounts, expect customer attention
• nonresponses: add’l confirms, ask client to follow up, alternative procedures

Question 13

Expenditure Cycle Risks

Answer 13

-biggest concern is understatement of expenses and liabilities

Question 14

Expenditure Cycle – Internal Controls

Answer 14

• Purchases: approved purchase requisition from dept needing good, purchasing dept places order/gets competitive bids/preps purchase order, purchase order sent to receiving dept (best to omit quantity, blind copy, forces dept to count goods) which accepts goods/forwards to requesting dept/ sends receiving report to acct dept
• A/P: acct dept matches purchase order/ receiving report/vendor invoice/requisition and records goods and payable, approved matched invoice for payment
• Cash: approved voucher packet sent to treasurer, treasurer signs/mails checks and cancels supporting docs, paid vouchers returned to acct dept

Question 15

Auditing Expenditure Cycle

Answer 15

• search for unrecorded liabilities: test for A/P completeness, look at payments made after year-end and examine supporting docs for unrecorded payables
• A/P confirms not required, may be used when weak controls (usually focus on vendors w/ zero or small balances)

Question 16

Cash Cycle Risks

Answer 16

Lapping: today’s cash receipts covers yesterday’s theft; auditor inspects date check deposited vs. when receivable credited; bank lock box best safeguard
Kiting: cash recorded in 2 bank accounts at once; auditor views bank transfer schedule; indicated when date check received by bank precedes date disbursement recorded

Question 17

Bank Confirmations and Reconciliations

Answer 17

• primary tests for existence/completeness/ valuation of ending cash balances
• confirms verify cash balances, loans, contingent liabilities, pledged collateral, guarantee or security arrangements
• reconciliation: match balance per books to general ledger, match confirm balance to reconciliation balance, match outstanding checks/deposits to cutoff bank statement

Question 18

Inventory Cycle Risks

Answer 18

• risk of inventory overstatement (vouch), risk of COGS understatement (trace)
• reconcile inventory and COGS

Question 19

Inventory Cycle – Internal Controls

Answer 19

-segregation of duties: purchasing (approved purchase orders prepped and sent to acct and receiving), receiving (verify items received, prep receiving report, delivery goods to warehouse), warehouse (custodian for verified goods received), shipping (shipment of goods after authorization – sales order approved by credit dept)

Question 20

Observation of Inventory Count

Answer 20

• required (alternative procedures if impractical to observe or immaterial inventory)
• may observe before/after year end for well-keep perpetual inventories periodically checked by physical counts
• observe inventory in public warehouses if material (otherwise confirm okay)

Question 21

Inventory Tests

Answer 21

• completeness: trace auditor test counts to physical inventory report, trace prenumbered inventory tags to physical inventory report
• valuation: analytics (inventory turnover) note concerns w/ obsolete goods
• existence: vouch from inventory report to auditor test count, vouch from inventory report to prenumbered inventory tags
• rights and obligations: consigned or pledged inventory

Question 22

Investment Cycle Risks and Internal Controls

Answer 22

• risk of overstatement of assets and income (vouch)
• board should authorize purchase/sale, separate custodian (third-party w/ no direct contact w/ client, or joint custody of 2 client officials), third person should maintain records of investments
• if no third-party custodian, should be held in safe deposit box, periodically counted and reconciled w/ ledger by independent person

Question 23

Tests of Investments

Answer 23

• valuation: recalculate interest/dividends, get valuation info from published sources
• existence: confirms to custodians, examine securities on hand (security count includes client acknowledgement all securities were returned; if safe deposit box can’t be counted on balance sheet date, request bank seals box until counted)
• equity method investments: examine audited F/S of investee
• derivatives: examine docs for risk exposure/ possible loss recognition

Question 24

Property Plant and Equipment – Internal Controls

Answer 24

• special requisition form, acquisitions tied to capital budget, board approves acquisitions over a certain amount
• info about each asset in subsidiary ledger
• ID plates for fixed assets & periodic inspections safeguard against theft/ unauthorized dispositions
• asset retirements authorized and documented, segregation between authorization and who disposes of asset

