Chapter 16- Study Flashcards
an indicator
of the health and well-being of corporations as well as of the overall economy
corporate earnings
are a major input
into the projection of future cash flows for the corporation, which determines its
value and stock price.
earnings of a corporation
often
a key factor in the determination of such issues as wage negotiations, income tax
rates, subsidies, and government fiscal policies.
relative level of corporate earnings
The ______ is a powerful force influencing decisions on revenues and expenses.
doctrine of conservatism
In fact, accountants generally agree
that the measurement of ____ is the most important single function of accounting.
income
Auditors obtain evidence about many income statement accounts concurrently with
related balance sheet accounts.
TRUE
On the other hand, to verify depreciation expense without
first establishing the nature and amount of assets owned and subject to depreciation
would obviously be a ______.
cart-before-the-horse approach.
- cross-referencing
- control testing
- analytical procedures
- analysis of specific transactions to bring to light errors, omissions, and inconsistencies not disclosed in the audit of
balance sheet accounts.
For example, business
segment controllers of a company might review the monthly schedule of revenues and
expenses for their segments for unusual amounts or relationships. In performing the
review, a controller may compare the amounts to prior year or forecasted amounts, and
evaluate expenses as a percentage of sales.
management review controls
The auditors will evaluate management review controls by considering the:
- relevance
of the assertions addressed - the level of aggregation of the data
- the consistency of performance
- the predictability of management expectations, 5. the criteria used to determine when items are investigated.
Accounts receivable
Sales
Notes receivable
Interest
Securities and other investments
Interest, dividends, gains on sales, share of
investee’s income
Property, plant, and equipment
Rent, gains on sale
Intangible assets
Royalties
by its very nature, is a mixture of minor items, some nonrecurring and others likely to be received at irregular intervals.
Miscellaneous revenue
Among
the items the auditors might find improperly included as miscellaneous revenue are the
following:
- Collections on previously written-off accounts or notes receivable.
- Write-offs of old outstanding checks or unclaimed wages.
- Proceeds from sales of scrap.
- Rebates or refunds of insurance premiums.
- Proceeds from sales of plant assets.
Accounts and notes receivable
E
Uncollectible accounts and notes expense
Inventories
E
Purchases, cost of goods sold, and payroll
Property, plant, and equipment
Depreciation, repairs and maintenance, and depletion
Intangible assets
Amortization
Accrued liabilities
Commissions, fees, bonuses, product warranty
expenses, and others
Interest-bearing debt
Interest
Auditors develop an expectation of the account balance by considering factors such
as:
- budgeted amounts
- the prior-year audited balances
- industry averages
- relationships
among financial data - relevant nonfinancial data.
will reduce the risk of material misstatement because
budgets provide management with information as to expected amounts.
effective budgeting program
The starting point for investigating significant variations in expenses generally is ___
inquiry
of management
To get additional evidence about the reasonableness of expense accounts, the following
substantive tests are appropriate:
- Perform analytical procedures related to the accounts.
a. Develop an expectation of the account balance.
b. Determine the amount of difference from the expectation that can be accepted without investigation.
c. Compare the company’s account balance with the expected account balance.
d. Investigate significant deviations from the expected account balance. - Review journals and ledgers for unusual items that may be indicative of misstatements.
- Obtain or prepare analyses of selected expense accounts.
- Obtain or prepare analyses of critical expenses in income tax returns.
Although the circumstances of the engagement determine the most important expense
accounts, the following are frequently among those considered in detail:
(a) advertising
(b) research and development
(c) legal expenses and other professional fees
(d) maintenance and repairs
(e) rents and royalties
Payroll frauds may be more difficult to
conceal for several reasons:
(1) extensive segregation of duties relating to payroll;
(2)
the use of computers, with proper controls, for preparation of payrolls; and
(3) the necessity of filing frequent reports to the government listing employees’ earnings and tax
withholdings.
The ____ in many companies is the largest operating cost and therefore deserves the
close attention of management as well as the auditors
Payroll
Payroll frauds may involve: listing fictitious persons (“ghost
employees”) on the payroll, overpaying employees, and continuing employees on the
payroll after their separation from the company
- listing fictitious persons (“ghost
employees”) on the payroll 2. overpaying employees - continuing employees on the
payroll after their separation from the company
means of securing accuracy and
dependability in accounting data as well as a means of preventing fraud.
internal control
Complete and accurate records of time worked are also necessary if a
company is to protect itself against lawsuits under the ____
Fair Labor Standards Act
Reason why emphasizing the importance of internal control over payroll is necessary:
- a great mass of detailed information concerning hours
worked and rates of pay must be processed quickly and accurately if workers are to be
paid promptly and without error. - the existence of various payroll tax and income tax laws that require that certain payroll
records be maintained and that payroll data be reported to the employee and to governmental agencies.
