Review Questions Solutions
Chapter 9, Substantive Procedures and the Financial Statement Audit
Page 435
A1 What is the difference between the target of controls tests and the target of substantive procedures?
The targets of controls tests are processes, I.D. initiation, authorization, monitoring, and the evidence of operating effectiveness.
The target of substantive procedures is management’s assertions about the account balances and disclosures that are presented in the financial statements. The auditor collects evidence about the account balance amounts and the related disclosures.
A2 What are tests of details of balances?
The examination of transactions to determine whether the underlying evidence ties to the amounts and other information that is in the company’s records.
A3 What types of human errors can occur in an audit, and how does the auditor reduce the likelihood that these human errors will go undetected?
Planning errors, using the wrong test or the wrong supporting document, making a mistake in performing a test or interpreting a result
The likelihood of human errors remaining undetected is reduced by quality control, including supervision and review
A4 What is sampling error?
Sampling error occurs when the sample that is selected does not represent the population from which it was drawn
A5 How do tests of details of balances and analytical procedures interact in affecting detection risk?
Analytical procedures can help auditors detect mistakes in their conclusions about account balances by highlighting unexpected amounts or relationships between account balances. Such situations are further investigated (through tests of details of balances) and this increases the likelihood of any error in the other tests being discovered.
Page 445
B1 Why might an auditor divide an account balance into more than one segment before performing audit procedures?
The auditor may want to segregate an account balance to focus on transactions that make up a significant portion of the dollar amount of the population, and apply 100 percent testing to that part of the population and sampling to the remainder. In tests of controls, the auditor may want to segregate an account balance based on classes of transactions to which different assertions or controls apply.
B2 What steps are followed when performing tests of details of balances and drawing conclusions using a sample?
1. Determine what account and assertion is being evaluated.
2. Decide what audit procedure needs to be used to test the assertion.
3. Determine the sample size needed; this can be decided using either a statistical or non-statistical approach.
4. Determine the method to be used to select the sample.
5. Determine the physical population from which the sample will be selected. This will depend on the assertion and the audit objective.
6. Decide what evidence must be examined to accomplish the audit test for each item in the sample.
7. Perform the test and identify discrepancies.
8. Evaluate the sample results.
B3 What does the auditor do when misstatements are identified that are not material? Why would these nonmaterial misstatements be reevaluated?
Document the discrepancies as unadjusted differences in the workpapers, and evaluate their materiality again and on an aggregated basis as more audit work is performed. When aggregated, they may be material.
B4 How does the auditor form a conclusion about the fair presentation of an entire account balance based on the results of tests of details of balances performed on a sample?
The auditor uses the results of the sample to form an opinion on the entire account balance. In addition to following up on the client’s correction of any material misstatements in the sample, the auditor estimates the likely error in the remainder of the transactions that make up the account balance given the misstatements discovered in the sample. If appropriate, the auditor proposes an adjusting journal entry based on the estimated likely misstatements.
Page 454
C1 How do the working trial balance, lead schedules, and detailed work papers articulate?
A trial balance lists the client company’s post-closing general ledger, providing both line item account titles and amounts. Generally, each line item on the trial balance is supported by a lead schedule, which is an audit work paper that lists and specifies the components that make up the line item on the working trial balance. Detailed work papers support the information on the lead schedule, providing information about the audit tests performed on each component of the trial balance line item and results of the tests.
C2 What does an auditor have to know about management’s estimation process? About the underlying assumptions management uses to make estimates?
The auditor has to understand the management estimation process and the assumptions. The auditor has to evaluate the reasonableness of the process and the assumptions and determine whether the process was followed in producing the estimate.
C3 To what extent is the auditor responsible for illegal acts that do not have a material, direct impact on the financial statements? Does the auditor’s responsibility for material financial statement misstatements differ if they result from fraud, error, or illegal acts?
The auditor does not have to search for illegal acts that do not have a direct effect on the financial statements. The auditor is less likely to become aware of illegal acts that have an indirect effect. If the auditor becomes aware of illegal acts that are not directly related to the financial statements the auditor must consider their impact, even though it is indirect. For example, violation of environmental protection regulations might ultimately cause a company to lose business.
The auditor’s responsibility for material financial statement misstatements does not differ whether they result from fraud, error or illegal acts; the auditor is responsible for detecting material misstatements of the financial statements from all of these sources.
C4 How do disclosures required by GAAP affect the auditor’s responsibilities for related party and related party transaction information? Why is the auditor concerned if management makes disclosures indicating that nonroutine related party transactions are at arms length?
The auditor performs audit procedures directed toward identifying any related parties, identifying transactions with related parties, and understanding the transactions with related parties in order to be able to tell whether the disclosures about the related party transactions are in conformity with GAAP. The risk for related party transactions is that they may have occurred at amounts or under terms that were not arms length. If management asserts that a transaction with a related party was arms length, the auditor has to evaluate whether the disclosure can be substantiated by management.
C5 What is substantial doubt about going concern? For what period of time after the close of the fiscal year does the auditor need to assess going concern? From what sources does the auditor get information about going concern?
Substantial doubt about going concern is uncertainty about the entity’s inability to continue to meet its obligations as they become due without substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions.
The period of time is a year following the date of the financial statements.
The auditor gets information about going concern from analytical procedures, Board of Directors meeting minutes, communications with the client’s attorneys, confirmations and audit evidence that relates to long term debt.
C6 What management assertions are primarily affected by an improper cutoff?
Existence or occurrence and completeness assertions
Page 464
D1 List and briefly explain the typical audit steps for the following financial statement accounts: cash, receivables, inventory, investment securities, prepaid assts, property-plant-and-equipment, current payables, long-term debt, owners’ equity, revenues, expenses.
See Exhibits and Auditing in Action:
Cash, Exhibit 9-6, Auditing in Action, p. 456
Receivables, Exhibit 9-7, Auditing in Action, p. 457
Inventory, Exhibit 9-8, Auditing in Action, p. 459
Investment securities, Exhibit 9-9, Auditing in Action, p. 459
Prepaid assets
Examine supporting documents
Recalculation allocation and agree to postings
Property, plant and equipment
Examine supporting documents
Physically examine the assets
Determine that additions are properly capitalized
Recalculate depreciation and tie to postings
Read and evaluate financial statement disclosures
Current payables, Exhibit 9-10
Long term debt, Exhibit 9-11, Auditing in Action, p. 462
Owners’ equity
Examine authorization in BoD minutes
Vouch supporting documents and agree to postings
Recalculate any valuations, eg., compensation expense
Trace net income from the income statement to retained earnings
Reconcile statement of owners’ equity to balance sheets
Reconcile OCI and accumulated OCI with other financial statements
Read and evaluate disclosures
Revenue and expenses
Perform analytical procedures
Vouch details of balances
1