Question 25

Tests of PPE

Answer 25

• valuation: recalculate depreciation for reasonableness, test for impairment (and reasonable revaluation under IFRS)
• existence: vouch additions by examining docs and inspecting asset, test for unrecorded retirements (insurance/taxes/tour plant)
• review repair and maintenance account for items that should be capitalized (completeness and classification)

Question 26

Payroll and Personnel Cycle Risks

Answer 26

-creation of fictitious employees and falsification of hours worked

Question 27

Payroll and Personnel Cycle – Internal Controls

Answer 27

-segregation of duties: HR dept (hire new employees, maintain records on salary), supervision (pay data approved by immediate supervisor – ensures completeness/accuracy of hours worked), timekeeping/cost accounting (pay data – hours/jobs completed – kept independent of other functions, should use time clocks/time sheets), check prep (payroll computes salary, issues unsigned checks, treasurer/CFO signs or oversees signature plate process), check distribution (by paymaster, no other payroll function, unclaimed checks investigated/not returned to payroll)

Question 28

Tests of Payroll and Personnel

Answer 28

• strong internal controls: focus on analytical procedures and recalculation of accruals (valuation)
• completeness: search for unrecorded liabilities, trace timecards to payroll register
• existence: vouch register entries to time cards and time reports, verify employee existence and current employment status

Question 29

Financing Cycle Internal Controls

Answer 29

• debt: authorization by board, records of debt w/ payments and amortization info
• equity: transactions authorized by board, stock transfer agent ensures compliance w/ articles of incorporation/regulatory requirements (if no stock agent, periodic reconciliation of stock cert book w/ # of shares outstanding)

Question 30

Tests of Financing Cycle

Answer 30

• valuation: recalculate interest/amortization
• existence: confirm w/ creditors
• completeness: confirm w/ stock transfer agent or review stock certificate book
• classification: review documents for restrictions on retained earnings

Question 31

Related Party Transactions

Answer 31

• focus on: valuation, allocation and accuracy
• not considered to be arms-length transaction
• CPA should understand relationships and transactions so as to: recognize fraud risks, determine if F/S fairly presented and if transactions appropriately ID’d and disclosed

Question 32

Tests of Related Party Transactions

Answer 32

• evaluate controls regarding identifying & authorizing such transactions
• ask mgt for all related parties, review SEC filings/confirms/minutes
• interest in: compensating balance arrangements, loan guarantees, unusual transactions near year-end, non-market-term transactions, nonmonetary transactions

Question 33

Unidentified/Undisclosed Related Party Transactions

Answer 33

• why controls failed to ID/disclose
• substantive procedures
• reconsider risk other such transactions not ID’s or disclosed
• evaluate implications if nondisclosure was intentional

Question 34

Accounting Estimates

Answer 34

• CPA evaluates risks from uncertain estimates
• assess policies on estimates
• verify all material estimates developed
• determine if estimates are reasonable
• ensure estimates presented and disclosed in accordance w/ GAAP
• understand how estimate developed; test procedures mgt used, develop independent estimate, review subsequent events (prior to report date) that corroborate estimate
• PCAOB: difference btw CPA’s best estimate and unreasonable client estimate is a misstatement

Question 35

Fair Value Reporting/Mgt Responsibilities

Answer 35

• market value (level 1, identical, or level 2, similar); estimates and valuation methods (level 3, often discounted cash flow)
• mgt uses appropriate valuation methods where no market prices, mgt identifies/ supports any significant assumptions

Question 36

Auditing Fair Values

Answer 36

• consistent method w/ prior period, past track record of valuation accuracy, justify any changes in approach, appropriate in relation to industry
• understand valuation process & controls, determine if assumptions provide reasonable basis for valuation, evaluate appropriateness of valuation model, develop independent valuation, review subsequent events (prior to report date) that corroborate valuation

Question 37

Testing Contingencies

Answer 37

• inquiries of mgt of contingent liabilities/ litigation/controls to identify such items
• review minutes, legal invoices, IRS correspondence, bank confirms, purchase commitments, long-term leases, inquiry letter from attorneys
• evidence concerning: when cause for legal action occurred, probability of unfavorable outcome, amount/range of potential loss