Payroll activities include the functions of:
(1) employment (human resources)
(2) timekeeping
(3) payroll preparation and record-keeping
(4) distribution of pay to employees.
The output of the payroll department may be thought of as:
(1) the payroll checks or direct deposits (or pay envelopes, if
wages are paid in cash);
(2) individual employee statements of earnings and deductions;
(3) a payroll journal;
(4) an employees ledger, summarizing earnings and deductions for
each employee;
(5) a payroll distribution schedule, showing the allocation of payroll costs
to direct labor, overhead, and various departmental expense accounts; and
(6) quarterly
and annual reports to the government showing employees’ earnings and taxes withheld.
Typical of the questions to be posed by the auditors prior to the completion of an internal
control questionnaire, a systems flowchart, or other record of payroll controls are the following:
- Are employees paid by check or direct deposit? Is a payroll bank account maintained
on an imprest basis?
2/ Are the activities of timekeeping, payroll compilation, payroll check
signing, and paycheck distribution performed by separate departments or employees? - Are all operations involved in the preparation of payrolls subjected to independent verification
before the paychecks are distributed? - Are employee time reports approved by supervisors?
- Is the payroll bank account reconciled monthly by an employee having no other payroll duties?
Perform tests of controls over payroll transactions for selected pay periods. Examples
of tests the auditors may decide to perform include:
a. Compare names and wage or salary rates to records maintained by the human
resources department.
b. Compare time shown on payroll to time cards and time reports approved by
supervisors.
c. If payroll is based on piecework rates rather than hourly rates, reconcile earnings
with production records.
d. Determine basis of deductions from payroll and compare with records of deductions authorized by employees.
e. Test extensions and footings of payroll.
f. Compare total of payroll with total of payroll checks and direct deposits issued.
g. Compare total of payroll with total of labor cost summary prepared by cost accounting department.
h. If wages are paid in cash, compare receipts obtained from employees with payroll
records.
i. If wages are paid by check, compare checks (ordinarily electronic copies) with payroll and with payroll records.
j. If wages are paid by direct deposit, compare listing of employee payments with
payroll and direct deposit authorizations.
k. Observe the use of time clocks by employees reporting for work and investigate
time cards not used.
After obtaining an understanding of the client and its environment, including internal
control, the auditors will assess the risks of material misstatement and design further
audit procedures, including:
- Perform tests of controls over payroll transactions for selected pay periods.
- Perform analytical procedures or data analytics to test payroll expense. As an example,
the auditors may perform the analytical procedure of developing an expectation about the
amount of payroll expense by multiplying the amount of one pay period by the number of
pay periods in the year and comparing that to the total amount recorded. Data analytics
may be used to simultaneously test controls over payroll and perform substantive tests. - Investigate any extraordinary fluctuations in salaries, wages, and commissions.
- Obtain or prepare a summary of compensation of officers for the year and compare to
contracts, minutes of directors’ meetings, or other authorization. - Test the period end accrual of payroll expense.
- Test computations of compensation earned under profit-sharing or bonus plans.
- Test commission earnings by examination of contracts and detailed supporting records.
- Test pension obligations by reference to authorized pension plans and supporting records.
To perform these tests, appropriate databases may be
joined or related with one another. As examples, the auditors may:
- Identify duplicate payroll checks (also, direct deposits or cash payments) to employees
within pay periods. - Identify multiple payments to the same bank account within pay periods, both with the
same and different employee names. - Identify pay deposited to the same bank account of that of a vendor in the vendor master file.
- Identify false, invalid, or duplicate Social Security numbers.
- Identify differences in pay between union agreements and actual payments.
- Compare and summarize costs for special pay, overtime, and premiums.
To
be effective, certain audit procedures described in previous chapters cannot be completed
before the end of the audit. Among those procedures are the following:
- Search for unrecorded liabilities.
- Review the minutes of meetings.
- Perform final analytical procedures.
- Perform procedures to identify loss contingencies.
- Perform the review for subsequent events.
- Obtain the representation letter.
- Communicate misstatements to management.
- Evaluate audit findings.
The audit problems with respect
to loss contingencies are twofold.
First, the auditors should determine the existence of
the loss contingencies.
Second, the auditors should appraise the probability that a loss has been incurred and its
amount.
In FASB ASC 450-20, “Loss Contingencies,” the Financial Accounting Standards
Board set forth the criteria for accounting for loss contingencies. Such losses should be
reflected in the accounting records when both of the following conditions are met:
(1)
Information available prior to the issuance of the financial statements indicates that it is
probable that a loss has been sustained before the balance sheet date and
(2) the amount of
the loss can be reasonably estimated.
Loss contingencies that do not meet both of the above criteria should still be disclosed
in a note to the financial statements when there is at least a _____ that a
loss has been incurred.
reasonable possibility
several of the more frequent types of
contingencies warranting financial statement disclosure
- Litigation
- Income Tax Disputes
- Accommodation Endorsements and Other Guarantees of Indebtedness
- Accounts Receivable Sold or Assigned with Recourse
- Environmental Issues
- Commitments
- General Risk Contingencies
auditors design and perform audit procedures to identify litigation, claims, and assessments that may give rise to a risk of material misstatement, including
- Inquiring about these matters with management and others in the organization, including in-house legal counsel.
- Obtaining from management a description and evaluation of litigation, claims, and
assessments, including identification of those matters referred to legal counsel. - Reviewing (1) minutes of meetings of those charged with governance; (2) documents
in management’s possession regarding litigation, claims, and assessments; and (3) correspondence with legal counsel. - Reviewing legal expense accounts and invoices from legal counsel.
An unasserted claim should be on the list if the legal counsel has devoted substantive attention to it
and ___
if it is (1) probable that a claim will be asserted and
(2) reasonably possible that a loss
will result.
Environmental remediation liability laws, written at all levels of government, are increasingly leading to both ___ and ___.
Environmental remediation liability laws, written at all levels of government, are increasingly leading to both contingent and accrued liabilities. T
Closely related to contingent liabilities are obligations termed ___.
commitments
The
auditors may discover during their audit any of the following commitments:
- inventory purchase commitments
- commitments to sell merchandise at specified prices
- contracts for the construction of plant and equipment
- pension or profit-sharing plans
- long-term operating leases of plant and equipment
- employee stock option plans
- employment contracts with key officers.
All classes of material commitments may be described in a single note to financial
statements, or they may be included in a ___ note.
“Contingencies and Commitments”
In addition to loss contingencies and commitments, all businesses face the risk of loss
from numerous factors called ___
general risk contingencies
represents a loss that might occur in the future, as opposed to a loss contingency that
might have occurred in the past.
general risk contingency
Examples of general risk contingencies
- threat of a strike or consumer boycott
- risk of price increases in essential raw materials
- risk of a natural catastrophe.
The Auditors’ Procedures for Loss Contingencies
- Review the minutes of directors’ meetings to the date of completion of fieldwork.
Important contracts, lawsuits, and dealings with subsidiaries are typical of matters
discussed in board meetings that may involve loss contingencies. - Send a letter of inquiry to the client’s lawyer requesting
a. A description (or evaluation of management’s description) of the nature of pending
and threatened litigation and tax disputes.
b. An evaluation of the likelihood of an unfavorable outcome in the matters described.
c. An estimate of the probable loss or range of loss, or a statement that an estimate
cannot be made.
d. An evaluation of management’s description of any unasserted claims that, if
asserted, have a reasonable possibility of an adverse outcome.
e. A statement of the amount of any unbilled legal fees. - Send confirmation letters to financial institutions to request information on contingent
liabilities of the company. - Review correspondence with financial institutions for evidence of accommodation endorsements, guarantees of indebtedness, or sales or assignments of accounts
receivable. - Review reports and correspondence from regulatory agencies to identify potential
assessments or fines. - Obtain a representation letter from the client indicating that all liabilities known to
officers are recorded or disclosed.
refers to an event occurring after the date
of the balance sheet but prior to the date of the auditors’ report (the date on which the
auditors have obtained sufficient appropriate audit evidence to support their opinion).
subsequent event
FASB ASC 855 divides subsequent events into two broad categories:
(1) those providing
additional evidence about facts existing on or before the balance sheet date (“recognized
subsequent events”) and
(2) those involving facts coming into existence subsequent to the
balance sheet date (“nonrecognized subsequent events”).
Other examples of this first type of subsequent event include the following:
- Customers’ checks included in the cash receipts of the last day of the year prove to be
uncollectible and are charged back to the client’s account by the bank. If the checks
were material in amount, an adjustment of the December 31 cash balance may be necessary to exclude the checks now known to be uncollectible. - A new three-year union contract signed two weeks after the balance sheet date provides evidence that the client has materially underestimated the total cost to complete
a long-term construction project on which revenue is recognized by the percentage-of completion method. The amount of income (or loss) to be recognized on the project in
the current year should be recomputed using revised cost estimates.