Question 38

Letter of Inquiry to Client’s Attorney

Answer 38

• prepped by mgt and sent by auditors to attorneys
• corroborates info provided by mgt
• may limit response to matters they have given substantial attention or to material matters (if understanding w/ CPA over what is material)
• if lawyer refuses to respond, scope limitation: qualified opinion or disclaimer of opinion
• if client refuses inquiry, disclaimer or withdraw

Question 39

Evaluating Audit Findings

Answer 39

• analytical procedures required in review phase
• evaluate if F/S free of material misstatement
• communicate all non-trivial misstatements to management

Question 40

Considering Materiality of Misstatements

Answer 40

• considerations: size of misstatement, effects (individually & in aggregate) of all uncorrected misstatements (known & likely), prior period misstatement impact on current period, qualitative considerations (affect profit trends, compliance w/ loan covenants, mgt compensation impact)
• PCAOB qualitative factors: legal/regulatory reporting requirements, needs of users, material effect in future, cost of correction
• whether misstatement is material is ultimately matter of professional judgment

Question 41

Documentation of Evaluation

Answer 41

-document: amount below which misstatements are trivial, all accumulated misstatements and whether corrected, summary of known & likely uncorrected misstatements, conclusion whether they cause F/S to be materially misstated and basis for conclusion

Question 42

Reviewing Work of Others

Answer 42

• review whether work performed in accordance w/ professional standards/laws/ regulations, findings needing further consideration, NET of work performed is appropriate, work supports conclusions and appropriately documented, evidence sufficient and appropriate to support the report
• engagement partner review: critical areas of judgment, significant risks

Question 43

Engagement Quality Review

Answer 43

• PCAOB requirement
• review: significant judgments, assessment of and responses to significant risks including fraud risk, judgments about materiality/ misstatements/control deficiencies, independence, documentation, financial statements, report on internal control, communications w/ management
• report may not be used until reviewer gives concurring approval of issuance (approval not allowed if not sufficient appropriate evidence, inappropriate overall conclusion, inappropriate report, or lack of independence)

Question 44

Ratios

Answer 44

Current (working capital) ratio = Current Assets / Current Liabilities

Acid-test ratio = (Cash + Securities + A/R) / Current Liabilites

A/R Turnover = Credit Sales / Average Receivables

Inventory Turnover = Cost of goods sold / Average Inventory

Working Capital Turnover = Sales / Average Working Capital

Total Asset Turnover = Sales / Average Total Assets

A/P Turnover = Cost of goods sold / Average A/P

Net Profit Margin = Net Income / Sales

Return on Assets = Net Income / Average Total Assets

Net Operating Margin = Net Operating Income / Net Sales

Gross Profit Margin = Gross Profit / Net Sales

Debt/Equity = Total Liabilities / Common Stockholders’ Equity

Debt Ratio = Total Liabilities / Total Assets

Question 45

Tests of Controls over Sales

Answer 45

• valuation: inquire about credit approval process, examine approved sale orders for credit checks, match billing invoice prices with master price list
• account for prenumbered shipping docs (completeness) and match to sales orders (existence)
• vouch sales from journal to shipping docs and sales orders (existence)
• trace shipping docs to sales invoice, sales journal (completeness)
• observe/reperform independent check of invoice totals and sales summary (valuation, existence, completeness)

Question 46

Tests of Controls over Cash Receipts

Answer 46

• inspect checks for endorsement (completeness)
• observe prep of check prelisting/cash summary (existence, completeness, valuation)
• compare deposit slip to cash summary (existence, completeness, valuation)
• observe/reperform matching of cash summary, prelisting of check and CR summary (existence, completeness, valuation)
• review bank reconciliation (existence, completeness, valuation)

Question 47

Tests of Controls over Purchases

Answer 47

• review receiving report for signed receipt (existence)
• trace receiving reports to journal entries (completeness)
• review vouchers for supporting docs (existence)
• observe/reperform matching of purchase summary totals to entries in purchase journal (valuation)
• observe/reperform reconciliation of vendor’s statements and A/P file (valuation, existence, completeness)

Question 48

Tests of Controls over A/P and Cash Payments

Answer 48

• compare A/P debits to cancelled voucher packages (existence)
• trace from cancelled vouchers to cash disbursement journal entries (completeness)