Perform the
Review for
Subsequent Events
Describe the auditors’ responsibilities for the detection and
evaluation of various types of subsequent events. - Litigation pending against the client is settled shortly after the balance sheet date, and
the amount owed by the client is material. This litigation was to be disclosed in notes to
the financial statements, but no liability had been accrued because at year-end no reasonable estimate could be made as to the amount of the client’s loss. Now that appropriate
evidence exists as to the dollar amount of the loss, this loss contingency meets the criteria for accrual in the financial statements, rather than mere note disclosure.
involves conditions that arose after the date of the
financial statements. These events do not require adjustment to the dollar amounts shown
in the financial statements, but they should be disclosed in the financial statement notes
if the statements otherwise would be misleading. T
second type of subsequent event
Other examples of nonrecognized subsequent events occurring after the balance sheet
date but before the release of the financial statements include
∙ Sale of a bond or capital stock.
∙ A business combination with another company.
∙ Settlement of litigation when the event giving rise to the claim took place after the
balance sheet date.
∙ Loss of plant or inventories due to a fire.
∙ Losses on receivables resulting from conditions (e.g., a customer’s major casualty)
arising after the balance sheet date.
∙ Changes in the fair value of assets or liabilities or foreign exchange rate.
Audit Procedures Relating to Subsequent Events
- Obtain an understanding of management’s procedures to ensure that subsequent events
are identified. - Inquire of management (and those charged with governance) about whether subsequent events have occurred.
- Read available minutes of directors, stockholders, and appropriate committee meetings that have been held after the date of the financial statements and inquire about
matters discussed at any such meeting for which minutes are not yet available. - Read the company’s latest subsequent interim financial statements, if any.
Finally, in the unusual circumstance in which the client does not agree to properly reflect
the event, the departure from generally accepted accounting principles may result in
either
a qualified or adverse opinion.
Misstatements identified by the auditors may be categorized as
- factual misstatements
- judgmental misstatements
- projected misstatements
What do the auditors do if, after considering all of the misstatements, they conclude that the
risk of material misstatement of the financial statements is too high?
First, they should request
that management record the adjustments needed to correct all factual misstatements other
than those considered trivial.
For judgmental misstatements, management should be asked to
review the assumptions and methods it used in developing their estimate (e.g., the warranty
liability); the auditors may then perform further audit procedures to reevaluate the reasonableness of the estimate after management has reconsidered its assumptions and methods.
For projected misstatements (generally arising from audit sampling), the auditors
should request that management examine additional items in the account in order to identify and correct other misstatements. The auditors also may expand the scope of their
audit procedures and reevaluate the reasonableness of the projected misstatement.
misstatements may be qualitatively
material if they
∙ Arise from an item capable of precise measurement (e.g., the amount of a sale) rather
than from an estimate (e.g., the amount in the allowance for doubtful accounts).
∙ Mask a change in earnings or other trends.
∙ Hide a failure to meet analysts’ consensus expectations for the company.
∙ Change a loss into income, or vice versa.
∙ Concern a particularly important segment or other portion of the registrant’s business.
∙ Affect compliance with regulatory requirements, loan covenants, or other contractual
requirements.
∙ Increase management’s compensation.
∙ Involve concealment of an unlawful transaction.
∙ Are of an amount that management or the auditors believe would affect the stock’s
price.
In addition, the auditors should be aware of the requirements of AICPA
Statement of Position 94-6, “Disclosure of Certain Significant Risks and Uncertainties.”
That statement establishes disclosure requirements concerning:
(1) the nature of company
operations,
(2) the use of estimates in the preparation of financial statements,
(3) certain
significant estimates, and
(4) current vulnerability due to concentrations (e.g., dependence upon a particular customer, supplier, or product).
Examples of other information include
- a report by management discussing the year’s operating results
- financial summaries or highlights
- employment data
- planned capital expenditures
- financial ratios
- names of officers and directors.
AICPA AU-C 730 and PCAOB AS 2705 require
auditors to apply the following procedures to supplementary information:
- Inquire of management about methods of preparing information, including whether (1)
it was prepared following prescribed guidelines, (2) methods of measurement or presentation have changed from the prior period, and (3) there were any significant assumptions or interpretations underlying the measurement or presentation of the information.
*Compare information for consistency with (1) management’s responses to the inquiries,
(2) the basic financial statements, and (3) other knowledge obtained during the audit.
*Obtain written representations from management (1) acknowledging its responsibility
for the information, (2) about whether the information is measured within guidelines,
(3) about whether the methods have changed, and (4) about any significant assumptions or interpretations.
